By Shanmuganathan Nagasundaram
The “fiscal cliff” in the US that business channels talk about is not the real cliff we need to worry about. I don’t think it is even a cliff. It is at best a fleeting bump – at least compared to the real ones that lie ahead.
The irony is that the supposed fiscal cliff is part of the solution that the US needs to undertake to avoid the bigger cliffs that lie ahead, which we will refer to later. The ability of the powers-that-be to label this very simple concept – of balancing the books in an out-of-control government – as being detrimental to the health of the nation is laughable. That this outlandish theory is naively accepted by the media and the corporate sector is astounding.
Avoiding/bypassing the fiscal cliff will only make the subsequent real cliffs that much deeper – and the accompanying pain that much more agonising. That said, I have very little doubt that the US will avoid the fiscal cliff – they will pass some tax increases that will kick in after a few years and some spending cuts that will kick in after a few decades, and bingo, the fiscal cliff would be averted. There may be some nail-biting last minute “principle preserving” give-and-take, but this only means US politicians share the predilection for a climax as much as Bollywood directors.
This brings us to the real cliffs. For starters, the most pressing cliff is the fiscal deficit cliff. While the reported deficit of $1 trillion is big enough and ultimately causes the US Fed’s balance-sheet to expand at an alarming rate, the real deficit is closer to $6 trillion (using GAAP accounting standards instead of accrual accounting’ source: shadowstats.com). For similar reasons, the official US debt of $16 trillion discounts the real debt which stands at well over $200 trillion, by an even wider margin.
But how are the above numbers going to manifest themselves in the markets? I believe that in 2013 we will see the rumblings of a “bond cliff” and, sooner rather than later, a “ US dollar currency cliff”.
We have witnessed quite a few bubbles in the recent past – the Nasdaq bubble and the US housing bubble. But in terms of sheer size and magnitude, the US treasury bubble (and consequently, a worldwide bond bubble) dwarfs anything that we have seen until now. Bonds that are seen as a safe-haven for the last few years have the most risk-averse people from around the world investing in them. By not understanding the nature of the risks they are exposing themselves to, these investors stand exposed to a major write-down of their capital in the months/years ahead.
The principal reason for that would be the QE4 (quantitative easing) announcement made by US Fed Chairman Ben Bernanke at the last meeting of the Federal Open Markets Committee (FOMC). How anybody would lend anything for 10 years or longer to a bankrupt government at less than 2 percent interest, especially when the US Fed has made its intentions explicit to monetise the deficits, is beyond me.
On the inflation target for raising rates, Bernanke essentially borrowed from Alice in Wonderland to say in effect: “Inflation is what I say it is and future estimates of inflation are what I want them to be.” How else can we interpret his statements that transitory international commodity prices shouldn’t be factored while calculating consumer price increases. Although, even by Bernanke’s own liberal standards, the movement of the last 10 years in the CRB index can hardly be described as “transitory”. He has essentially promised the ventilator-like 0 percent interest rates till there is a bond cliff.
But a word of caution on the timing — if somebody had told me five years back that the official deficits would be well in excess of $1 trillion and that the Fed would be monetising a major chunk of the deficits, and that long-term interest rates would be less than 2 percent, I would have said “nuts”! It just doesn’t mean that the laws of economics are not valid… but simply because economics is about “human action”, predicting the timeline of events is especially fraught with risk. After all, as long as the US Treasury/Fed can maintain the illusion of safety in the US dollar, the game can continue. It just doesn’t mean that the game will continue forever.
If 2008 witnessed a Black Swan in terms of the credit crisis, conditions are very ripe for a much bigger “bond cliff” in 2013 (though terming the bond cliff as a Black Swan would be a mistake, in the sense that it is very obvious – much as the housing bubble in the US was, the collapse of which lead to the banking and credit crisis).
For various reasons, the bond crisis could first manifest itself in one of the smaller countries of the developed markets rather than US itself – and my guess, at this point, is that Japan would be the likely candidate given their own attempts at QE as well as their continued purchases of US treasuries. After that, it would only be a question of time before the crisis spreads to the US.
Where is the safety?
Despite 12 straight years of gains, I believe that the price of gold remains quite undervalued in comparison to the amount of fiat currencies that have been created. So gold should continue to remain the core of an investor’s holdings to avoid the ongoing implosion in the purchasing power of fiat currencies. This process will only get accelerated in the months and years ahead.
So why the rather subdued performance of gold in 2012? If, at the start of the year, we had known about the QE series planned by Bernanke, then $2,000 per ounce would have been a very reasonable, if not modest, target for gold. But inspite of Bernanke having done more than what the gold bugs would have dreamt of in their wildest imaginations, the reactions have been muted.
Two possible answers indicate the “not-for-profit” actions leading to the above situation. First is the white paper from Sprott Asset titled “Do western central banks have any gold left?” and the second is the analysis by Ted Butler (butlerresearch.com) indicating the concentrated precious metals short positions in the future markets by the top four participants, particularly JP Morgan.
On both fronts, I think the manipulation of precious metal prices by and on behalf of the US/UK central banks have pretty much reached the end of the road. So we should witness much higher returns from gold than what we witnessed in the previous decade.
Shanmuganathan “Shan” Nagasundaram is the founding director of Benchmark Advisory Services – an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of International Man. He can be contacted at firstname.lastname@example.org