“This Is Not Normal”

A timely guest post by David Galland & Chris Wood from Casey Research. In the wake of a change of helm in the US Congress and Ben Bernanke’s “Quantitative Easing II” announcement last week, David & Chris look both forward and backward—looking at how we got into a situation where the debasement of the world’s reserve currency looks like an answer, and what happens now that the deluge has started. There is information here ever intelligent commentator needs to get their head around.

Dear Readers,

Over the last couple of days, I’ve had some interesting exchanges with readers – the majority equal parts excitement and fear about rising precious metals prices… and especially the explosive gains in so many of our recommended stocks.
    After surveying a portfolio that has daily been gaining in leaps and bounds, regular correspondent Dennis M. observed, “This is not normal.”
    And he’s right.
    The chart just below shows the ratcheting price of SLV, the silver Exchange Traded Fund (ETF). As you can see, in the last three months alone the price has steamed ahead by over 50%.

    The next chart shows the share price of Silver Wheaton, a silver royalty company, over the same period of time. Again you can see that it has more than doubled over roughly the same time period.

    It’s notable that Silver Wheaton is no thinly traded microcap – even though it has been acting like one of late – but rather a $12.7 billion company.
    Happily, we first recommended Silver Wheaton as our “go to” silver stock in the International Speculator service on December 10, 2004, when it traded for just $3.35 a share.
    But the same breathless excitement at having been dead right almost simultaneously unsheathes the proverbial double-edged sword that has so many dear readers wondering if what Mr. Market has so kindly provided (with a little help from Casey Research, one is tempted to add), he might soon take away.
    Put another way, given the size of the gains so many subscribers are sitting on in Silver Wheaton – and many other precious metals stocks – is it any wonder they are getting a bit nervous? Is it time to sell? Hold? Buy more?
    With the mind-numbing complexity of today’s globally interconnected economy, I’d be the last person to claim special knowledge about where the precious metals express will stop next – especially now that we’ve taken out the $1,400 level that our own Chief Economist Bud Conrad has been forecasting for 2010. Is $1,500 in the near future, or could a surprise action on the part of the U.S. government hammer the precious metals sharply lower?
    It may be useful to step back to the 50,000-foot view and see if there is any discernable pattern apparent on the landscape.

The 50,000-Foot View

    By now I suspect that all but the newest dear readers are well versed in the reasons behind the stunning rise in precious metals.
    Simply, ever since Nixon yanked gold out from under the U.S. dollar in 1971, the world’s nation-states have operated on a pure fiat monetary system. The great advantage of a fiat money system is that as long as no one pays too much attention to the details, a government can create money out of thin air – usually in support of social spending programs designed to win support from the grateful plebes.
    All to the good – until it isn’t. More on that momentarily.
    In any event, armed with the power of the printing press, the nation’s governments – all with the best of intentions, I am sure – began taking on bigger and bigger spending commitments, and because it was also politically pleasing, began papering over even normal business cycle gyrations. Unfortunately, kicking the can down the road didn’t really resolve much of anything, but rather caused the dislocations to become ever larger.
      Skipping  to the present, the consequence of these actions is a world awash in historic levels of debt, on both the individual level and particularly the governmental level. 
    Of course, individuals who find themselves deep in debt can try to cure the situation by reducing their spending, taking a second job, or even declaring personal bankruptcy in order to begin the process of working things out with creditors.
    By contrast, governments don’t actually produce any wealth and so, when faced with mountainous debt loads as they are now, have a very limited range of options available. For instance, they can raise taxes – but that’s counterproductive in a struggling economy. As for belt-tightening, decades of establishing large bureaucracies and taking on hard-coded obligations aimed at pleasing the citizenry – mandatory spending programs such as Medicare and Social Security – make cutting the budgets increasingly more difficult. In fact, thanks to simple demographics, the mandatory spending is only set to rise from here – and significantly so.
    So here we are, with the U.S. government – long the provider and protector of the world’s reserve fiat currency – up to its eyeballs in debt, and piling on more by the trillions.
    A moment ago I made a passing comment that fiat systems work as long as no one pays too much attention to the details of the government’s monetary actions. Generally speaking, this fact ensures that governments are nuanced and even somewhat reserved in their money printing. If they become so extreme that the market begins to notice, the bond vigilantes will demand higher and higher interest rates.
    Unfortunately, the scale of the problems now facing the U.S. have reached the point where…

• The U.S. government’s debt and mandatory spending obligations are intractable. Simply, there is no conceivable way that the debt can be paid and the obligations met, at least not through any “normal” government operations.
• Evidence that this is true can be seen in that it is now accepted as a fait accompli by Democrats and Republicans alike that annual U.S. budget deficits approaching $1.5 trillion will be the norm for years into the future.
  A few days ago, I ran an interview with a newly elected Tea Party congressman in which he states that even the Tea Party has no interest in touching Social Security and Medicare spending. Tack that politically sensible but economically unviable position onto the Republicans’ Pledge to America that explicitly excuses military and homeland security spending from further scrutiny, and you end up with exactly zero chance of making even the slightest of dents in runaway government spending.
• A lot of people are paying attention. In fact, pretty much everyone is watching the desperate follies of the U.S. government. The watchers may hope for the best, but if the prices of gold and silver are any indication, they are beginning to suspect the worst.
• Desperate to avoid the debt death spiral that will be triggered by rising interest rates, the Fed has announced that even if no one else shows up at the almost daily auctions of Treasury debt, the Fed will. By doing so, Bernanke & Friends hope to lull the watchers back to a less vigilant posture. So far, it is “sort of” working… the watchers are buying the argument that as long as the Fed keeps buying Treasuries, rates should remain dampened.

