If you want to know when a society is set to vanish, watch the money. Whenever destroyers appear among men, they start by destroying money, for money is men´s protection and the base of moral existence. Destroyers seize gold and leave to its owner a counterfeit pile of papers. This kills all objective standards and delivers men into the arbitrary power of an arbitrary setter of values. Gold was an objective value, an equivalent of wealth produced. Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it. Paper is a check drawn by legal looters upon an account which is not theirs: upon the virtue of the victims. Watch for the day when it bounces, marked: account withdrawn. – Francisco D´Anconia (fictional character in Ayn Rand´s 'Atlas Shrugged´)
As I write today's commentary, I note that it has been exactly one year now since the global stock markets reached their lows of March 9th, 2009. The Dow, for instance, had fallen to around 7000 at the time. Today, it has rebounded to 10552, rougly 50% higher than a year ago. That is an impressive stock market recovery…a good thing. But, in looking back over the last decade, we further notice that the Dow has really not done that much at all. We're still below the Y2K level. Compared to the Y2K, the level of public debt has grown exponentially.
What bothers me is the cost at which the lifting of stock markets has been accomplished…the trillions and trillions of debt that has been created in an effort of stimulating and mending. In America, the non-partisan Congressional Budget Office announced last Friday that based on the Obama Administration's budget proposal, deficits over the next decade would be $1.2 trillion higher than what the White House had originally estimated. At this point, this kind of news seems to simply fly over our heads with little notice. These estimates and numbers are reported so frequently, and they are so huge, that they defy our ability to comprehend them any longer.
And, what concerns me even more is the fact that despite this gigantic and concerted global effort of 'monetary and fiscal flooding', there is actually very little to show for it in the REAL economy.
The critical question was posed accurately by Bill Gross of Pimco in his recent Investment Outlook: "What if – to put it simply – you couldn't get out of a debt crisis by creating more debt? Can you get out of a debt crisis by piling on another layer of debt? The answer, of course, is that 'it depends'."
After all the stimulus, so little to show for
While over this past year we´ve been served up all kinds of Green Shoot stories and statistical wonders, the truth of the matter is that, fundamentally, the global economy and particularly the economies of the 'developed economies´ are still ailing badly. In the US, all one needs to do is look at the unemployment numbers and the still-falling home sales. According to official statistics, one-third of Americans are living below the "poverty line" and every EIGHTH American depends on food stamps.
In essence, the only thing that appears to support the much-cited 'Green Shoot Recovery' story is this past year's rally in stock markets. Backing the story, mainly, is the Dow being above 10000 and possibly heading higher…for at least a little longer. What the spendings may have also helped to achieve is the retention of power for those currently in political offices…at least for a little longer. And, finally, the financial system overall appears to have been kept alive…for at least a little longer, too.
However, even to the most un-interested observer, the whole situation still looks very shaky. The sticky question we are all confronted with is whether all this additional spending, all the trillions of debt, have been able to ignite a sustainable recovery, and whether they have saved the REAL economy. Personally, I have considerable doubts.
Obesity can hardly be overcome by increasing your daily dose of calories. Similarly, it would appear that increasing the monetary dose of paper money – adding yet more debt – will hardly fix a severe debt crisis. But I of course forgot that governments can print money! They can create liquidity at discretion. So, why should deficits and debt matter?!?! Let´s just keep spending and pumping because at some point, the economy will find traction again.
The truth is that this kind of thinking and doing has worked for a long time. But, it is not that simple either. Whether it will continue to work again depends primarily on one thing: TRUST.
The growing problem of shrinking trust
For decades now, the thought that the government of an industrialized nation — certainly one as large as those of the UK, Germany, France or the US — could go bankrupt has been scoffed at. However, over the past few weeks, in the wake of the Greek debt crisis, the potential of SOVEREIGN DEFAULT is increasingly being discussed, even in the mainstream press.
The strategy of making an example of Greece's need to tighten its belt (and rest assured, this was a concerted strategy, not some sudden fateful occurrence) and clean up its fiscal balance sheet may backfire. The question of sovereign default is proving difficult to contain. The question of the potential of bankruptcy of other countries is on the front pages.
In a fiat-currency system, where the notes issued by a country's government are not redeemable in any real commodity — in honest money (gold or silver) — the entire system relies on the TRUST the participants in that system have in the issuer of these notes and their purpose of facilitating the exchange of goods AND store of value. When that trust is lost, the system fails.
