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Ronald Stoeferle

Ronald Stoeferle

Ronald is a metals analyst at Erste Group. Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4…

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Excessive Structural Debt Suggests Further Appreciation of Gold

“Jesting is the third-best disguise. The second-best: sentimentality. But weirdly, the best and safest disguise is still the blatant, naked truth. Nobody will believe that.“

The debt of the USA currently amounts to USD 14.3 trillion . Debt in terms of economic output is 93%, i.e. the highest ratio since the end of the 1940s. The new debt taken out since 2008 alone accounts for more than 40% of the aggregate government debt amassed in the past 240 years. Inclusive of the debt and entitlements of the States, authorities, pension funds etc. the situation is dramatic, painting a picture of vastly excessive debt. The fiscal gap  amounts to USD 200 trillion, i.e. 14 times GDP. According to the IMF  in order for the gap to be filled, a yearly adjustment of 14% would have to be implemented.

However, the GDP is of limited explanatory power as far as the payoff of debt is concerned, as has been criticised many a time. Rather, the discussion should focus on tax revenues. And for the case of the USA, the picture looks even more dramatic from that angle. In the past 40 years government spending has averaged 21% of GDP, while tax revenues have typically amounted to 18% . In 2010 the tax revenues were down to 14%, which represented the lowest percentage since 1950, whereas government spending in terms of GDP had increased to 24%. This means that it is virtually impossible to consolidate the budget from the revenue side. If one wanted to balance the deficit of 2010, the tax rates would have to be raised by the factor of 2.4x according to the US Tax Foundation.

Outlays, receipts, and budget deficits USA (logarithmic scale)

Outlays, receipts, and budget deficits USA
Source: James Turk: www.fgmr.com

The Congressional Budget Office (CBO) forecasts deficits until at least 2021 . The aggregate deficit will hit USD 8,400bn in the next ten years. And the dimensions are changing fast as well. Whereas in fiscal 2001/2002 the USA recorded a fiscal deficit of USD 120bn, the deficit in October 2010 alone reached USD 140bn. For the first time since WWII, the US debt will exceed the GDP, and the long-term outlook is “discouraging” according to the CBO. By 2035 the government debt could increase to 185% in terms of GDP. These numbers sound disillusioning, and the CBO forecasts are actually based on very optimistic estimates. The Office expects real economic growth of +4.4% until 2014 and of +2.4% subsequently. It also assumes a continuous decrease in the unemployment rate to 5%, low interest rates, and a moderate increase in spending. The CBO model does not allow for another recession. Given that from our point of view the forecasts are unrealistic, we expect the new debt to climb much higher than to the estimated USD 8,400bn.

CBO forecasts: budget deficits until 2021 (in USD bn)

CBO forecasts: budget deficits until 2021
Sources: Erste Group Research, Datastream, Congressional Budget Office

“I wish it were possible to obtain a single amendment to our Constitution…Taking from the federal government the power of borrowing” Thomas Jefferson

The Bank for International Settlements (BIS) also comes up with a shattering assessment of the US budget. From the analysis of the public debt ratios the BIS concludes that the current fiscal policy is unsustainable. It recommends “drastic measures” in order to slow down current and future debt and to mitigate the negative consequences in the long run for growth and monetary stability. The clear and straightforward way of communication by the BIS these days indicates the precarious situation and the urgency of drastic reforms. The future of the next generation has already been mortgaged to a large extent.

The official financial report of the US government  for 2010 also contains numerous charts that illustrate the gloomy future. In the meantime the majority of items on the expenditure side has been earmarked. Due to the sharply increasing healthcare costs, the advancing retirement of the baby-boomer generation, and the rising life expectancy the costs for Medicare, Medicaid etc. have recorded a substantial increase.

If it is not even possible to generate a surplus in times of economic prosperity, then it become clear that the problems are of a systemic nature. As a result of compound interest, debt can grow exponentially, which in the long run causes enormous trouble. As soon as debt and interest rise at a faster pace than revenues, the vicious circle of excessive debt is set off. The growing gap between revenues and spending clearly shows that the path the USA is on cannot be sustained for much longer.

Total spending, interest rate expenses, and tax revenues until 2080 in % of GDP

Total spending, interest rate expenses, and tax revenues until 2080 in % of GDP
Source: 2010 Financial Report of the United States Government

The quarrels over the debt ceiling will probably only be sorted out shortly before 2 August because we are looking at a political power game here. There seems to be no doubt about the fact that the ceiling will be raised, as a look back into history shows. The debt ceiling, or debt limit, was introduced in 1917 and fixed at USD 11.5bn. Since then it has been raised 93 times, and the momentum seems to be accelerating. Since 1962 it has been raised 74 times, and since 2001 ten times already. It therefore makes sense to question the point of such a limit  altogether.

“Public debt has gradually enfeebled every state which has adopted it.“ Adam Smith

At the moment interest payments amount to almost USD 230bn. per year; should the interest rate rise to 5%, interest payments would increase to USD 900bn. If we were to assume that the CBO forecasts are correct, we would be looking at aggregate debt of about USD 24 trillion in 2021. At an interest rate of 5%, interest payments would therefore exceed USD 1 trillion. For this reason we expect interest rates to remain low for a while, with the Fed having to stay behind the curve by a mile and then some. This is one of the strongest arguments for real interest rates to remain negative or at least low, and as a consequence, in favour of the gold price.

The aging population is gradually turning into a sword of Damocles for the public finances, and not only in the USA. According to the study “Global Aging 2010 – An Irreversible Truth”   by S&P, which analysed 32 OECD countries and 17 emerging markets, the burden caused by pensions, healthcare, and eldercare will push up debt in the industrialised nations dramatically. For example the net debt in Germany will increase from 75.2% in 2010 to 97.1% in 2020, to 155% in 2030, to 254% in 2040, and to 400% in 2050. The referential figures for Austria are 88.5% of GDP expected for 2020, and 328% of GDP for 2050.

There are only a few ways out of the debt trap: growing out of one’s debt much like the USA did after WWII, or alternatively drastic spending cuts and rigid budget consolidation like Scandinavia in the 1990s. Massive tax hikes, the repeated calling on seigniorage , the creation of inflation, the depreciation of the currency as in 1934 in the USA (Gold Reverse Act), a continuous dose of financial repression in combination with negative real interest rates, or ultimately, national bankruptcy. We expect gold to benefit in practically all of these scenarios.


Average real T-bill rate: industrialised nations & emerging countries 1945-2010

Average real T-bill rate: industrialised nations & emerging countries 1945-2010
Source: The Liquidation of Government Debt , Carmen Reinhart, Belen Sbrancia, NBER Working Paper

“A hundred wagon loads of thoughts will not pay a single ounce of debt.“ Italian saying

Nikolaus von Oresme warned against inflationary public financing as early as in the 14th century : “If it is the prince’s prerogative to implement a minor adjustment to the currency in order to reap some profit from it, surely it is also his prerogative to implement a major change and reap an even bigger profit; and also to do so more than once and benefit even more profoundly… Eventually the prince would be in a position to seize almost all funds or wealth of his subjects and to enslave them. And this would be a tyrant’s work, and it would be a true and absolute tyranny, much like the ones the philosophers and the ancient world have shown us so hauntingly.”

By. Ronald Stoeferle of Erste Group

Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4 million clients in 3,200 branches in 8 countries (Austria, Czech Republic, Slovakia, Romania, Hungary, Croatia, Serbia, Ukraine). As of 31 December 2010 Erste Group has reached EUR 205.9 billion in total assets, a net profit of EUR 1,015.4 million and cost-income-ratio of 48.9%.

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