In a recent interview, Boston University economics professor Laurence Kotlikoff gets right to the point:
“Forget the official debt,” he tells Aaron in this clip. The “real” deficit – including non-budgetary items like unfunded liabilities of Medicare, Medicaid, Social Security and the defense budget – is actually $202 trillion, the professor and author calculates; or 15 times the “official” numbers.
“Congress has engaged in Enron accounting,” says Kotlikoff, who recently penned an op-ed for Bloomberg entitled: The U.S. Is Bankrupt and We Don’t Even Know It.
The fact that real US debt greatly exceeds what is publicly advertised is nothing new to readers of the The Financial Panner. The “real” deficit was outlined last fall in “The Empire’s Silent Default” which was a review of Sprott Asset Management’s September 2009 investment newsletter.
What is new, however, is the growing focus on the bubble in US Treasury Bonds, which Kotlikoff also touches on:
Yet, the debt market continues to have an insatiable appetite for U.S. Treasuries; heading into Monday’s session, the yield on the 30-year Treasury bond (which moves in opposition to its price) was at its lowest level since April 2009.
Kotlikoff says that’s because the market is focused on the “mole hill” of official debt. In time, the U.S. will have a major inflation problem to rival that of Germany’s post World War I Weimar Republic, he predicts. “We have to think about the fact that unless the government gets its fiscal act in order we’re going to have the government printing lots and lots money to pay these enormous bills that are coming due over time.”
One of the reasons interest rates are so low is that investment dollars all over the world are flooding into US bonds in a perceived safety play. Once investors begin to accept the fact that the unofficial debt position of the United States makes it the next Greece, US bonds will no longer function as the “flight to safety” cash parking lot they currently are.
The realization of this inevitable outcome and the rush out of bonds that will result is exactly how a hyperinflationary situation could materialize. Recently, an article titled “How Hyperinflation Will Happen” (posted on zerohedge.com), proposed a possible hyperinflationary scenario which is sparked from a rush out of bonds.
The author first correctly defines, and therefore delineates between inflation and hyperinflation. The explanation provided is widely accepted in the majority of the resources reviewed by The Financial Panner.
But hyperinflation is not an extension or amplification of inflation. Inflation and hyperinflation are two very distinct animals. They look the same – because in both cases, the currency loses its purchasing power – but they are not the same.
Inflation is when the economy overheats: It’s when an economy’s consumables (labor and commodities) are so in-demand because of economic growth, coupled with an expansionist credit environment, that the consumables rise in price. This forces all goods and services to rise in price as well, so that producers can keep up with costs. It is essentially a demand-driven phenomena.
Hyperinflation is the loss of faith in the currency. Prices rise in a hyperinflationary environment just like in an inflationary environment, but they rise not because people want more money for their labor or for commodities, but because people are trying to get out of the currency. It’s not that they want more money – they want less of the currency: So they will pay anything for a good which is not the currency.
The following are key highlights:
So this is how hyperinflation will happen:
One day – when nothing much is going on in the markets, but general nervousness is running like a low-grade fever (as has been the case for a while now) – there will be a commodities burp: A slight but sudden rise in the price of a necessary commodity, such as oil.
This will jiggle Treasury yields, as asset managers will reduce their Treasury allocations, and go into the pressured commodity, in order to catch a profit. (Actually it won’t even be the asset managers – it will be their programmed trades.) These asset managers will sell Treasuries because, effectively, it’s become the principal asset they have to sell.
It won’t be the volume of the sell-off that will pique Bernanke and the drones at the Fed – it will be the timing. It’ll happen right before a largish Treasury auction. So Bernanke and the Fed will buy Treasuries, in an effort to counteract the sell-off and maintain low yields – they want to maintain low yields in order to discourage deflation. But they’ll also want to keep the Treasury cheaply funded. QE-lite has already set the stage for direct Fed buys of Treasuries. The world didn’t end. So the Fed will feel confident as it moves forward and nips this Treasury yield jiggle in the bud.
The Fed’s buying of Treasuries will occur in such a way that it will encourage asset managers to dump even more Treasuries into the Fed’s waiting arms. This dumping of Treasuries won’t be out of fear, at least not initially. Most likely, in the first 15 minutes or so of this event, the sell-off in Treasuries will be orderly, and carried out with the idea (at the time) of picking up those selfsame Treasuries a bit cheaper down the line.
However, the Fed will interpret this sell-off as a run on Treasuries. The Fed is already attuned to the bond markets’ fear that there’s a “Treasury bubble”. So the Fed will open its liquidity windows, and buy up every Treasury in sight, precisely so as to maintain “asset price stability” and “calm the markets”.
The Too Big To Fail banks will play a crucial part in this game. See, the problem with the American Zombies is, they weren’t nationalized. They got the best bits of nationalization – total liquidity, suspension of accounting and regulatory rules – but they still get to act under their own volition, and in their own best interest. Hence their obscene bonuses, paid out in the teeth of their practical bankruptcy. Hence their lack of lending into the weakened economy. Hence their hoarding of bailout monies, and predatory business practices. They’ve understood that, to get that sweet bail-out money (and those yummy bonuses), they have had to play the Fed’s game and buy up Treasuries, and thereby help disguise the monetization of the fiscal debt that has been going on since the Fed began purchasing the toxic assets from their balance sheets in 2008.
But they don’t have to do what the Fed tells them, much less what the Treasury tells them. Since they weren’t really nationalized, they’re not under anyone’s thumb. They can do as they please – and they have boatloads of Treasuries on their balance sheets.
So the TBTF banks, on seeing this run on Treasuries, will add to the panic by acting in their own best interests: They will be among the first to step off Treasuries. They will be the bleeding edge of the wave.
Here the panic phase of the event begins: Asset managers – on seeing this massive Fed buy of Treasuries, and the American Zombies selling Treasuries, all of this happening within days of a largish Treasury auction – will dump their own Treasuries en masse. They will be aware how precarious the U.S. economy is, how over-indebted the government is, how U.S. Treasuries look a lot like Greek debt. They’re not stupid: Everyone is aware of the idea of a “Treasury bubble” making the rounds. A lot of people – myself included – think that the Fed, the Treasury and the American Zombies are colluding in a triangular trade in Treasury bonds, carrying out a de facto Stealth Monetization: The Treasury issues the debt to finance fiscal spending, the TBTF banks buy them, with money provided to them by the Fed.
Whether it’s true or not is actually beside the point – there is the widespread perception that that is what’s going on. In a panic, widespread perception is your trading strategy.
So when the Fed begins buying Treasuries full-blast to prop up their prices, these asset managers will all decide, “Time to get out of Dodge – now.”
Note how it will not be China or Japan who all of a sudden decide to get out of Treasuries – those two countries will actually be left holding the bag. Rather, it will be American and (depending on the time of day when the event happens) European asset managers who get out of Treasuries first. It will be a flash panic – much like the flash-crash of last May. The events I describe above will happen in a very short span of time – less than an hour, probably. But unlike the event in May, there will be no rebound.
Notice, too, that Treasuries will maintain their yields in the face of this sell-off, at least initially. Why? Because the Fed, so determined to maintain “price stability”, will at first prevent yields from widening – which is precisely why so many will decide to sell into the panic: The Bernanke Backstop won’t soothe the markets – rather, it will make it too tempting not to sell.
The first of the asset managers or TBTF banks who are out of Treasuries will look for a place to park their cash – obviously. Where will all this ready cash go?
The Financial Panner believes this path is a near lock given the amount of capital currently parked in US Treasury Bonds. The bond rush backfire that will result once floodgates open could be staggering.