COMING FLIGHT TO GOLD

By Scott Silva
Editor, The Gold Speculator
2-1-11

The battle to increase the US Debt limit will increase financial tensions in the US and impact markets around the world. The US debt is approaching its legal limit of $14.3 Trillion. The debt limit sets the amount that the US Treasury can borrow from its citizens other government agencies and foreign investors by selling AAA-rated US Treasury securities, also known as US sovereign debt instruments. As with all spending measures, the US debt limit is authorized by the US Congress. Although Congress has authorized every increase in the debt ceiling requested by preceding presidents, this time the issue is likely to be a decisive political fight between Congressional deficit hawks and the progressive administration. The stakes are much higher than political victory; the sovereign credit rating of the United States is at risk; Moody’s Investors Service warned on Thursday that lack of U.S. government action on the budget deficit increases the likelihood of a negative outlook on the country’s AAA credit rating. Moody’s report came just hours after Standard & Poor downgraded Japan’s sovereign debt to AA. Today, S&P downgraded Egypt’s rating as its government teeters on collapse.

The statutory limit on US federal debt began with the Second Liberty Bond Act of 1917, which helped finance the United States’ entry into World War I. The sale of Liberty Bonds to the public at large helped keep interest rates low. Before World War I, Congress authorized specific loans, such as the Panama Canal loan, or allowed the Treasury to issue specific types of debt instruments, such as certificates of indebtedness, bills, notes and bonds. The Second Liberty Bond Act expanded Treasury authority to aggregate debt instruments. Debt limit legislation in the following two decades set separate limits for different categories of debt, such as bills, certificates, and bonds.

In 1939, Congress created the first aggregate limit that covered nearly all public debt. US debt tended to approach the limit under the new rules. For example, the 1919 Victory Liberty Bond Act (P.L. 65-328) raised the maximum allowable federal debt to $43 billion, far above the $25.5 billion in total federal debt at the end of FY1919. The debt limit in 1939 was $45 billion, only about 10% above the $40.4 billion total federal debt.

Congress raised the debt limit to cover the costs of World War II in each year from 1941 through 1945, when it was set at $300 billion. After World War II ended, the debt limit was reduced to $275 billion. The limit remained at $275 billion until 1954 (the Korean War was financed primarily by tax increases). After 1954, Congress reduced the debt limit twice and increased it seven times, until March 1962 when it reached $300 Billion, the same level as a the end of World War II. Since March 1962, Congress has enacted 75 separate measures that changed the debt ceiling.

How did we get to such a precarious position today? The answer is unchecked deficit spending. Most of the debt buildup has come from the various spending measures enacted stimulate the economy and solve the financial crisis of 2008-2009. In July 2008, the Housing and Economic Recovery Act increased the debt limit by $800 billion to $10.615 trillion. In October, a $700 billion increase was attached to the Emergency Economic Stabilization Act of 2008. In February 2009, the American Recovery and Reinvestment Act of 2009 raised the statutory limit to $12.104 trillion -- an increase of $789 billion. Last February, The Statutory Pay-As-You-Go Act of 2010 (P.L. 111-139) raised the limit to the current level of $14.294 trillion, an increase of $1.9 trillion.

The effects of a negative outlook report or credit downgrade of US sovereign debt would be devastating. The floor would drop out of the US bond market. US interest rates would spike, sending a shockwave through the stock market. Massive Wall Street sell-offs would spread to equity markets around the world. Retirement accounts would be washed out. Real estate values would plummet. GDP would grind to a halt and unemployment would reach or exceed Great Depression levels. The US Dollar would collapse and ultimately succumb to a de facto new reserve currency, perhaps the BRIC Bancor, the UN Special Drawing Rights established by Russia, China, India and Brazil. The United States would relinquish its role as the strongest economy on the globe, and join the ranks of fallen empires.

By way of comparison, Japan's long-term government debt is set to reach 869 trillion yen ($10.57 trillion) at the end of March this year, or181 percent of its GDP. Greece’s debt is 137 percent of GDP; Ireland is at 113%, according to data from the Organization for Economic Cooperation and Development. Could the US be close to such dire straits?

In a recent letter to Congress US Treasury Secretary Geithner said that if the government hits the debt ceiling, it would not be able to pay interest to those holding Treasury bonds and would default on that debt, "causing catastrophic damage to the economy, potentially more harmful than the effects of the financial crisis of 2008 and 2009."

The battle lines are drawn for a gangbuster Congressional showdown between fiscal conservatives in Congress and the high-spending White House. Any compromise will come only after bruising confrontations and divisive campaigns that are likely to whipsaw the markets, as we saw when the House rejected the initial $700 Billion stimulus bill and again when the Administration outlined it’s “stimulus by spending” plan. In January 2008, when the president’s stimulus plan finally was unveiled, the stock market tanked – the worst January performance in 113 years.

There can be no doubt that the next several months, if not the next two years will be a period of great uncertainty in the financial markets in the US and across the globe. And as we have seen during the last few weeks, political tensions in Tunisia, Lebanon, Egypt and Jordan are changing the balance of power in a region important to the developed world.

