The Truth About America’s Debt Downgrade… and How You Can Profit

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What a week.

What more is there to say?

A lot, apparently. First to Europe.

The Germans are getting jittery. And their newspapers may be partly to blame:

Will the stock markets tear us into the abyss today?’ – Bild Zeitung.

Is the world going bankrupt?’ – Der Spiegel print issue.

How is the world economy supposed to continue?’ – your editor’s German Grandma in an email.

Why do you care about Germany? Well, it’s the only remaining source of hope for a debt-laden Europe. But don’t be too optimistic. Many Germans, including your editor’s Grandma, are sick of seeing their Chancellor ‘blow money up other countries’ backsides’.

And as for the European Central Bank’s new money printing, well… Germans are taught a rhyme in primary school about the fact that money printing causes inflation. So don’t expect that policy to be popular.

On a more positive note, we’ve found a share for you to buy: McGraw-Hill publishing company (NYSE: MHP)

You see, it’s all got to do with Standard and Poor’s downgrade of American bonds. Apparently, lending to the US government is no longer risk free. Famed investor Jim Rogers aptly said this was ‘not news. It’s not even old news. It’s just not news.’ More importantly, for our stock tip, the downgrade throws an entire generation of economics and finance textbooks out of date (or too obviously out of date to keep ignoring). McGraw-Hill publishes many of those economics and finance textbooks. And they’ll require new editions. Which could mean a serious increase in demand for textbooks is coming McGraw-Hill’s way.

And here is what makes us so sure it’s a good bet: Standard and Poor’s is a subsidiary of McGraw-Hill. In other words, the whole downgrade thing is just a conspiracy to sell textbooks.

(This latest educational expense increase also means even more students will be turning to more desperate measures to pay their education expenses, as covered last week.)

Some have said the S&P downgrade is just symbolic. But for symbolism, you should look no further than the plane that was hired to fly around New York City towing a sign that read ‘Thanks For The Downgrade. You Should All Be Fired.

It’s unlikely the employees of S&P who the message was intended for got the message. That’s because they work 5585 kilometres away, in London…

There are several important – and serious – implications of the S&P downgrade. The lack of an obvious choice for a risk-free asset and risk-free rate creates some intriguing problems for the finance profession. Whether it’s the Black-Scholes Option Pricing Model, the Capital Asset Pricing Model, bond pricing models, or just plain old net present value calculations, all refer to US bond interest rates as their choice for the risk-free rate. And all those models use that rate in their calculations for determining stock, bond and derivative prices. In other words, all those models will go haywire now that US debt is no longer AAA rated. And that creates a big mess for the finance world and markets.

From an investor’s point of view, there are no longer any definitive safe havens. Of course, US Treasury bonds remain quite safe in the sense that you will get your cash. It’s just a question of what that cash will be worth by the time you get it. Put differently, the chances of a Federal Reserve Chairman standing up to the politician who appoints him and refusing to print money to buy bonds is quite small. And that’s no secret. But more money means existing money is worth less.

In Europe, they are already a step ahead towards this backwardness. They’re creating more money to buy bonds. European Central Bank President Jean-Claude Trichet has his ‘bazooka’ out, according to Bloomberg. And that’s not in the sense fellow Frenchman Dominique Strauss Kahn had his out in New York a few months ago. It’s in the sense of a money spilling bazooka pointed at the Italian and Spanish bond markets.

But the rally in response to the announcement of more liquidity proved short lived. The bazooka turned out to be more like the Maginot line. Bond vigilantes went around it and invaded France – the next in line to have its budget called into question.

Speaking of bazookas, has anyone seen Charlie Wilson’s War lately? It’s a movie about Russia invading Afghanistan in the 1980s. The turning point of that war, according to the movie, was when the Mujahedin figured out how to shoot down Russia’s helicopters. Well, an American politician figured it out and gave the freedom fighters the guns and the money to do it.

The moral of that war was how the Mujahedin won it. They bled Russia dry of money and morale. Several years later, Bin Laden’s bunch has stated their goal is the same. But with the Americans in their sights.