When money can be created without limit by being borrowed into existence at the whim of the issuer, the trust in the issuer is the sole linchpin of the entire system. So, Bill Gross is right: will it be possible to fix the debt crisis with more debt? It depends. It depends on whether government, the great debtor of last resort, is trustworthy.
Is government trustworthy? Is sovereign default a realistic scenario to beware of? Does this question only apply to Greece? Or, will it soon apply to the UK, to Italy, to the US??? The topic was explored last week in a Financial Times article titled A Greek Crisis Is Coming to America, by Niall Ferguson. He notes: "This is more than just a Mediterranean problem with a farmyard acronym [PIIGS]. It is a fiscal crisis of the Western world. Its ramifications are far more profound than most investors currently appreciate."
He points out a fact that is generally missed: "Yet, the idiosyncrasies of the eurozone should not distract us from the general nature of the fiscal crisis that is now afflicting most western economies. Call it the fractal geometry of debt: The problem is essentially the same from Iceland to Ireland to Britain to the U.S. It just comes in widely differing sizes."
In a recent Mountain Vision Update, we had shared the most critical debt-to-GDP ratios. Greece is not the most indebted nation by far. Mr. Ferguson concludes his article as follows: "On reflection, it is appropriate that the fiscal crisis of the West has begun in Greece, the birthplace of Western civilization. Soon it will cross the channel to Britain. But the key question is when that crisis will reach the last bastion of Western power, on the other side of the Atlantic."
The shrinking trust in ratings, and the growing threat of rising interest
Trust is built over long periods and does not come easily. Yet, it is fragile and can be destroyed in the blink of an eye. At this point, the trust in governments and their fiscal and monetary policies has been cracked, not broken. A big part of that crack comes from the loss of credibility in the rating system used today.
After the somewhat arbitrary down-grading of Greece's credit rating, some European politicians are asking for a new rating authority; a new rating authority that is not monopolized by US rating agencies with questionable methods. Some have suggested that the European Central Bank (ECB) take on the role of rating the countries in Europe. That will not happen. It´s important for the ECB to be politically independent. However, it is clear to all that the current rating agencies have served their time and are NOT TRUSTWORTHY. They themselves, urgently, need a downgrading.
In February of 2009, Moody's evaluated the chance of a downgrade for a AAA rated nation as follows: "For a AAA government to be downgraded, Moody's must have concluded that the deterioration in credit metrics is (1) observable and material in absolute terms; (2) observable and material in relative terms; and (3) unlikely to be reversed in the near future. The decision underlying a potential downgrade would also depend on the extent of the actual and potential deterioration of a government´s balance sheet; whether a country's economic model can be regenerated, thereby allowing the economy to rebound; and whether governments can repair their fiscal position by raising taxes or cutting expenditure."
I suggest you reread the above paragraph thoroughly. And then ask yourself: Today, which AAA-nation should NOT be downgraded on the basis of this criteria?!?!
At the time of this Moody´s quote, there were 18 nations with a Moody´s AAA-rating. Since then, Moody's has downgraded one nation only: Ireland. Really, in consideration of the above, it becomes a farce when a nation IS downgraded. In the case of Greece, it appears that on some whimsical notion it was decided that the "deterioration in credit metrics" clearly taking place in Greece is "unlikely to be reversed in the near future".
A lower rating very quickly leads to a higher cost of financing one's deficits and debt. The spreads on credit default swaps (CDS) — in other words, the cost of 'insuring´ against default risk — quickly multiplies. This is what happened to Greece. The Greek government was forced to "repair their fiscal position by raising taxes or cutting expenditure." No more stimulus programs for the Greeks. No more easy money. No more government sponsored jobs and deficit-based 'growth'.
The threat of this happening in other nations is quickly growing in the minds of politicians, investors and citizens around the world. The threat of lost trust, leading to a higher cost of servicing debt and financing deficits, leading to a visible loss of credibility and power – this is the scenario that governments from Berlin, to Paris, to London and Washington fear. It is their greatest nightmare. The threat is real, as is the fact that these governments will do whatever it takes to avoid it.
Will it work? It depends…
Will they succeed? In the long-term, I seriously doubt it. At some point, something will have to give. In the short- to medium-term? I don't know. I think they still have a few rabbits in their hat and a few aces up their sleeves. Can trust be restored? There are still a lot of people that believe in the system, in the good nature and competencies of their governments.
So, after adding a few trillion more, we might actually see a few more points upwards in stock markets…at least that.