Sunday, July 18, 2010

United States Debt Default

"The greatest trick the devil ever pulled, was convincing the world he didn't exist."
                                                                      -Keyser Soze

The most important important topic of this decade will be if and when the United States defaults on its debt, and what impact that will have on the world. (Economy, Markets, Wars)

Many believe the United States has 15-20 years before the day of reckoning.  Others watch every auction thinking this could be the one.

Before I go further let me explain what default means.  In a normal environment (Greece) a country would default if no one shows up to purchase their debt at auction.  They can no longer roll over the existing debt they owe.  They would have to declare bankruptcy and then pay out some percentage to lenders based on their current tax receipts.

The United States today has the reserve currency of the world.  This means that most transactions around the world are completed in dollars, which has been a huge boost to the US economy for decades.  Why? Because it has allowed us to borrow far more money than would otherwise be possible.  This borrowing has boosted the economy year after year.

Think of if you took out an extra $20,000 on your credit card every year to take vacations and buy things.  This would be a nice boost to your lifestyle.

We also have a Federal Reserve here in America which means a formal default (discussed above) is extremely unlikely.  If there was ever a time when the US could not raise debt from the public or foreign countries, the Federal Reserve stands ready to purchase an unlimited amount of debt.

So the question is, how close are we to the point where the Federal Reserve is the dominant buyer of debt?  How close are we to this "informal" default? (This situation is not an if, but a when, as it is now not possible to pay off what is owed without depreciating the currency)

It is crucial to watch who is buying our debt today.  Let's look at the three main buyers:

1.  The American Public

Americans for the past 12 months have been taking their money out of stock mutual funds and putting it into bond mutual funds.  A large portion of those bonds are US treasuries. (US government debt) This has created what is called domestic savings.

2.  Commercial Banks

The Federal Reserve has allowed commercial banks to borrow hundreds of billions of dollars at 0% interest to help heal their balance sheets after the credit crisis.  The banks have not lent this money out to businesses or real estate, they have lent this money to the Federal government.  They have become the second major buyer of debt.  It is also a great situation for the banks; borrow at 0% from the Fed and collect 4% from the government in interest. 

As you can probably tell, this is just another way for the Fed to print money and buy bonds.  Only they are doing it through the banks.  This is important to watch because the Fed is playing a game of sleight of hand that is not visible to the untrained eye.  There is one other optical illusion they are using today:

3.  Foreign Buyers

This week we received the Treasury International Capital (TIC) report that shows what foreign countries are purchasing our debt and how much they are buying.

The money to fund our spending for years has come from China and Japan.  They are export oriented countries that run a massive trade surplus, giving them extra money every year to invest.  They have always put their money back into America because it has always been considered safe and because it keeps the value of their currencies artificially lower, thus helping their exports.

Things have changed, however, over the past 18 months and this most recent report was no different.

China dumped $33 billion treasuries in the month of May (the data is released two months in arrears) and Japan offloaded $9 billion.  They are now net sellers.

So the obvious question is, if they are selling, who is buying?  It is the UK.  They purchased $28 billion in the month of May and their US debt holdings have risen from $180 billion in December to $350 billion in the month of May.  Their holdings are now growing exponentially.

Here is the secret to the optical illusion:  The UK has no money.  They are currently in a debt crisis similar to Spain and Portugal.  They have no ability to purchase $170 billion of US debt over 6 months, they can barely pay their own bills and are in the process of an austerity program.

We know this buyer is not China purchasing debt through the UK, and we also know it is not hedge funds.  Hedge funds make their purchases through offshore accounts in Caribbean banking centers which saw an increase of $14 billion in treasuries in the month of May.

The buyer is the Federal Reserve.

Can you now see the full picture?

The Federal Reserve is printing money and giving it to commercial banks at 0%, who then are lending the money to the US government.

They are also purchasing the debt through the UK to stay hidden from the public eye.

The United States is not 15 years away from its informal default, it is happening today, right in front of us.  You only need a trained eye to see the illusion.

Warren Buffett made news this week when it was discovered he was reading a book titled "When Money Dies", a book about Wiemar Germany and their hyperinflation in the early 1920's.

One of the most fascinating parts about that period is that the Germans had no idea they were on the verge of hyperinflation just weeks before it arrived.  In fact, it was a consensus that they were in a deep deflation because the economy was so bad.  Behind the scenes, however, their central bank was secretly printing money to purchase debt to pay for war reparations.  The hyperinflation arrived in an instant, like someone turning on a light, when it was discovered what the government was doing.

This is why it is crucial to keep a portion of your wealth in precious metals today as insurance. (At least 10%)  Then take the time to study history, study what is happening in the world today, and make your own decision on if you should purchase more.

The United States debt default will be the most important news event of this decade, and possibly this century, as it will reshape the world around us.  I will continue to provide real time information on this topic as it develops.

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