It is, however, our contention that this charade cannot last. A sentiment shared, it is clear, by the number of big money players recently piling into sound money.
    There are a number of big questions yet to be answered, but the core issue surrounding the ability of the U.S. government to meet its obligations using normal operations is not one of them. It can’t. Therefore, by definition, it must either default or attempt to debase the dollar to the point where fixed-amount obligations erode back into a range where they can be paid.
    Dipping just a bit deeper into the ability of the government to claw back out of its deep, deep hole, our own Chris Wood took a quick look at the 2011 Federal Budget and found nothing to cheer about. Here’s Chris…

A Quick Look at the U.S. Federal Budget 2011
By Chris Wood

First, here’s a useful interactive graphic on the budget from The New York Times:
http://www.nytimes.com/interactive/2010/02/01/us/budget.html
    Now, the Times indicates that the 2011 Federal Budget Proposal is $3.69 trillion, but using the actual budget itself (specifically Table S-4 Proposed Budget by Category on page 151) we find total budgeted outlays of $3.834 trillion, of which $1.415 trillion is discretionary and $2.419 trillion is mandatory (including net interest).
    Some sound bites:

• If you got rid of the whole Department of Education, you’d only shrink the budget 1.9%.
• If you got rid of the Department of Agriculture, you’d only shrink the budget 3.4%.
• If you were able to get rid of the EPA, NASA, and the Department of Interior, you’d only shrink the budget by 1.0%.
• If you were able to cut all discretionary spending from the budget, you’d only be cutting 36.9%.
• Mandatory budgeted outlays of the Department of Health and Human Services (responsible for Medicare and Medicaid) are greater than the total budgeted spending of all the following departments combined:
  • Dept. of Agriculture
  • Dept. of Commerce
  • Dept. of Education
  • Dept. of Energy
  • Dept. of Housing & Urban Development
  • Dept. of Interior
  • Dept. of Justice
  • Dept. of State & Other International Programs
  • Dept. of Transportation
  • Dept. of Treasury
  • Dept. of Veterans Affairs
• If you cut the Department of Defense budget in half, you’d only shrink the budget 9.4%.
• Mandatory budgeted outlays of just the Department of Health and Human Services and the Social Security Administration exceed total discretionary budgeted spending by 13%.

    David again. As Chris’s quick look makes clear, nothing short of profoundly altering the role of government as an actor in our society will slow the out-of-control spending. And even that assumes the best case: throw in large-scale economic damage caused by higher oil prices (now nearing $87/bbl),  another war in the Middle East, a nascent trade war with China, etc., and the train leaves the rails even quicker.
    But there’s enough to worry about as it is without adding to the pile. Which brings us back to the worries of some that precious metals may now be too expensive and headed for a fall.

Are Precious Metals Too Expensive and Headed for a Fall?

Trying to arrive at a useful answer, ask yourself the following…

1. Is there any politically feasible way that the U.S. government can avoid an overt or covert default on its obligations?
   Per the data points provided above, we simply cannot see how such a default will be avoided at this point.
2. As the coming default becomes obvious to a broader universe, is there any way the Fed will be able to keep a lid on interest rates?
   Again, the answer has to be “no.” For awhile the bond vigilantes may continue to show tolerance, but such tolerance has a limit… especially if the Fed continues to become a bigger and bigger factor in the Treasury auctions. Once interest rates start up, the interest expense on the debt will quickly become self-propelling and crushing.
3. As the dollar era grinds to a halt, will central bankers, institutions, and investors want to replace their dollars with alternative fiat currencies – the euro? British pound? Yen? Renminbi?
   At least for awhile, the answer is likely to be, “All of the above.” But it seems a very safe bet that the shift into precious metals will also continue.
   Given that the combined size of global stock and bond markets is on the order of $120 trillion – with trillions more at risk in faltering dollars and other fiat currencies – it doesn’t take an Einstein to figure out that even a slight additional shift towards the precious metals will send them soaring.

    And, of course, this problem of too much debt is not limited to the U.S., but is the same for all the world’s leading economies. On that topic, this out today in the UK’s Telegraph…

Is there a second credit crunch looming? Between now and the end of 2012, UK banks and building societies must find ways of refinancing between £750bn and £800bn of lending. That's a number approaching half GDP.

    Full story here.
    So, now, ask yourself again that question of whether precious metals are overvalued.
    Personally, my answer is that they have definitely gotten ahead of themselves. But this is little more than the entirely ordinary ebb and flow to be expected in a secular bull market. It would be shocking to me if the precious metals didn’t take a breather in here – but I don’t think that if they do, they’ll drop overly far (5%?) or stay down for any length of time.
     Put another way, the situation today – and the outsized returns for precious metals investors – are definitely not normal, but then again, neither is the nature and scale of the crisis now gripping the globe.
    In fact, given the fast-eroding global confidence in the fiat currencies, it seems entirely normal to me that the currencies will continue to stumble against all sorts of tangibles, gold and silver included. And so maybe the rise of precious metals is normal, after all?
    Though you have to make your own decisions, in my view, while the trend for the global economy may not be friendly, those with the foresight – and at this stage, the guts – to stay invested in the precious metals will be well rewarded.
    That said, it is never wise to rule out the government doing something very unconventional to disadvantage gold… so it is worth maintaining a disciplined approach to your investment portfolio. A failure in any particular asset class shouldn’t cause you to have to downgrade your lifestyle.
    Moderation in all things, including your excesses.
    And with that, I’m going to dash for the day. As always, thank you for reading … 

David Galland
Managing Director
Casey Research

Reposted by permission from Casey Research.
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