Ignoring The Obvious

By: Eric Sprott & Etienne Bordeleau

Not a day goes by without hearing about the fiscal cliff, the debt ceiling or another political deadlock. We would not disagree that some of these are important issues that need resolving but, in the grand scheme of things, they are relatively superficial.

As we all know, central banks around the world have been frantically expanding their balance sheets. While exceptional times might warrant exceptional measures, Figure 1 below paints a rather troubling picture. The monetary base, the amount of money in circulation in the economy, has expanded at an incredible pace.

Since the mid-80s, the U.S. monetary base had been very stable at around 5-6% of GDP. Through fractional reserve banking, this amount was sufficient to maintain annual inflation around 2-3%. With the banking system collapsing in 2008-2009, it was necessary for the Fed to increase the monetary base. However, banks are now in much better shape than they were in that period and the benefits of monetary expansion seem to be waning.

The Fed is not the solution to every economic and social woe and trying to hide real problems (eg. structurally high unemployment and rampant poverty, unsustainable income inequality and exploding government liabilities) with money printing achieves nothing constructive.

Source: Federal Reserve Bank of St. Louis, U.S. Department of Commerce: Bureau of Economic Analysis


First, while we are supposed to be in the midst of an economic recovery, about one in five Americans are on food stamps (Figure 2). As the chart below shows, this measure of poverty has been fairly steady for the past year. We also find it hard to reconcile this data point with the headline unemployment numbers, which seem to be improving. We prefer a more comprehensive measure of unemployment, commonly referred to as U6, which includes discouraged workers and those working part time against their will. By this measure, we see that “Total Unemployment” has come down, but remains extremely elevated at around 14% of the labour force. Moreover, food stamps and “Total Unemploymenttend to move together. If food stamps users stabilize at current highs, we believe that it is a sign that the natural unemployment rate in the U.S. economy is now significantly higher than it was pre-crisis.

Source: U.S. Department of Labor: Bureau of Labor Statistics

Income Inequality

Second, income inequality has been growing steadily since the mid-1980s. Figure 3 shows the share of total U.S. income earned by the middle class and the top 5% of households. As of 2011, the top 5% of households brought home over 22% of all income generated in the country, whereas the middle 20% of households (quite literally the middle class) got less than 15%.

Coupled with the unemployment picture, this shows that a majority of the U.S. population has been losing ground to the most wealthy. In a society that relies on consumption for 70% of its economic activity, this certainly does not bode well for the future, since the wealthiest traditionally do not consume much of their income. To top it off, the recentfiscal cliff deal” just reduced disposable income further by increasing payroll taxes by 2% for all those working, putting additional strain on the working class and their discretionary spending dollars. (See Figure 3).

Source: U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplements

Government Obligations

Another obvious problem is the liabilities of the Federal Government. The current cash reporting basis that the Department of the Treasury uses, vastly understates its deficit and future liabilities. Some estimates put the current unfunded liabilities of the Federal Government at about $222 Trillion and show an increase in the deficit from 2010 to 2011 of around $11 Trillion, which represents about 70% of the U.S. total GDP.1

Simple back of the envelope calculations can be made using the Treasury’sFinancial Report of the United States Government – 2012”, which comprises a detailed breakdown of its future financial obligations for health care, social security and other government services.2 This reporting is similar to what every corporation is mandated to calculate for the purposes of U.S. GAAP reporting.

Of course, accounting can always be “massaged” to improve one’s situation. This problem is most acute when there are many assumptions, like for pension and benefits accounting (a.k.a. social security and Medicaid/Medicare).

ShadowStats makes the necessary adjustments and finds that for 2012 alone, the deficit amounts to $6.9 Trillion.3 This represents about 45% of annual GDP. While laudable, the current haggling by policy makers for a meager $2 Trillion in deficit reduction over 10 years represents only the tip of the iceberg.

A significant part of these deficits is caused by current and future health care spending. The Deloitte Center for Health Solutions recently published a report entitled “The hidden costs of U.S. health care: Consumer discretionary health care spending”, in which they analyze the many components of health care spending and how those expenses are underreported in official numbers. Figure 4 shows their estimates for total health care spending by age group for 2010.

Source: The hidden costs of U.S. health care:
Consumer discretionary health care spending, Deloitte

Source: US Census Bureau 2012 National Population Projections

What is striking - but not that surprising - is the very large increase in health care costs faced by seniors. The report cites that “Seniors and Baby Boomers account for 64 percent of health care costs, but comprise only 40 percent of the U.S. population.

For seniors, total health care costs represent, on average, approximately $30,000 per person per year. Other estimates by Carnegie Mellon University professor Paul Fischbeck (although a bit dated) show that these annual costs increase dramatically as people age, reaching as much as $45,000 for 80+ year olds.4

Considering that GDP per capita was about $46,800 in 2010 and the income inequality mentioned earlier, these are figures that would put most households in dire straits.

