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The Promises Must Be Broken



June 18, 2010 – Comments (7)

Another good article by Steve Saville. This is a bad situation: Many people depend on these entitlements but there is absoulutely no way all of the entitlements can be honored. Not even close. This is another fundamental reason why we will have a sovereign debt crisis: 1) We have a failed financials system that is only functioning today because of serious ad-hoc changes made to basic accounting rules, 2) Massive defecit spending is the only reason for the growth observed (i.e. it is unsustainable), 3) Demographics - a huge portion of the population is entering into retrirement (much more than is entering into the workforce) which reduces tax revenues and puts downward pressure on assets that retires need to live on and 4) The culmination of points 1-3, the government has put all three points on its balance sheet.... except the government does have any wealth. We have unfunded entitlements plus a national defecti that are 5 times GDP, we have a GDP that is unsustainable (consumer based and all recent growth is driven by stimulus dollars that we borrowed into existence), and a declining tax base.

Saville makes good points about the entitlements to begin with, that they are fradulent on a basic level, and I find it very difficult to escape this conclusion. But even beyond that, even if we were to try to pay for these entitlements via debt monetization (the key wording being 'try'), the result would be massive and extended economic devastation. The Dollar is the reserve currency, currently, but that does not mean we can monitize and devalue with impunity. And for those that argue that the Federal Reserve Note will stay the reserve currency because America's economy is the largest and most productive, they really don't know why it became the reserve currency to begin with.

"In 1931, President Roosevelt confiscated all privately-held gold in the US.  Following the confiscation, the US government first offered to pay USD 17, and then USD 35, an ounce for foreign gold. A substantial portion of the world’s gold was sold to the US, and every dollar outside the US was convertible into gold. It was these two elements, the fact that the US owned a large percentage of the gold and that the dollar was convertible into gold, that enabled the US dollar to become the world’s reserve currency. When, in 1971, President Nixon reneged on the US’s promise to redeem paper dollars into gold it was too late for the rest of the world. There were too many dollars in circulation already and no other major currency could take the dollar’s place as reserve currency. At that point, it was also impossible for governments to return to the gold standard, as this would have caused astronomical gold prices. Hence, the US dollar remained the reserve currency, not because of the US’s large and powerful economy, or its monetary and fiscal policy, but merely as a remnant of the time when the currency was backed by gold" [SOURCE].

The US Dollar earned reserve currency status to begin with because it was backed by real assets. It has stayed that way for the past few decades due to liquidity, inertia/laziness, and uncertainty regarding a better alternative. But the rest of the world will not accept massively devalued promises (Federal Reserve Notes) in order for the US Governement to attempt to cover promises it can't make good on to begin with. But since the Government, Treasury and Fed have given every indication that they will try anyways, hence we will have a soverign debt crisis. In this game of chicken, the market will not be the one that blinks first.

There are simply too many obligations and not enough production to cover those obligations. Unfortunately, I think this is a foregone conclusion.


The Promises Must Be Broken
Steve Saville
15 June 2010

Many governments, including those of the US, Japan, and most euro-zone countries, have made extremely costly promises to provide entitlements to their citizens and to repay their creditors. These promises must be broken, firstly because they cannot be kept and secondly because they should not be kept.

It should be blatantly obvious to anyone with a basic knowledge of finance that the promises cannot be kept. The government of Japan, for example, has amassed liabilities to bondholders amounting to two-times the country's annual gross domestic product (GDP), and on top of the debt that has already been issued there is an unknown (to us) -- but undoubtedly large -- quantity of "unfunded" (off-balance-sheet) liabilities associated with various entitlement programs such as social security. Taking another example, within the next 12 months the liability to bondholders amassed by the US federal government will exceed one-times GDP, but when the so-called "unfunded" liabilities are added to the equation it can be seen that the total present value of all US government promises to pay is already more than 5-times GDP. Considering other examples, the debt-related predicaments of the "PIIGS" governments are well known, but less well known is that the governments of both France and Germany have total (on- plus off-balance-sheet) liabilities exceeding 4-times GDP. So, what's the point of pretending that these liabilities will ever be covered?

There is not only no point pretending, it is dangerous to pretend. It is dangerous because attempting to keep alive the illusion of solvency necessitates theft on an increasing scale, either directly via more taxation or indirectly via more inflation. A case in point is the plan put together by Europe's political leadership with the aim of preventing the Greek government from immediately defaulting on its debt. This plan involves higher taxes in Greece, the transferring of Greek government obligations from private bondholders to other governments, and debt monetisation (inflation) by the ECB, but leaves the overall debt burden the same. It therefore wastes resources, confiscates savings and reduces economic growth for the sole purpose of delaying the 'day of reckoning'. Another case in point is the claim made by a famous economist (Joseph Stiglitz) to the effect that the large and rapidly-growing debt burden of the US federal government won't lead to a default thanks to the government's ability to print whatever amount of money it needs. It is true that the US government could turn to the printing press (with the help of the Fed), but it is vital to understand that an attempt by the US government to use monetary inflation to cover the bulk of its liabilities would, in effect, be an attempt to surreptitiously transfer tens of trillions of dollars of wealth from the most productive parts of the economy to bondholders and the recipients of entitlements. This type and scale of wealth transfer would destroy the dollar and devastate the economy, all for the sake of maintaining an illusion.