Over the weekend, the parallels between the Soviets and the Americans became stark. S&P downgraded America’s debt and the Taliban shot down a helicopter full of soldiers belonging to the same ‘team’ that killed Bin Laden.

A turning point? Ironies abound, either way.

Daily Reckoning editor extraordinaire Bill Bonner and executive publisher Addison Wiggin wrote a book called Empire of Debt (2006), in which they outlined the source of America’s dominance – debt. But now that empire is no longer AAA. And the outlook isn’t good either.

That means something else will take its place. And this kind of change usually isn’t peaceful. That’s why Marc Faber, along with other respected forecasters, are predicting war. The Western world’s problems are so bad they would only ‘go away’ (i.e. be deferred to the next election cycle) if we can find a bigger distraction.

Here comes the part where we upset several readers.

Your editor has never been patriotic. We’re not sure which country to be patriotic for. The country of our birth, citizenship, or citizenship by choice (i.e. residence for tax purposes…)?

All three are enthusiastic war mongers. And all three treat your editor like a criminal at customs, no matter which passport we use.

So what’s a libertarian to do? Move to Switzerland?

Atlas Shrugged fans will note that the book wouldn’t have been very good if the protagonist had abandoned uncivilised society in favour of civilised seclusion early on. So it’s up to us to stick around and watch in fascination.

And what better place to do so than in a country with an un-popped housing bubble? Then there’s the Aussie resources sector, which is reliant on that Chinese construction bubble.

But don’t worry, our ‘fundamentals are strong’, says Treasurer Wayne Swan. (And he said it about four times during the Bloomberg interview.)

You’d think he’d come up with something better. It’s the same phrase the Greeks, Irish, Portuguese, Italians and now French use. And look at them!

****

An Australian Mises Seminar – 25th-26th November

Join leading libertarians and Austrian economists for a dinner and seminar in Sydney.

To find out more, visit https://mises.org.au/

***More thoughts…

Most money nowadays isn’t cash. It’s just a bunch of numbers on computer screens. And that money came into existence by being lent into existence. Banks don’t have the money they lend, they only have reserves. And they are a small percentage of the funds they lend.

All these factors come into play during a debt deflation. Consider this: If one million people pay off $1000 of their credit card debt at the same time, that wipes $1 billion off the money supply.

It’s gone.

Normally, there are about one million people borrowing more than $1000 at the same time, making the net effect positive. That’s how governments and central bankers create GDP growth… By fiddling with interest rates. But eventually, an economy maxes out its credit card. And the trend changes… We pay off more debt than we rack up. That implies the money supply begins shrinking.

All this applies to all personal debt, corporate debt and government debt.

And here is the kicker: A shrinking money supply implies deflation. That in turn makes debts harder to pay back. Things get really serious when the effects of deflation outweigh the speed at which people are able to pay off their debt.

That’s the scenario of the debt deflationists. They might tell you to invest in treasuries for some time yet. But what of the inflationists?

Well, we may have come up with a new trade of the decade for the sneakier amongst them.

Short gold futures, go long physical gold.

Sound stupid?

Here’s how it would play out (ideally).

Because people invest in gold as an inflation hedge, when serious inflation begins, they will want to be able to hold the physical metal. Right now, large investors often use gold futures, which settle in cash, not gold. In other words, when the gold price goes up, the gold futures buyer will get $$$, not gold. Sometimes futures buyers do elect to take delivery, but that gets complicated. Because as people figure out there is far less physical gold than there are futures, they will panic.

As mentioned, gold investors invest in gold as anti-cash. So if they’re getting paid cash for their profitable futures positions – and inflation picks up – it won’t help them. At some point, this will make futures far less attractive relative to investing directly in the physical stuff in a vault. The prices will diverge. Maybe dramatically.

The beauty in this is that you can use a short position to finance a long position. In other words, selling a gold future short gives you cash in hand. Cash that can be invested in the physical stuff.

The cost of maintaining a short futures, long physical gold position is probably quite high. But as things heat up at the central banks of the world, this one could be a real winner.

Until next week,

Nick Hubble
Daily Reckoning Australia Weekend

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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Comments

  1. So what’s a libertarian to do? Move to Switzerland?
    No
    The answer is Mozambique or Namibia.

    Reply

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