KENWOOD, CA –
The Gold Report: Standard & Poor’s (S&P) has given a warning to the U.S. government that it may downgrade its rating by 2013 if nothing is done to address the debt and deficit. What’s the real impact of this announcement?
John Williams: S&P is noting the U.S. government’s long-range fiscal problems. Generally, you’ll find that the accounting for unfunded liabilities for Social Security, Medicare and other programs on a net-present-value (NPV) basis indicates total federal debt and obligations of about $75 trillion. That’s 15 times the gross domestic product (GDP). The debt and obligations are increasing at a pace of about $5 trillion a year, which is neither sustainable nor containable. If the U.S. was a corporation on a parallel basis, it would be headed into bankruptcy rather quickly.
There’s good reason for fear about the debt, but it would be a tremendous shock if either S&P or Moody’s Investor Service actually downgraded the U.S. sovereign-debt rating. The AAA rating on U.S. Treasuries is the benchmark for AAA, the highest rating, meaning the lowest risk of default. With U.S. Treasuries denominated in U.S. dollars and the benchmark AAA security, how can you downgrade your benchmark security? That’s a very awkward situation for rating agencies. As long as the U.S. dollar retains its reserve currency status and is able to issue debt in U.S. dollars, you’ll continue to see a triple-A rating for U.S. Treasuries. Having the U.S. Treasuries denominated in U.S. dollars means the government always can print the money it needs to pay off the securities, which means no default.
TGR: With the U.S. Treasury rated AAA, everything else is rated against that. But what if another AAA-rated entity is about to default?
JW: That’s the problem that rating agencies will have if they start playing around with the U.S. rating. But there’s virtually no risk of the U.S. defaulting on its debt as long as the debt’s denominated in dollars. Let’s say the U.S. wants to sell debt to Japan, but Japan doesn’t like the way the U.S. is running fiscal operations. It can say, “We don’t trust the U.S. dollar. We’ll lend you money, but we’ll lend it in yen.” Then, the U.S. has a real problem because it no longer has the ability to print the currency needed to pay off the debt. And if you’re looking at U.S. debt denominated in yen, most likely you would have a very different and much lower rating.
TGR: Is there a possibility that people would not buy U.S. debt unless it’s in their currency?
JW: It is possible lenders would not buy the Treasuries unless denominated in a strong and stable currency. As the USD loses its value and becomes less attractive, people will increasingly dump dollar-denominated assets and move into currencies they consider safer. And you’ll see other things; OPEC might decide it no longer wants to have oil denominated in U.S. dollars. There’s been some talk about moving it to some kind of basket of currencies-something other than the U.S. dollar, possibly including gold. This would be devastating to the U.S. consumer. You’d get a double whammy from an inflation standpoint on oil prices in the U.S. because the dollar would be shrinking in value against that basket of currencies.
TGR: Different countries are starting to discuss the creation of an alternative to the USD as reserve currency. How rapidly could an alternative currency appear?
JW: That would involve a consensus of major global trading countries; but just how that would break remains to be seen. Let’s say OPEC decides it no longer wants to accept dollars for oil. Instead, it wants to be paid in yen. It’s done. It’s not a matter of creating a new currency-it’s a matter of how things get shifted around.
TGR: What other commodities or monetary issues would that create?
JW: Again, the dollar’s weakness is doubly inflationary. It is the biggest factor behind the ongoing rise in oil prices. Let’s say you’re a Japanese oil purchaser. Oil, effectively, is purchased at a discount in a yen-based environment due to the dollar’s weakness. Usually, the market doesn’t let such advantages last very long. As the dollar weakens, you see upside pressure on oil prices. If, hypothetically, you’re pricing oil in yen, there’s no reason for anybody to hold the USD. The dollar would sell off more rapidly against the yen and oil inflation would be even higher in a dollar-denominated environment.
TGR: You’ve mentioned that hyperinflation will happen as soon as 2014. If that is true, wouldn’t OPEC want to shift off dollar pricing as quickly as possible?