Also, structural trends will lead to an ever greater share of the nation’s income being dedicated to health care. Figure 5 above shows the evolution of the U.S. population for the 65+ age group, as forecasted by the U.S. Census Bureau. The U.S. will end up with a steadily increasing segment of its population (from 13% in 2010 to 20% in 2030) composed of persons aged 65 and over. This matters for two important reasons.

First, this means a smaller workforce contributing to GDP growth and paying taxes to support government programs. Second, and this is related to the first point, this trend will put tremendous pressure on social security and health care spending in the country, thus leading to structurally higher deficits.

These facts are by themselves troubling, but coupled with the population trends described in Figure 5, they become alarming. To illustrate the impact of overall population aging on total health care costs, we use the per capita numbers implied by the Deloitte study and apply them to the U.S. Census Bureau projections for all age groups. While we believe that those numbers fundamentally underrepresent health care inflation, we inflate per capita costs for each age group using the averagemedical carecomponent of the U.S. Department of Labor Consumer Price Index. Finally we assume a 4% nominal GDP growth, which some might argue is overly optimistic when taking into account the smaller workforce we discussed earlier. In any case, Figure 6 shows the results of our simulation.
Only with the change in the composition of the U.S. population, total health care costs are forecasted to go from 22% of GDP in 2010 to over 30% in 2040. These are huge numbers! To put them in perspective, in 2011 total U.S. GDP was $14,500 Billion, so an increase from 22% to 30% of GDP would represent a $1.2 Trillion increase in health care spending in that year. If we increase the health care inflation rate by only 100bps, we calculate that by 2040, the share of GDP attributed to health care will jump to 40%.

maag-1-2013-5.gifSource: US Census Bureau 2012 National Population Projections,U.S. Department of Commerce: Bureau of Economic Analysis, U.S. Department of Labor: Bureau of Labor Statistics & The hidden costs of U.S. health care: Consumer discretionary health care spending, Deloitte

According to the Deloitte study, about 60% of those costs are borne directly by households and the remaining 40% by the public sector (30% to Medicare and Medicaid). This means that households, of which the majority is either poor or in the declining middle class, will face an even larger squeeze in their discretionary spending.


To conclude, 20% of the population is on food stamps, an ever increasing gap between the wealthy and the rest and ever-increasing health care spending are all deep rooted and immensely important problems that get a ridiculous fraction of the attention that they deserve. The impact of these issues on both government finances and future economic growth are enormous.

As we discussed, the purpose of asset purchases by the Fed might no longer be improvements in the real economy, but rather a more subtle financing of U.S. government deficits. However, in the long run, expanding the money supply inevitably leads to inflationary pressures. Luckily for the Fed and the U.S. government, there is so much slack in the labour market that inflation might be years away.

And, if we are right about the long run unemployment rate being structurally higher, then the Fed has all the room it needs to continue Quantitative Easing (QE) to infinity. This might allow them to continue to hide the true financial position of the government for many years to come.

Nonetheless, the rising GAAP deficit and the sheer size of the U.S. Federal Government’s liabilities to its citizens makes it clear that one day or another, services (health care, social security) will have to be cut. Financial alchemy can hide reality, but it does not provide any tangible services.

Europe’s (unresolved) experience with its debt crisis provides an insightful window into the future. Austerity measures in Ireland, Portugal, Spain and Greece have caused tremendous pain to their citizens (25% unemployment rates) and wreaked havoc in their economies (double digit retail sales declines).

Are we going to ignore the obvious?

1See website of Professor Lawrence Kotlikoff of Boston Universityfor details: http://www.kotlikoff.net/opinions
2Updates to his calculations for FY2012 should be made available in the near future.
3Our calculations are similar to those carried by ShadowStats.
4Our calculations are similar to those carried by ShadowStats. http://www.shadowstats.com/

Bank of America issues `bond crash' alert on Fed tightening fears
The return of confidence and healthy growth in the US risks setting off a “bond crash” comparable to 1994 and triggering a string of upsets across the world, Bank of America has warned.
By Ambrose Evans-Pritchard

7:32PM GMT 24 Jan 2013

Taxis drive past a Bank of America branch in New York on February 23, 2009
Bank of America said the “Great Rotation” under way from bonds into equities closely tracks the pattern of 1994, with bank stocks leading the way. Photo: AFP

This happened in 1994 under Federal Reserve chief Alan Greenspan when yields on US 30-year Treasuries jumped 240 basis points over a nine-month span, setting off a “savage reversal of fortune in leveraged areas of fixed income markets”.

A similar shock this year is “likely” if the US economy continues to gather strength. “The moment we hear the first rhetorical talk of exit strategies by central banks this could turn,” said chief investment strategist, Michael Hartnett. There was already a whiff of this in the most recent Fed minutes.

“The period of Maximum Liquidity is close to an end. Yes, the Japanese reflation is gaining steam in 2013 but we regard this as the last of the great reflations. The big picture is a transition from deflation to normal growth and rates,” he said.

