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In 2008, the sum of all U.S. government, private and corporate debt was $31.7 trillion. It is now $36.4 trillion, according to the Federal Reserve Bank's statistics, an increase of $4.7 trillion in the last four years. Looking into the statistics further, we see that although the total debt has increased by $4.7 trillion, $4.6 trillion of that increase is federal government debt.
The private sector has gotten its act together during the last four years; the federal government has not. It has exacerbated our position by increasing total U.S. debt by 14%. In that same period of time, federal government debt, alone, has risen 90%.
How does this affect the markets, what does the Fed intend to do about it, and how will that affect our investments?
At this point, U.S. debt is so great that the only thing to do is inflate it away. In order to accomplish this, the government needs a constant 4% to 6% inflation, annually. The Consumer Price Index (CPI) rose 3.1% in 2011, up from 1.5% in 2010. So, we can see the direction inflation is headed.
Four percent inflation, annually, would reduce the principal purchasing power of our debt by 35% in only 10 years, and 6% inflation would reduce the purchasing power by 45% in only 10 years. Since 2002, our purchasing power has been reduced by 25% because of inflation.
Although inflation is already a part of our economy and our life, the government will look to ratchet it up and make it more “acceptable” to voters, sometime in the next few years. There is no alternative.
Bankers and other buyers of government debt are discerning and intelligent people. Why would they purchase these securities?
Market Watch pointed out in May that literally a handful of banks in this country hold 56% of the country's deposits. The people who run these top-five banks are largely responsible for managing the bulk of government deposits worth hundreds of billions of dollars. These banks also receive the bulk of political campaign deposits. Keeping the government growing keeps the banks growing. The top bankers must contribute considerable amounts of money to leading politicians to keep those politicians from enacting legislation that would break up the big banks.
Most of the federal debt is short-term. Inflation only works over a longer period of time, so what does the government intend to do if most government debt is short-term?
The Fed announced a few months ago a new gimmick it calls “operation twist.” All that means is converting short-term government debt to long-term government debt. If the government succeeds in converting the bulk of its debt from short-term to long-term, it is easier to inflate away the purchasing power of the debt and, hence, the debt's value.
For example, it is most desirable for the government to have debt that matures in 30 years. One million dollars borrowed for 30 years is, over a period of 30 years at 5% inflation, reduced in purchasing value to $215,000.
Remember that if the volume of debt grows, the amount of inflation increases accordingly. A $1 million investment 30 years ago in 30-year government bonds would now have a purchasing power of only $430,000.
The government has destroyed more than 50% of our purchasing power in less than 30 years!
This ruins savings — how do people expect to retire and why can't Congress put a stop to this?
Congress could put a stop to this if it wanted to, but it does not want to. Our undisciplined Congress has not passed a budget in three years. Congress, instead of doing its job, has not been able to make cuts, but has relied upon a general across-the-board cut “if certain matters are not addressed during this three-year time.”
In addition to not doing its job to protect our currency, Congress is also failing to act upon things critical to this country, like defense.
I thought that our defense spending was huge. How could the defense of this country be at risk?
Defense cuts imposed by “sequester” signed into law last year will leave the U.S. with the smallest ground forces since 1940, the smallest naval fleet since 1915 and the smallest tactical fighter force in the history of the Air Force.
Further, unless this law is addressed before the end of October, about 1 million defense workers will lose their jobs because funding will cease for programs currently under way.
Are there some encouraging signs in our economy?
Yes, there are in the private sector. The public sector, however, remains a drain on the private sector, which is inhibiting serious private-sector growth.
Although the recovery does not seem particularly robust, there has been substantial debt reduction, and the economy in the private sector is doing well. Output has been growing for three years. Production is expanding; employment is expanding; and the unemployment rate is falling, although slowly.
The problem remains the continuing increase in debt of the federal government. The increase in federal debt has a negative effect upon the private sector in two ways: 1.) The federal government is competing with the private sector for funds, and 2.) business is careful about investing too much of its cash in growth because it appears there will be some big tax assessments in the future to cover the government's expanding debt.
Now that we have discussed what the government intends to do about debt, how will the government's actions affect our investments and affect the stock market?
On June 4, Dow Theory signaled a primary bear market. May 1, the Dow Industrials rose to a high of 13,279 points, and the Dow Jones Transports failed to confirm this new Dow Industrials high. Both the Industrial and Transportation Average then turned down and broke below their April lows.
This is confirmation that a primary bear market is in progress. A primary bear market will remain in progress until both the Dow Jones Transports and Dow Jones Industrials exceed the May highs of 5,286 and 13,279, respectively.
Conclusion
This is not the time to invest in any stocks other than the highest-grade securities; and then only if their dividend yields are above 3% and their price-earnings ratio is below the long-term average of 14 times earnings.
Most likely to obtain long-term capital gains are real estate and assets such as gold and silver, all of which are undervalued in an inflating economy that is poised to inflate much more in the future.
Cash still allows an investor to remain in a position to buy good deals when they become available. Gold and silver can be purchased anytime and put away, because over a period of time they will continue to increase in value.
These are dangerous times and dangerous markets in which to invest. The direction of the government is uncertain. The direction of the European economy is down, and China is settling into a recession.
There is no plan to reduce our federal debt and, indeed, no plan to reduce federal spending so that the federal government does not have to borrow money for current operating purposes. Should the politicians that we put in office make a real attempt to straighten out the size, direction and indebtedness of the federal government, we are in great shape to succeed; however, there is no evidence that our politicians are interested in reducing the size of government.
Therefore, we will be mired in a mess, in which the government continues to borrow and the private sector continues to reduce debt to put its balance sheets in better shape. Government borrowing continues to produce a drag on our economy, and that will affect the stock market negatively.
Caveat Emptor.
George Rauch, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.
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