JW: From a purely financial standpoint, that would make sense. Other factors are at play, though, including political, military and unstable times in both North Africa and the Middle East. Those who are able to get out of dollars, I think, will do so rapidly and as smoothly as possible.
TGR: And how will they do that?
JW: They will sell their dollar-denominated assets. They will convert dollars to other currencies. They will buy gold. Generally, they will dump whatever they hold in dollars and sell the dollar-denominated assets they don’t want. There’s a market for them; it’s just a matter of pricing. As the pressure mounts to get out of the USD, the pricing of dollar-denominated assets will fall, which in turn would intensify that selling. The dollar selling will intensify domestic U.S. inflation, which is one factor that picks up and feeds off itself and will help to trigger the hyperinflation.
TGR: The U.S., even in recession, is still the largest consuming economy. If the U.S. continues in, or goes into a deeper, recession, doesn’t that impact the rest of the world?
JW: If the U.S. is in a severe recession, it will have a significant negative economic impact on the global economy. That doesn’t necessarily affect the relative values of other currencies to the USD. If you look at the dollar against the stronger currencies, a wide variety of factors are in effect-including relative economic strength. The U.S. is probably going to have an economy as bad as any major country will have, with higher relative inflation. The weaker the relative economy and the stronger the relative inflation, the weaker will be the dollar. Relative to fiscal stability, the worse the fiscal circumstance in the U.S., the weaker is the dollar. Relative to trade balance, the bigger the trade deficit is, the weaker the currency. As to interest rates, the lower the relative interest rates in the U.S., the weaker will be the dollar.
Part of the weakness in the dollar now is due to the way the world views what’s happening in Washington and the ability of the government to control itself. That’s a factor that may have forced S&P to make a comment. So, even having a weaker economy in Europe would not necessarily lead to relative dollar strength.
TGR: If the U.S. experiences a continued, or even greater, recession, doesn’t that impact spill over into Canada?
JW: The Canadian economy is closely tied to the U.S. economy, and bad times here will be reflected in bad times in Canada. However, I’m not looking for a hyperinflation in Canada. Its currency will tend to remain relatively stronger than the U.S. dollar. Canada is more fiscally sound; it generally has a better trade picture and has a lot of natural resources. Keep in mind that economic times tend to get addressed by private industry’s creativity and, thus, new markets can be developed. For instance, you’re already seeing significant shifts of lumber sales to China instead of to the U.S.
TGR: What about the effect on other countries?
JW: The world economy is going to have a difficult time. You do have ups and downs in the domestic, as well as the global, economy. People survive that. They find ways of getting around problems if a market is cut off or suffers. I view most of the factors in Canada, Australia and Switzerland as being much stronger than in the U.S. Even when you look at the euro and the pound, they’re generally stronger than in the U.S. Japan is dealing with the financial impacts of the earthquake. There’s going to be a lot of rebuilding there. But, generally, it’s a more stable economy with better fiscal and trade pictures. I would look for the yen to continue to be stronger. Shy of any short-term gyrations, the U.S. is really in the worst condition of any major economy and any major country in the world and, therefore, in a weaker currency circumstance.
TGR: Then why are media analysts talking about the U.S. being in a recovery?
JW: You’re not getting a fair analysis. There’s nothing new about that. No one in the popular media predicted the recession that was clearly coming upon us, and the downturn wasn’t even recognized until well after the average guy on Main Street knew things were getting bad. We have some particularly poor-quality economic reporting right now. The economy has not been as strong as it advertised. Yes, there has been some upside bouncing in certain areas, but it’s largely tied to short-lived stimulus factors.
Let’s look at payroll numbers and the way those are estimated. In normal economic times, seasonal factors and seasonal adjustments are stable and meaningful. What’s happened is that the downturn has been so severe and protracted it has completely skewed the seasonal-adjustment process. It’s no longer meaningful, nor are estimates of monthly changes in many series. The markets are flying blind-it’s unprecedented, in terms of modern reporting.
