Precious Metals for the Long Run

The potential, and, perhaps, inevitable meltdown of the European Union due to the overpromising of entitlements and habitual deficit spending speaks directly to the reasons that our advisory firm has remained so cautious, keeping client assets in defensive positions with lower than normal equity levels and higher allocations to precious metals.  During the Greek debt crisis, precious metals have moved to the upside toward historic high prices.  Our view is, and has been, that the U.S. is not immune from similar dire consequences of its own profligacy.  In fact, the country may have already passed the point of no return with regard to solutions.  The uncertainty surrounding the long term direction of taxes, fiscal policies, and monetary policies makes precious metals a natural long term hedge.

The financial industry generally ignores academic studies and conclusions.  But, every once in a while, a study, based on well documented historical data, reports conclusions so compelling that they cannot be ignored.  Reinhart and Rogoff’s 2009 book, This Time Is Different: Eight Centuries of Financial Folly made an impression on some business savvy folks regarding the fallacies of the use of debt to resolve a financial crisis.  Now comes along another study, this one relatively obscure, by Cecchetti, Mohanty, and Zampolli of the Bank for International Settlements (BIS) entitled The Future of Public Debt: Prospects and Implications, March, 2010, which concludes that the current and future state of fiscal policies and accumulated liabilities along with the lack of political will make future inflation and devaluation the most likely future scenario.  Below are some of the study’s observations as seen and focused through my lens:

• The deficits in the U.S. are now structural, not cyclical.  Deficits are now present as far as the eye can see even after the economy recovers and taxes increase;
• Reinhart and Rogoff indicate that, after a banking crisis, the debt/GDP ratio rises by 86%.  That rise is now projected to be 111% for the U.S. in 2011.  Furthermore, once debt/GDP rises to 90%, future economic growth rates fall significantly;
• With little likelihood of robust growth due to structural unemployment issues, there is little hope that the debt/GDP ratio in the U.S. can fall anytime soon;
• Age related public spending (Social security, Medicare, and the new healthcare legislation) is not included in the BIS study calculations, nor are the huge unfunded liabilities in state and local pension plans which are just now coming to light.  It is estimated that federal expenditures for healthcare alone, which today are 5% of GDP, will rise to 10% by 2035 and 17% by 2080.  And this doesn’t count the burden the federal government puts on the states to support the social entitlements;
• Deficit issues are not unique to the U.S. and are present in most industrialized nations.  Greece and the other weak European Union members (Portugal, Spain, Italy, Ireland) as well as the U.K. are all in the same boat.  The authors conclude: “the data show that the current fiscal policy is unsustainable in 19 industrial countries studied”.

The authors looked at several sets of plausible assumptions about fiscal policy and spending and they conclude that under almost any set of assumptions, debt in the industrial world explodes.

Assumption Set 1: Non-age related spending/GDP stays constant at 2011 projected levels.

While most U.S. voters want the Congress to have fiscal restraint, perhaps with the return of “pay as you go” which requires Congress to find money through reductions elsewhere or new fees or taxes in order to spend on something new or increase funds for existing programs, because of entitlements already promised, deficits rise precipitously with debt/GDP exceeding 150% in the U.S. (300% in Japan, and 200% in the U.K.).

Assumption Set 2: The U.S. follows the Obama plan to bring its deficit down to 4% of GDP by 2015.

Once again, the vested entitlements catapults the debt/GDP ratio toward 300% by 2040.  “This suggests that consolidation along the lines currently being discussed will not be sufficient to ensure that debt levels remain within reasonable bounds over the next several decades”, the authors contend.

Assumption Set 3: Freeze the age related spending/GDP at projected 2011 levels. 

This would appear to be politically impossible.  But, even if it could be done, the debt/GDP ratio falls in some industrial countries, namely Austria, Germany, and the Netherlands, but not in France, Ireland, the U.K., or the U.S.

The authors calculate that, for the U.S. to get back to the 2007 debt/GDP ratio, it would have to run a surplus/GDP ratio of 8.1% for the next 5 years, 4.3% for 10 years, or 2.4% for 20 years.  Note that the 2010 projected surplus/GDP ratio is -11%, i.e. we have an 11% deficit/GDP ratio.  Given the low likelihood of significant improvement, what are the consequences?

• As the debt/GDP ratio rises, interest rates rise because investors demand a higher risk premium; higher rates imply slower economic growth;
• Excluding age related expenditures, in order to maintain a given level of public services, taxes must rise.  If tax rates rise, depending on where the country is on the Laffer curve (the U.S. is among the highest taxing countries in the world and is almost certainly to the point on the Laffer curve where tax rate increases are a disincentive to work) tax revenues are likely to fall;
• The constant tapping of the credit markets by the government “crowd out” the private sector which leads to higher interest rates, less investment, and lower economic growth;
• As debt rises, there is likely to be an increase in inflation or inflation expectations;
• Rising debt puts political pressure on central banks to monetize the debt to keep rates low both to increase economic growth and to hold down the cost of the debt.  “History shows that countries that ran high public debts eventually ended up with high inflation because governments were unwilling to pay high interest rates.”

Conclusions

• Fiscal problems confronting the U.S. and other industrial economies are more serious than official debt figures show due to age related liabilities which are not accounted for in official budget figures, and this doesn’t include the huge underfunded liabilities present in almost all state and local pension plans.  “As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population”;
• Interest rates on government debt will rise as debt explodes making the deficit problem worse;
• Long-term fiscal imbalances pose significant risks as central banks are pressured into direct debt monetization or governments succumb to the temptation to reduce the real value of government debt through higher inflation;
• High levels of public debt drive down capital accumulation, productivity, and long-term economic growth.

Implications for Investors

Ask yourself how confident you are that the U.S. Congress could soon accomplish any one of the three sets of assumptions, i.e.: 1) hold non-age related spending at 2011 projected spending levels; 2) follow the Obama plan to reduce the deficit/GDP ratio to 4% by 2015, especially in the face of high structural unemployment; or 3) freeze the age related spending/GDP ratio at projected 2011 levels, especially given the new health care legislation.  Given the spending track record of the Congress under both Republican and Democratic leadership since 2001, one should have little confidence that 1) or 2) could be accomplished.  And 3) would take political will not seen in our lifetimes.  Yet, even if any one of these is accomplished, the authors conclude that the U.S.’s debt/GDP ratio would still reach at least 150%.  It thus appears inevitable that the dollar will lose purchasing power (even if it doesn’t fall vis a vis other currencies due to those countries’ debt/GDP ratios) against hard assets.  Finally, history shows that it is politically more palatable for politicians to choose inflation, rather than higher interest rates, as the way out.  Increased portfolio allocations to inflation hedges (precious metals), then, would seem to be the rational long-term response.

Robert Barone, Ph.D.

May 5, 2010