It is argued that the direct default by a government would eliminate that government's future access to the debt market, which is true. But that would be a huge positive rather than a negative. The world would be a better place if governments were not able to access the debt market. For one, there would be much less chance of war.

It is also argued that government promises must somehow be 'made good' because many people have come to depend on these promises. In particular, many people have paid taxes and social security contributions throughout their working lives on the understanding that the government would provide them with certain payments and other benefits after they retired. The problem with this argument is twofold. First and as explained above, it is not possible to make good on the promises. The promises will eventually have to be broken, the only question relates to how much more damage will be done in the period between now and when default is confirmed. Second, a wrong cannot be made right by committing another wrong. To be more specific, while it is certainly wrong that promises were made that could never be kept, this wrong cannot be corrected by stealing more money from savers and current taxpayers.

Some governments now appear to be coming around to the realisation that their debt situations are untenable, and are introducing "austerity measures" in response. However, while such measures could prevent the debt problem from worsening in the short-term they don't address the main issue, which is that current debt levels are already so high that default or major restructuring is both essential and inevitable.

The bottom line is that the promises made by governments will have to be broken and should be broken, the sooner the better.

7 Comments – Post Your Own

#1) On June 18, 2010 at 10:32 PM, russiangambit (29.45) wrote:

> The bottom line is that the promises made by governments will have to be broken and should be broken, the sooner the better

The entitlements will be paid via slow dilution of USD. I don't see China abandoning USD any time soon.As long as this siamise union US-China exists the things will continue as is with US quality of life slowly decresing due to dollar dilution and domesitc policies that discorage productive activities. The only risk I see is some sort of an abrupt crisis in China. But I don't know China well enough to make a prediction one way or another. If China tumbles, US will be left high and dry. 

All the posturing by Russia such as buying gold is irrelvant. Russia is not big enough to do anything. And their relationships with chinese are rather strained . So China will not side with Russia in this paticular fight. I think I alredy posted last year tht Putin was trying to convince chinese at the hight of financial crisis to sell US tresuries and chinese refused.

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#2) On June 19, 2010 at 12:07 AM, binve (< 20) wrote:

russiangambit ,

Hey russian!

>>The entitlements will be paid via slow dilution of USD.

Fair enough. But I think this overused option will not work so well in the future. And I do hear what you are saying about Russia, China, and (I would surmise) Saudi Arabia, etc., but I think we will have some interesting developments in the next couple of years that changes this dynamic. My $0.02. Thanks!..

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#3) On June 19, 2010 at 12:08 AM, atarigod (< 20) wrote:

Much of what is being said is correct except for the first point, "serious ad-hoc changes to accounting rules". No one ever talks about the other side of the coin, mark-to-market is complete and utter BS. A more accurate architecture would be based on a cash-flow basis of accounting. Mark-to-market is useless because companies misstate asset values on the way up and then are inaccurately punished on the way down. Take it from a CPA & MTAX, anyone who complains about "serious accounting changes" doesn't know anything about accounting in the first place. Sorry for the rant, all the whining about accounting changes just annoys me to no end.

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#4) On June 19, 2010 at 12:14 AM, binve (< 20) wrote:

atarigod ,

Fair enough. But like I wrote here Of Modeling, Risk, Financial Innovation, and Liquidity Crises -

So why did these models perform so poorly? Why was risk so grossly under-represented?

Because the financial systems these risk models are trying to describe are also extremely non-linear

Models such as Value at Risk / VAR are fine for short term forecasts where the liquidity environment is known. But leverage greatly alters the liquidity environment and a very small change in leverage can completely change how liquid any asset is. Does that change its underlying value? YOU BET IT DOES!. An MBS is worth the fully securitized cost only if somebody is willing to pay you that amount for it. And if liquidity is only available to purchase that asset in a highly leveraged environment, then its value is a function of liquidity and leverage. Regarding Economic Debates and Opinions: The Fallacy of "Purely Objective" Analysis -

Additionally these models looked at housing risk simply from a historic default rate standpoint, without considering the possibility of a massive fall in the underlying assets (housing prices) and how that would further impact the default rate. (Effects combining in a very non-linear fashion).

Maybe you think market to market is flawed. Fine. But I think you would have a uphill battle in justifying the mark to imagination system we have now..

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#5) On June 19, 2010 at 12:26 AM, atarigod (< 20) wrote:

Oh, I in no means are trying to insinuate that the current system is good. I am just trying to say that what they are currently doing is not really all that different than what they were doing before. Values were grossly overvalued before and are grossly overvalued today. I just do not buy the fact of people saying accounting rule changes are propping up the financial system. I am in 100% in the same camp you are in regards to the unimaginable problems we face.

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#6) On June 19, 2010 at 12:30 AM, atarigod (< 20) wrote:

I hope you do not take my post as some sort of a dig. I personally love your blogs and respect your work.

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#7) On June 19, 2010 at 10:52 AM, binve (< 20) wrote:

atarigod ,

>>Oh, I in no means are trying to insinuate that the current system is good. I am just trying to say that what they are currently doing is not really all that different than what they were doing before.

I can definitely buy that. In market to market, at the height of the market the market values were nosebleed insane, and we are just pretending that they are still worth that.

>>I just do not buy the fact of people saying accounting rule changes are propping up the financial system.


>>I hope you do not take my post as some sort of a dig. I personally love your blogs and respect your work.

No worries. Thanks! I appreciate that!..

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