Are we really seeing a surge in retail sales? If so, you should be seeing growth in consumer income or consumer borrowing-but we’re not seeing that. The consumer is strapped. An average consumer’s income cannot keep up with inflation. The recent credit crisis also constrained consumer credit. Without significant growth in credit or a big pick-up in consumer income, there’s no way the consumer can sustain positive economic growth or personal consumption, which is more than 70% of the GDP. So, you haven’t started to see a shift in the underlying fundamentals that would support stronger economic activity. That’s why you’re not going to have a recovery; in fact, it’s beginning to turn down again as shown in the housing sales volume numbers, which are down 75% from where it was in normal times.
TGR: But we were in a housing boom. Doesn’t that make those numbers reasonable?
JW: Housing starts have never been this low. Right now, they are running around 500,000 a year. We’re at the lowest levels since World War II-down 75% from 2006-and it’s getting worse. I mean the bottom bouncing has turned down again. We’re already seeing a second dip in the housing industry. There’s been no recovery there.
In March, all the gain in retail sales was in inflation. Retail sales are turning down. You’re going to see a weaker GDP number for Q111. The GDP number is probably the most valueless of the major series put out; but, as the press will have to report, growth will drop from 3.1% in Q410 to something like 1.7% in Q111.
TGR: You’ve stated that the most significant factors driving the inflation rate are currency- and commodity-price distortions-not economic recovery. Why is that distinction important?
JW: The popular media have stated that the only time you have to worry about inflation is when you have a strong economy, and that a strong economy drives inflation. There’s such a thing as healthy inflation when it comes from a strong economy. I would much rather be in an economy that’s overheating with too much demand and prices that rise. That’s a relatively healthy inflation. Today, the weak dollar has spiked oil prices. Higher oil prices are driving gasoline prices higher-the average person is paying a lot more per gallon of gas. For those who can’t make ends meet, they cut back in other areas. The inflation of Q410, which is now running at an annualized pace of 6%, was mostly tied to the prices of gasoline and food.
You also have higher food prices. It’s not due to stronger food or gasoline demand-it’s due to monetary distortions. Unemployment is still high, even if you believe the numbers. I’ll contend the economy really isn’t recovering. At the same time, you’re seeing a big increase in inflation that’s killing the average guy.
TGR: Why isn’t there more pressure on the U.S. government to reduce the debt deficit?
JW: When you get into areas like debt and deficit, it’s a little difficult to understand. The average person, though, should be feeling enough financial pain that political pressure will tend to mount before the 2012 election; but whether or not the average person will take political action remains to be seen. I don’t think you have until 2012 before this gets out of control and there’s hyperinflation. It could go past that to 2014, but we’re seeing all sorts of things happening now that are accelerating the inflation process.
TGR: Like the dollar at an all-time low.
JW: If you compare the U.S. dollar against the stronger currencies, such as the Australian dollar, Canadian dollar and Swiss franc, you’re looking at historic lows. You’re not far from historic lows in the broader dollar measure.
TGR: In your April 19 newsletter, you stated, “Though not yet commonly recognized, there is both an intensifying double-dip recession and a rapidly escalating inflation problem. Until such time as financial market expectations catch up with the underlying reality, reporting generally will continue to show higher-than-expected inflation and weaker-than-expected economic results.” What do you mean by “until such time as financial market expectations catch up with the underlying reality?”
JW: A lot of people look closely at and follow the consensus of economists, which is looking at (or at least still touting) an economic recovery with contained inflation. I’m contending that the underlying reality is a weaker economy and rising inflation. I think the expectation of rising inflation is beginning to sink in. Given another month or two, I think you’ll find all of a sudden the economists making projections will start lowering their economic forecasts. Instead of looking at half-percent growth in industrial production, they’ll be expecting it to be flat; if it comes in flat, it will be a consensus-and the markets will be pleased it wasn’t worse in consensus. But the consensus outlook will have shifted toward a more negative economic outlook.
