5 Economic Lessons All Investors Must Learn

The US avoided default this week. But that's not the end of the drama...

DID ANYONE seriously think for even a second that the US was about to default? asks David Galland, managing director at Casey Research.

Of course, in time the US government (along with many others) will default. However, they are highly unlikely to do so by decree or even through the sort of legislative inaction recently on display. Rather, it will come about through the time-honored tradition of screwing creditors via the slow-roasting method of monetary inflation.

Yet most people still bought into the latest drama put on by the Congressional Players – a troupe of actors whose skills at pretense and artifice might very well qualify them for gilded trophies at awards banquets. Instead, rather than glittering statuettes, these masters of the thespian arts settle for undeserved honorifics and the pole position at the public trough. Followed by lifelong pensions.

But to the heart of the current matter, do I think that the latest antics out of Washington will have any more lasting effect on the trajectory of the economy than what I had for breakfast this morning?

Absolutely not. Sorry to say, but the trajectory of the economy at this point is well established, and closely resembles that of a meteor streaking through the night sky. What's left of the solid matter of the nation's accumulated private wealth is fast being burned off by an unstoppable inferno of government spending, inevitably leading to an earth-shaking crash.

I make this dire prediction not out of an aberrant psychology (I hope), but rather due to certain fundamental truths about our current situation.

And that brings me to the five things you need to know about the US economy (much of which also applies to the other large developed nations)…

1. The US remains in the grip of a debt-induced depression. While personal levels of debt have eased somewhat since the crash, most of the improvements have come at the expense of debt repudiation, and are offset by the steep decline in housing prices that have left something like 50% of mortgages underwater. Meanwhile the debt on the balance sheets of the US government and the country's largest financial institutions remain at record highs – and much of that debt is toxic.

So, what's the one thing that the heavily indebted – individual or institution – most fears? Answer: Rising interest rates.

2. Interest rates can't stay low. Despite the debt, interest rates remain near historic lows – which is to say, well below the norm. At some point they have to at least revert to the mean, which would push the 10-year treasury rate north of 5% from current rates below 3%. But in reality, the levels of monetary inflation, the nature of the debt, and mind-numbing scale of the government's other financial obligations – in total upwards of $70 trillion – all but guarantee that interest rates must go much higher than 5%. That in turn torpedoes the half-sunk real estate market and risks kicking off a debt death spiral as higher interest payments suck the financial juice out of the economy and causes debtors to demand even higher rates. 

The last time the US economy found itself in such dire straits was back in the 1970s, when the problem was raging price inflation. Back then, though, the debt levels were considerably lower than they are now. Then, Fed Chairman Paul Volcker had the latitude to raise rates and by so doing helped to choke out inflation. 

By contrast, today the Fed is virtually helpless. Rates certainly can't be pushed lower by any appreciable amount, and the Fed sure as hell doesn't want them to go up. While the Fed has been a primary factor in controlling interest rates up to this point in the crisis, in the near future the direction of interest rates – particularly long-term rates – will increasingly be determined by skittish market participants. Specifically, the sovereign and institutional buyers whom the US Treasury so desperately needs to keep showing up at their auctions.

To use a metaphor, the situation today is akin to a bunch of gunfighters facing off in a dusty street, hands poised over their six-shooters, eyes nervously shifting this way and that – to the Eurozone, to the housing markets, to the situation in Japan, to the US government spending, to the crumbling balance sheets of the banks, to the Fed. Everyone is anxiously watching, waiting for someone else to start making the first move. The standoff can't last – and when the lead starts flying, there will be few places to hide.

3. There is no non-disruptive way to resolve the debt. I can't stress this point enough. Simply, there is no magic wand that can be waved in order to make the debt go away. In order for this crisis to end, someone's ox has to be gored, and gored badly.

Yet, because we live in a democracy, where any politician wanting to be re-elected has to cater to their constituency – and politicians make their careers by being re-elected – it is considered business as usual for the denizens of Washington to hand out bread and put on circuses. It is this situation that has brought us to this place in the first place.

But it is the flip side of that equation that provides a clear signal as to where things are headed. Namely that politicians will jump through every possible hoop in order to avoid making politically unpopular decisions – even if they know that failing to act will have serious and lasting negative consequences for the nation. The trick is to make sure that those consequences only become acute during the next guy's watch.

The key point is that there is no easy fix, and there is no politically convenient time to take the draconian measures needed to rebalance the budget and get the nation's finances in order. To actually take the measures needed to curb the deficits, let alone reduce the debt, would be political suicide.