In uncertain times, prudent investors turn to the stability and certainty of hard assets, such as gold and silver. Gold has proved to be a safe haven and a hedge against the vagaries of inflation, political turmoil, war and revolution.

The question for you to consider is how are you going to protect yourself from the slings and arrows of outrageous fortune? We publish The Gold Speculator to help people make better decisions about their money. Our Model Conservative Portfolio gained 66.7% in 2010. Subscribe by visiting our web site, www.thegoldspeculatorllc.com and pressing the PayPal button ($300/yr) or by sending your check for $290 ($10 cash discount) The Gold Speculator, 614 Nashua St. #142 Milford, NH 03055

FED SPINNING GOLD

by Scott Silva

Editor, The Gold Speculator

1-18-11

The Fed is spinning gold. Deep in his subconscious, Ben Bernanke secretly yearns to return the country to the gold standard, but he knows that if this were to happen, he’d be out of job. And so would thousands on the government payroll who have perfected the art of printing money out of thin air. So, every day Chairman Bernanke issues the money printing quota to the cohorts, who print away, day after day, to the monotonous beat of the ”deflation”drum.

There can be no other reason that the Chairman has stuck to the easy money policies of the last several years, despite the fact that his persistent intervention in the markets and his efforts to stimulate the US economy utterly have failed.

But Bernanke is not the first Fed chief to do the wrong things in the face of economic challenge. In the 1930’s, the Fed contracted the monetary base by 30%, totally misreading crisis conditions of the time. According to Friedman and Schwartz (1963), Fed malfeasance in the early 1930’s was the major cause of the Great Depression.

All economies have boom and bust business cycles. History shows the longest downturns are the result of government intervention. The most egregious government intervention has come in the name of salvation. “Raising interest rates will restore economic growth and prosperity” (1930) “By taking these steps, we will stimulate the economy and create millions of jobs.” (Bernanke, 2009) “Quantitative easing will stimulate the economy and bring down long term interest rates.” (Bernanke, 2010)

When the housing bubble burst, the Fed and the Treasury conflated the crisis at a few Wall Street banks with a “systemic crisis in the global banking system.” Failing banks and insurance companies were deemed “Too big to fail.” This lie spread quickly in mainstream media. Bernanke’s first misguided step was his unprecedented expansion of the monetary base by $1.4 Trillion (top curve in the chart below). The idea was to inject liquidity into the banking system, allowing consumers to borrow and spend and producers to borrow and expand to meet increased demand. But the Chairman did not expect the banks to horde the new credits and stop lending. Bank Excess Reserves skyrocketed (lower curve below); banks essentially quit lending, leaving consumers and small businesses in a lurch. More recently, the Fed began its Quantitative Easing 2 program to add another $600 Billion in “stimulus” funding, further adding to Excess Reserves.

The Fed’s action was intended to 1) thaw the credit freeze and 2) fend off deflation. But two years later, the banks continue to restrict consumer and business loans. Deflation in the housing sector continues today, but prices in the broader sectors, such as commodities have continued to rise since the meltdown lows of 2009. Inflation always follows over-expansion of the money supply compared to GDP growth. Irving Fisher’s equation holds:

MV=PT

Where M is the money,

V is the velocity of money (economic activity),

P represents price, and

T is transaction for goods or service

The important conclusion from this equation is that an increase in MV must increase PT. In other words, when the Fed expands the money supply, prices and/ or transactions rise. Freidman maintains that the proper balance is achieved when money growth equals modest GDP growth. Excessive printing of money by the Fed creates devastating inflation and devalues the Dollar.

We have seen a rapid and continuing rise in commodity prices since Fed intervention of 2009. Higher commodity prices are feeding through to increases in producer prices (PPI) and consumer prices (CPI). Actually, reported CPI numbers do not reflect prices most Americans experience (e.g the so-called Core CPI excludes food and fuel). GDP growth remains sluggish, which may portend a return to the stagflation of the 1970’s.

But what if the amount of money were fixed, as in the gold standard? Returning to the Fisher equation, if we fix M as a constant, any increase in T must coincide with a decrease in P or an increase in V to maintain the equation. When more transactions occur in an economy with a fixed currency, prices must fall or the velocity must increase or both. As the economy grows, prices can actually decline. Because money is constant it gains value in exchange for more goods and services or commodities. Fixing money does not change the economy; the economy changes the value of money without changing the amount in circulation.

Bernanke’s nightmare may be our salvation. History has shown that in uncertain times, investors at every level turn to gold. Owning gold is hedge against paper currencies vulnerable to inflation, corrupt governments, war and revolutions. Those who chose to own gold have prospered, while assets linked to fiat currencies have seen the value of their assets wither away.

The question for you to consider is how are you going to protect yourself from the vagaries of the financial world and the secession of economic bubbles and crashes which characterize our age? We publish The Gold Speculator to help people make better decisions about their money. Our Model Conservative Portfolio gained 66.7% in 2010. Subscribe by visiting our web site, www.thegoldspeculatorllc.com and pressing the PayPal button ($300/yr) or by sending your check for $290 ($10 cash discount) The One-handed Economist, 614 Nashua St. #142 Milford, NH 03055

Thank you for your interest.

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