TGR: Do you think economists will shift their outlooks before we get into hyperinflation or a depression?
JW: In terms of economists who have to answer to Wall Street, work for the government or hold an office like the Federal chairman, by and large, they’ll err on the side of being overly optimistic. People prefer good news to bad news. If Fed Chairman Ben Bernanke said we were headed into a deeper recession, it would rattle the market. People on Wall Street want to have a happy sales pitch. What results may have little to do with underlying reality.
TGR: In your April 15 newsletter, you mentioned that a signal of an unfolding double-dip recession is based on the annual contraction of the M3, which was the Fed’s broadest measure of money supply until it ceased publishing it in 2006. Recent estimates show that the annual contraction of M3 went down from 4.3 in February to 3.6 in March. Is this good news?
JW: No. It doesn’t have any particular significance as a signal for the economy. You do have recessions that start without M3 going negative year over year. In the last several decades, every time the M3 went negative, there followed a recession-or an intensifying downturn-if a recession was already underway. If you tighten up liquidity, you tend to tighten up business conditions. Again, though, you’ve had recessions without those signals. When it goes positive, it does not signal an upturn in the economy. It doesn’t make any difference if it continues negative for a year or two, or if it’s negative for three months. The point is-when it turns negative, that’s the signal for the recession.
We had a signal back in December 2009, which would have indicated a downturn sometime in roughly Q310. We already were in a recession at that point. According to the National Bureau of Economic Research, the defining authority in timing of the U.S. business cycle, the last recession ended in June 2009. So, this current recession will be recognized as a double-dip recession. The Bureau doesn’t change its timing periods.
I’ll contend that we’re really seeing reintensification of the downturn that began in 2007. Although it’s not obvious in the headline numbers of the popular media, you’ll find that September/October 2010 is when the housing market started to turn down again. That is beginning to intensify. We’ll see how the retail sales look when they’re revised. When all the dust settles, I think you’ll see that the economy did start to turn down again in latter 2010. Somewhere in that timeframe, they’ll start counting the second or next leg of a multiple-dip recession.
TGR: Does M3 have anything to do with calculating potential inflation or hyperinflation?
JW: It does; but when you start looking at the inflation picture, you also have to consider that we are dealing with the world’s reserve currency and the volume of dollars both outside and inside the U.S. system. Right now, M3 is estimated at somewhat shy of $14 trillion. You have another $7 trillion outside the U.S., which is available for overnight liquidation and dumping into the U.S. markets. It’s not easy to measure how much is out there, but that has to be taken into account to assess the money supply related to inflation. Again, that’s where the Fed chairman’s policies come into play.
Efforts have been afoot to weaken the U.S. dollar. Usually with the weakening of the U.S. dollar, you see increased repatriation of dollars from outside the system. If everyone is happy holding the dollars, the flows can be static; but when they start shifting and the dollars are repatriated, you begin to have currency problems. That’s when you have the money supply and the inflation problems we’re beginning to see.
TGR: This has been very informative, John. Thank you for your time.
Walter J. “John” Williams has been a private consulting economist and a specialist in government economic reporting for 30 years, working with individuals and Fortune 500 companies alike. He received his AB in economics, cum laude, from Dartmouth College in 1971 and earned his MBA from Dartmouth’s Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar. John, whose early work prompted him to study economic reporting and interview key government officials involved in the process, also surveyed business economists for their thinking about the quality of government statistics. What he learned led to front-page stories in the New York Times and Investor’s Business Daily, considerable coverage in the broadcast media and a joint meeting with representatives of all of the government’s statistical agencies. Despite a number of changes to the system since those days, John says that government reporting has deteriorated sharply in the last decade or so. His analyses and commentaries, which are available on his ShadowStats website have been featured widely in the popular domestic and international media.
Article published courtesy of The Gold Report – www.theaureport.com