Why the System is Doomed

It seems hard to believe that a delay to an increase in US debt levels is causing the financial world so much angst. It just goes to show how twisted, screwed up and debt dependent this ‘modern’ financial system is.

‘Give us more debt or we’ll be ruined!’

Sadly, that statement is not far from the truth. Without an ever-expanding debt structure, the international financial system will start to implode. Consider these figures from the US Fed Flow of Funds Report, released quarterly.

In 2000, total US credit market debt outstanding was $27.14 trillion. By 2005, thanks to Greenspan’s easy money policy, it had jumped to $41.28 trillion. In 2008, at the height of the credit bubble, it was $52.43 trillion. That figure dipped very slightly in 2009 as private sector debt writedowns offset growing government debt. And at 31 March 2011, total debt outstanding hit $52.63 trillion – a record amount.

And you thought the US was in a post-credit-crisis debt-reduction phase?

Not a chance. The system is not designed that way. When the financial and household sectors began to reduce debt in late 2008, the Federal government came in to prop up the system. According to the Flow of Funds report, it ran a deficit of $1.24 trillion in 2008, $1.44 trillion in 2009 and $1.58 trillion in 2010.

The government did this so total debt outstanding would not decline. It needed to prop the system up.

The US has been on this path ever since it abandoned the discipline of the gold standard back in 1971. With few exceptions, credit market debt has been growing faster than the overall economy since this time.

We don’t have the exact figures but you can see from the above numbers that the total debt growth since 2000 (it has nearly doubled) far exceeds the rate of economic growth over the same timeframe. Each dollar of additional debt therefore produces less and less wealth.

If the US were a company, its share price would be sinking. If a company added more and more debt to produce minimal net profit growth, its return on assets would continually fall. The costs of debt servicing would most likely kill the company.

In such a situation, shareholders would sack the board and appoint new management…that’s if the receivers weren’t called in first.

Unfortunately in politics you only get the occasional opportunity to sack the board and management. In the meantime, you must put up with their incompetence.

Right now, US political incompetence is about as large as the $14.3 trillion US debt pile. Not because they can’t approve an increase to the debt ceiling. No, it’s because they’ve presided over a system that is hopelessly unsustainable and is eating away at the world’s wealth.

The US has emitted so much paper in the form of Treasury securities the world’s financial system has indigestion.

Investing in government paper (i.e. buying Treasuries) is an oxymoron. Governments don’t create wealth – they take it from the private sector. The interest payment on a government bond can only be paid via the taxation of the private sector. The government taxes the wealth created by the entrepreneur (by taxing profits or income) to pay its liabilities.

We recognise there is a role for government bonds to play in society. Government spending can be productive to the extent that it provides the infrastructure for private enterprise to flourish. But let’s face it – it doesn’t need to do much for that to occur.

Today, government borrowing in the US is completely out of control. It issues bonds to pay interest on existing bonds. It’s a classic ponzi scheme.

How long will the game go on? Maybe a few more years at the most. That’s our best guess.

While we’re waiting, let’s have a look at where all this $14.3 trillion in US debt is residing…

The first thing to point out is that this figure represents the gross amount of debt. According to the Treasury, as at March 2011, the Federal Reserve and other government departments held just under $6 trillion in US debt securities, with the remainder being classified as ‘privately held’.

So the government holds nearly half of its own debt issuance. Apart from the Federal Reserve’s stash, which amounts to $1.43 trillion (as at March 2011), the rest is held in various accounts to pay retirement benefits for government workers, social security and unemployment benefits.

There’s a very good chance those accounts are completely under-funded. Oh… and these numbers do not include the guarantees provided to entities like Fannie Mae and Freddie Mac, the bankrupt mortgage providers propping up the housing market.

Let’s move on…

Of the privately held portion, foreign investors own a rather large $4.48 trillion. As a percentage of total privately held US government debt, these foreigners (mostly central banks) hold 54 per cent. That’s a hefty reliance on foreign funding. Ten years ago, in March 2001, that proportion was 35 per cent.

So you can see why foreign central banks are getting tetchy with the US Congress and why the US dollar is under pressure.

Tying all this in, you can see that foreign central banks are complicit in prolonging the unsustainable international credit system by continuing to invest in US government debt. Through their own short-term political self-interest (trying to maintain cheap currencies) these central banks invest their nations’ savings in a country engaging in ponzi finance.

Whichever way you look at it, this will result in a destruction of wealth on a massive scale. It’s also why the current system of international finance is doomed.

How all this will play out is anyone’s guess. We’re in the hands of the politicians and the bankers who advise them.

If you want to put your wealth into your own hands, we suggest owning gold.


Greg Canavan
Markets and Money Australia

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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“Governments tax …. “! Gasp …. surely not …

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