Is This System Too Sick To Survive?

Includes: GLD, MOO, XLB, XLE
by: Mike Burns

It is possible that the U.S. political and economic systems are too sick to survive. The current U.S. debt level (excluding bonds held by the Federal Reserve) is right around 100% of GDP. When Greek bonds fell off the cliff in late 2009 the level of debt to GDP was around 127%, a level that the U.S. expects to reach as soon as 2013. If there is even a modest uptick in interest rates then the U.S. would reach Greek levels even sooner. Furthermore many U.S. states and large cities are close to defaulting, and the U.S. Fed would likely rescue many of them in the name of financial stability. The added debt of at-risk states and cities is around 30% of U.S. GDP, meaning that the U.S. is already at the Greek level. Let's hope that the world fails to notice a little while longer.

But the U.S. is special right?

The U.S. has the privileged position of being the overwhelming reserve currency of the world. Countries hold our currency and bonds as proof of their own solvency. The U.S. dollar is used in most international trade, including commodities such as oil and gold. So other countries would like to see the system continue without major disruption, so the U.S. could enjoy a grace period before there is a run on our bonds such as happened to Greece. However there are already many players trying to find ways to avoid exposure to the dollar. Witness the recent deal between China and Russia to use the renminbi to settle their account. The IMF, France and Dubai recently called for using SDRs (a market basket of many currencies) to settle accounts.

The special nature of the U.S. works to our disadvantage as well. If the U.S. experiences higher inflation, economic slowing or bond downgrading, then many other countries that hold U.S. obligations see their own solvency threatened. This positive feedback loop tends to exaggerate any instability that is likely to occur.

More problems on the horizon

There are many U.S. cities that are close to defaulting on their own bonds. But it is assumed that states would step in and prevent any real defaults (and the resultant crashing of the muni bond market). However many states are already very close to their own default, even without having to prop up individual cities. It is assumed that the U.S. would, in one way or another, prop up the states and prevent those defaults. Ugly events could unfold quickly as a few cities threaten default, leading a few states to threaten default. Other states would surely line up for their own bailout as investors dump the bonds and drive up interest rates. No one wants to be the last one out of the burning theater, and investors are already nervously watching the door.

The political climate makes change impossible

Two possible solutions to the ever-increasing U.S. budget deficit would be to greatly increase taxes or greatly decrease government spending. If either of these actions were easy or even feasible they would have been done a decade ago when the changes required were small and the change in course much easier. Increasing taxes is an easy way for a politician to get booted from office as the taxed parties push for repeal and the rest of the population hates the slowdown in general economic activity that always comes from substantial tax increases. Decreasing spending is nearly impossible since most of the federal spending is already "mandatory" such as social security. Minor political shows such as Obama's freezing of federal salaries (amounting to about 0.1% of the budget deficit) are done merely to score political points as if to say "See we're all suffering in this together." Instead of higher taxes or reduced spending both political parties agree to punt the ball down the road and let the next Congress or the next president deal with it. As a result the U.S. Federal Reserve is monetizing progressively larger amounts of the U.S. debt as fewer borrowers are willing to buy the treasury bonds, especially at the currently unrealistically low interest rates.

But what about the Tea Party?

Imagine that you're in a bus going 65 mph toward a sheer cliff that's only 30 feet away. Even if you hit the brakes as hard as possible right now you're still doomed. Yes, the Tea Party is making the right sales pitches about reducing spending and reducing the size of government, but it has become irrelevant. The obligations of the U.S. are out of control and must grow BY LAW since social security and Medicare and government pensions are all tied to the cost of living. Maybe 10-20 years ago the policies espoused would have changed our current fate, but now they are powerless to hold back the tide. It is the author's opinion that the Tea Party is only given press coverage now so that there is a scapegoat to blame when The Collapse does come. The U.S. power elite are playing for the rebound; just as Communism has recently made a rebound in Russia and some Eastern European countries after democratically elected governments were unable to clean up the mess caused by the implosion of the USSR around 1989.

How to mitigate the coming destruction?

The U.S. and the world can't really avoid the coming destruction as U.S. bonds are downgraded and inflation increases. The best you can hope for is to reduce the exposure that you and your family have. Holding U.S. dollars or similar paper assets (bonds, stocks, annuities, pensions) must necessarily fare badly. Real assets such as your own home, gold, oil, silver, base metals and agriculture will preserve wealth better. It is also good if you have a significant amount of home loan debt. With real interest rates (nominal rate minus inflation) near zero there is no risk to having large debt. If there is large inflation then the debt becomes easy to pay off and you will own a home that you can live in for a very low real price.

In view of these risks to the system and the very real possibility of large inflation after the U.S. presidential election, I would choose to invest in GLD, XLB, XLE and MOO.

Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.