The 1994 bond shock - and seared in the memories of bond-holders - ricocheted through global markets. It bankrupted Orange Country, California, which was caught flat-footed with large bond positions. It set off the Tequila Crisis in Mexico as the cost of rolling over `tesobonoslinked to the US dollar suddenly jumped.
Most emerging markets now raise debt in their own currency but the effect of a worldwide tightening cycle could expose a host of problems. Frontier markets are attracting tremoundous capital inflows and this new carry trade could reverse quite violently. The risk of local bubbles bursting is high,” said Mr Hartnett.

Bank of America said the “Great Rotationunder way from bonds into equities closely tracks the pattern of 1994, with bank stocks leading the way.

Over the past seven years US investors have pulled $600bn from US equity funds and poured $800bn instead into bond funds. This process is going into reverse. Equity funds have drawn $35bn over the last 13 trading days alone, creating the risk of an unstable melt-up” in stocks over coming months.

The Bank for International Settlements has issued an alert on the high-yield `junk’ bonds and mortgage debt, currently trading at record lows. The Swiss-based watchdog said parts of the credit market credit are “highly valued in a historical context relative to indicators of their riskiness.”

The European Central Bank’s Mario Draghi warned earlier this month that leveraged buyouts and private equtiy deals are becoming frothy again.

Wall Street’s veteran technical analyst Louise Yamada said a whole generation of small investors has been lured into bonds since the stock market crash in 2008 in the belief that is a safe store of wealth, seemingly unaware of the risk once inflation returns. “I am quite concerned. It’s distrubing to see a lot of retirees who got stuck at the top of the stock market, now got stuck at the top of the bond market,” she said.

She says the world may be at a turning point comparable to 1946 when deflation was defeated and the last bear market in bonds began, though it is likely to be a slow process. She advises people to switch into shorter term maturities, citing a “bottoming process in rates, which means a topping process in price”.

The great question is whether the world economy really is at the start of a fresh cycle of growth, or whether the roaring asset rally of the last few months is another false dawn driven by central bank liquidity that is failing to gain economic traction.

The International Monetary Fund’s said this week that the world economy is not yet out of the woods. “It is clear that financial markets are ahead of the real economy. The question is whether they are too much ahead or not, whether we are seeing a bubble,” said chief economist Olivier Blanchard.

Albert Edwards from Societe Generale said the bullish mood has returned to the “heights of optimism last seen in mid-2007” even though the global and US profit cycles have both peaked, and some shipping indicators point to a further economic relapse.

Mr Edwards said the markets will be caught out yet again as the West slides deeper into the same deflationary trap as Japan and bond yields fall to historic lows.

Investors will have to wait a little longer for a “once in a life-timechance to buy stocks dirt cheap, he said.

January 24, 2013 6:59 pm
Fears over ECB longer-term funding scheme

Concern is mounting among senior bankers that the European Central Bank’s special longer-term funding scheme risks backfiring, stigmatising the region’s weaker banks a year after it was launched.

From the end of January banks have the opportunity to start paying back the cheap three-year money they borrowed under the ECB’s longer-term refinancing operation.

But with stronger banks expected to repay and weaker institutions still in need of the funds, bankers fear the early repayment window will hasten the advent of a two-tier banking market in the region, potentially reigniting eurozone nervousness just as sentiment is brightening.

“We will repay the money early,” said one bank boss. “But there is a risk that this creates a stigma for the banks that are left in.”

On Thursday, several banks announced repayment plans. They included Lloyds, which is repaying 75 per cent of the €13.5bn it took a year ago to finance its shrinking business in Ireland, Belgium and the Netherlands.

Germany’s Commerzbank stated publicly last year that it planned to repay early. And Société Générale is also planning a similar move. Some smaller Spanish banks pledged repayments too, though mostly only small portions of the funds borrowed.

Analysts expect between €100bn and €200bn of the total €1tn of LTRO money to be repaid in the first quarter of 2013, largely by banks from northern Europe. The funds carry a low interest rate of 75 basis points.

When it was launched by ECB president Mario Draghi in 2011, the LTRO was hailed as a decisive move to restore confidence in the financial system. Many stronger banks, which had been frozen out of bond markets, found commercial issuance became possible again, as investors were reassured by the ECB backstop.

Now, though, according to several top financiers at the Davos World Economic Forum, there is a growing impatience to exit the LTRO among banks that are flush with liquid funds. In some cases large chunks of banks’ ECB borrowing simply remain on deposit at the central bank, making the banks’ balance sheets inefficient.

Many lenders say they only signed up to take funding in the two-stage scheme, in December 2011 and February 2012, because they were encouraged to do so by the ECB in an effort to destigmatise the LTRO.

Jan Hommen, chairman of Dutch bank ING, which did not draw funds under the scheme, told the Financial Times: “We always felt there could be a stigma about it. That did not happen because Draghi persuaded so many people to participate but it could return now.”

Bankers and analysts believe that once the repayment trend among stronger banks takes hold, second or third-tier eurozone banks, particularly in the southern periphery in Europe, could look vulnerable.

Many have large amounts of non-performing loans and little or no access to capital markets. RBS analysts say another LTRO aimed at smaller banks is quite possible in the first quarter of 2013.

Copyright The Financial Times Limited 2013