The Pointy End of a Crisis

Gold as the "ultimate extinguisher" of debt...

GOLD, oil, stocks...you name it, writes Dan Denning in Melbourne, Australia for The Daily Reckoning – pretty much everything was down on Friday in the United States and the Dow broke its eight-day winning streak, still on light volume.

And the market's reaction after the US House of Representatives passed the Senate health care bill? More of the same, except stocks bounced courtesy of healthcare providers.

Say what you'd like about the proper role of government in your life. But no matter which way your politics lean, it's clear that making expansive social promises is an expensive business. Someone has to pay for these things. Whether it's business, rich people, or the unborn children of the next three generations (debt), someone has to pay.

It does seem a little odd that America is expanding the Social Welfare State at just the moment the whole experiment seems to be collapsing in Europe. It's amazing no one is taking Greece more seriously. It's as if investors and pundits are convinced this is just a run of the mill deficit problem and not an indication that the finances of the Welfare State are hopelessly compromised and failing.

Perhaps fiscal collapse lies in the eye of the beholder. But we reckon it's a more tangible phenomenon. Either your finances are sound or they are not. Either your money is sound or it is not. Come to think of it, either your civilization is sound, or it is not.

That might sound like hyperbole. But according to America's self-described "No.1 political prisoner", Martin Armstrong, the Western world's fiscal malfeasance has left it trapped between two equally undesirable but unavoidable outcomes: default of civil unrest. We are at the pointy end of the crisis (Phase Two as he describes it). Yet very few people seem to appreciate what's actually happening.

In his latest missive, Armstrong points out that the structure of the European Monetary Union – twelve economies, twelve difference fiscal policies, one interest rate [Ed.: 16 actually, but Armstrong has been inside since the Euro launched in 2000...] – made this day inevitable.

"The EC is in dire position and a debt crisis at [the] sovereign level and the CFTC move to limit currency trading by the public from 100:1 to 10:1 can cause a liquidity crisis that backfires, magnifying everything."

You have to unpack Armstrong's analysis a bit to see what he's getting at. This is just our interpretation. But we think he's suggesting that the sovereign debt crisis in Europe will lead to rising interest rates (borrowing costs) in the debtor countries. He says the interest rate rises will "cause only an outflow of national wealth."

That is, faced with a sovereign fiscal crisis, investors in Europe will head for the exits and take their money with them. This would explain (and predict) a short-term US Dollar strength. But this reaction is also just the sort of thing government's want to avoid. And they can begin to do so with capital controls and restrictions on cross-border currency transactions.

Hence the move by the Commodities Futures Trading Commission above, mooted in January, that would reduce retail leverage from 100:1 to 10:1. The target here is currency speculation, although one wonders why the retail investors are the target and not institutions. Besides, is excessive leverage in currency trading really the cause of the Greek crisis?

Armstrong fears capital controls and reduced leverage could create a liquidity crisis.

"I have burned my brain raw trying to come up with a solution. But there is only one! A complete restructure that is a debt for equity swap. Debts will never be paid and interest expenditures are the greatest transfer of wealth in history. This is causing rising rising taxes in all areas from Europe to the US, suppressing economic activity, fuelling higher unemployment and civil unrest. Western society is falling apart."

It may not look or feel that way if you're dialled in to American Idol or getting your Dream Team ready for the footy season. But Armstrong has many points worth considering. For starters, he makes the deflationists point that in a world with too much debt, the only instruments that can cancel that debt are worth buying.

As we understand them, this is the main reason the deflationists are bullish on the US Dollar and near-cash US Treasury notes. On the other hand, Professor Antal Fekete, whom we had the pleasure of meeting at last year's Gold Standard Institute annual conference in Canberra, reckons that "gold is the only ultimate extinguisher of debt." This is presumably why central banks have been net accumulators of gold recently.

Whether the Dollar rallies or Gold Price rallies, or the Dollar crashes and gold rallies, or everything falls...it's clear that something has to be done with the debt. There are no more rugs large enough to sweep it under. Europe needs a bigger rug.

The rug that just might conceal the debt problem is the debt-for-equity swap Armstrong refers to. This is a bit like the "bad bank" we mentioned recently for the US mortgage market. But building a new institution of the transmogrified debt of an institutions or a government is not exactly cutting edge financial alchemy. It's old school hokus pokus.

The South Sea Company was capitalized with nearly £10 million in British government debt which was then resold as interest-bearing units to investors. Voila! Debt becomes equity becomes capital. The government got its debt financing in exchange for trading concessions in South America granted to the company. This is what investors expected to produce huge returns, and what generated a premium (bubble) in the company's shares.

How would a scheme to convert sovereign debt or mortgage debt into equity work today? Who knows? Only the government would be stupid enough to buy shares in a company capitalised by bad debts. But we live in such times. So it's not a huge leap to predict it will happen.

The shareholders will be the "public." And the securities will be backed by the underlying assets (houses, or the government's promise to pay.) The interest will be paid in some new scrip, or in America, perhaps by a new GST or VAT. If the Fed or Europe can pull out a debt-equity swap that cleans up bank/national balance sheets without undermining currency confidence or leading to spiralling interest rates, it will be the greatest magic trick ever.

But if not?

"If we do not act, civil unrest will explode," Armstrong finishes. "The current choice is default or higher taxes and civil unrest...As Europe weakens, the Dollar, Dow, and Gold would rise. When the debt concerns then turns to the US, the Dollar will get hit only then."

So there is no Dollar crisis yet. But if you care to acknowledge it, there IS a Euro crisis. And if you think we're just wearing our tin-foil hat today, keep in mind that IMF deputy managing director John Lipsky has also warned that the finances of the fiscal welfare state are not exactly healthy.

In remarks delivered in Beijing and reported by the Wall Street Journal, Lipsky said the advanced economies need to begin reigning in deficits now, even if economic recovery remains in doubt. He said that, "Merely winding down the stimulus won't come close to bringing deficits and debt ratios back to prudent levels, considering the projected increases in health care and other entitlement spending."

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