So despite a lot of talk blowing out of Washington, if you have to make a bet, bet on the crisis continuing and getting worse. Greece provides a reasonable look at how things are likely to unwind. And the problems in Greece – problems which will increasingly include social unrest – are far from over. As I write, lenders are starting to pressure Italian bond yields up, clearly indicating the Eurozone's problems are only going to worsen, as will those of the US as we move toward systematic breakdown.

4. The monetary system is irretrievably broken and will be replaced. For a recent edition of The Casey Report I interviewed monetary scholar Edwin Vieira, who pointed out that every 30 to 40 years the reigning monetary system fails and has to be retooled. The last time around for the US was in 1971, when Nixon cancelled the convertibility of Dollars into gold. Remarkably, the world bought into the unbacked Dollar as its reserve currency, but only because that was the path of least resistance. But here we are 40 years later, and it is clear to anyone paying attention that the monetary system is irretrievably broken and will fail.

What will replace it is still unclear, but I suspect that when the stuff really hits the fan and inflation rages the government will try the approach taken by the Germans to end their hyperinflation back in the 1920s, coming up with the equivalent of the Rentenmark – a Dollar that is loosely linked to some basket of commodities and financial instruments. 

It won't be convertible, because it would be impossible for bank tellers to exchange your Dollar for a cup of oil, and a coupon off of a bond, and a chip of gold, or whatever makes up the basket – but it might restore some semblance of confidence in the currency. That's one option. Another is that some government decides to make its currency convertible into precious metals; but that will only happen when all other less fiscally restraining systems have been floated and failed. Simply, at this point we can't know what will replace the current monetary system, or when. All we can know is that the status quo cannot and so will not survive this crisis.

Between now and the point in time where the Fed throws in the towel on today's fiat monetary system, you would have to be naïve in the extreme not to expect volatility, uncertainty, and wholesale financial dislocations.

5. The government is not your friend. Another simple truth is that the politicians, being just average humans, will always look after themselves first. They are well aware how difficult it is becoming to kick the can down the road and are only growing more desperate. And as the economy worsens and cries from the masses grow for the government to do "something," the politicians will grow more desperate still.

As should now be clear to anyone, today's political apparatuses are not operating based on any core principles – other than getting members of the government re-elected, that is. Thus the government of the US and all the highly indebted Western nations are free to do almost anything in the name of the "public good." Exchange controls? Higher taxes on the productive elements of society? Deliberate debasing of the currency? Outright confiscations for regulatory infractions? All of that – and literally anything else that helps mollify the masses and continue the charade – is likely.

Ironically, the worse the situation gets – and today's GDP data again confirm the weakness in the economy – the greater the demands will be from the public for the government to do more, even though the government was mostly responsible for bringing us to this place. And so the government's reach into your private affairs, and especially your finances, will only grow.

As this coincides with the rapid deployment of new monitoring technologies and procedures that allow the US government in particular to cast its Sauron-like eye into every nook of the globe, the free flow of capital and legal avoidance of whatever new taxation schemes are passed will become increasingly challenging.

Summing up…

Unless and until the deficits and the debt are tangibly dealt with, expect things only to worsen and prepare accordingly. As there will never be a good time to deal with the debt, the situation will continue to deteriorate until there is a systematic breakdown.

Inflation remains the only politically viable way to continue the charade. Pretty much anything tangible will help offset the coming inflation, though the monetary metals of gold and silver will likely do better than most.

There is a lot of cash floating around. As equities are representative of a tangible (i.e., a share in an operating company), selective equities – especially those that provide essential services – will probably do okay, even if only keeping up with the inflation. 

Those of precious metals companies should do much better than that, but again, being selective is key because a lot of these companies actively pursue policies that are not advantageous to shareholders, most importantly steadily diluting existing shareholders by regularly issuing large swaths of new shares. While we expect volatility, and probably even sharp sell-offs, these should be considered as potential opportunities to fill in your portfolio with high quality resource companies.

Diversification across two or more political jurisdictions also makes a lot of sense to me. There is no place you can invest which doesn't entail taking some risk at this point, but that fact only adds weight to the argument for spreading your assets around.

Finally, it's important to remember that, as far as we know, you only live once. In some ways the transition we are going to live through is going to be pretty exciting. Perilous, certainly, but exciting as well. If you take the right steps, you should come out much better than most.

But if you overly obsess about this stuff – or the latest disingenuous move by the politicians – it will drive you crazy. Thus, it's better to take the steps necessary to get in sync with the fundamental factors driving today's troubled economy and then get on with your life.

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