Banana Republic!


By Puru Saxena    
September 29, 2006

BIG PICTURE –The US is widely adored as the world’s greatest empire, yet few realise that the emperor has no clothes.  As the masses look up to the nation in admiration, they are fooled into believing that it is swimming in wealth; the reality being that it is up to its eyeballs in debt.  The US economy is living on borrowed time and judgement day is inevitable.  No nation in history has ever managed to escape such economic imbalances and I suspect the US won’t get away with it either.  Let’s take a look at how this imaginary cloak has been woven:  

The economic recovery since the 2001 recession has been manufactured by excessive credit-growth and consumption.  For the first time ever, a central bank has purposely engineered a credit bubble with the intention of bringing artificial prosperity via rising asset-prices.  The Federal Reserve dropped interest-rates and the majority of Americans became the proverbial kids in the candy store, unable to resist the temptation of cheap credit.  This is evident from the fact that over the past 6 years, US household debt soared from $6.99 trillion to almost $12 trillion – a staggering increase of 70%!  However, some economists today discard this record debt-explosion as irrelevant because the net-worth of US households over the same period has surged from $42 trillion to roughly $54 trillion (largely due to the housing boom).  In other words, due to rampant credit and leverage in the economy, asset-prices have risen much more rapidly than debt levels.  But the key question is whether this is sustainable and at what cost?

In my opinion, asset-prices can continue to rise for a long time if there are willing borrowers and a central bank armed with an endless supply of credit.  However, you have to understand that rising asset-prices only give the illusion of prosperity.  The truth is that rapid monetary inflation and credit growth always impoverish a society as money becomes abundant and therefore less valuable.  So, everyone may feel richer as their homes and stock portfolios appreciate in value, but it’d be a mistake to confuse rising asset-prices in an economy with real wealth creation.  After all, wealth is a relative concept and if everyone else’s homes have also risen in value, how wealthy have you really become?  
Given the levels of debt in the US, I have no doubt that the Federal Reserve wants to keep the game going for as long as possible.  It will achieve this by continuing to inflate the supply of money and credit.  Under this scenario, the US dollar will surely depreciate against other major world currencies and especially against precious metals whose supply can’t be increased at the same pace.          

In order to assess the US economy’s prospects, the most important issue to understand is that the recent economic expansion hasn’t been typical.  The US wage growth has been extremely poor and the capital spending by American companies has also been dismal.  In fact, real disposable income growth is now almost zero and over the past 5 years, capital spending has increased by a paltry 12%.  So far, the US consumer alone has carried the baton through record-high indebtedness and consumer-spending; with home prices no longer appreciating, you have to wonder where the future borrowing-power will come from. 

In my view, the US looks more and more like a bubble economy, a banana republic of some sorts, which is desperate for ever-rising asset-prices for its very survival.  Should American home and stock prices stall, let alone decline, the fate of this great bubble will be sealed.  Depreciating asset-prices will act like a dagger in the heart of this artificial recovery, so the Federal Reserve must continue to inflate at all costs.
Figure 1 clearly shows that in the US, the total debt as a percentage of GDP is currently at an all-time high.  It is worth noting that the last time the US faced a meaningful contraction in debt relative to the size of its economy, it coincided with the depression years of the 1930’s.  So, you can bet your farm that Mr. Bernanke & Co. will try their best to avoid a repeat of such a disaster by continuing to aid deficit spending through their ultra-loose monetary policies.           

Figure 1: Gigantic debt-bubble in the US!

Source: Ned Davis Research

With the US consumer leveraged to the hilt, the fate of the US economy now lies with its corporations and its government.  For sure, American companies have recently registered great profits and are flush with cash, however so far they haven’t shown any willingness to spend their money – capital spending is non-existent and wages haven’t increased in line with the inflation-rate.  At least the American government has been more “responsible” by contributing to the economy through the deficit spending program surrounding the various wars being fought – albeit under false pretences!        

CREATIVE ACCOUNTING – “Lies, damn lies and statistics” – Mark Twain

The world is littered with statistics which, more often than not, are misleading and distort the truth.  In this regard, the “official” statistics released by the US establishment are no different.  Take the US budget for example.  The budget reported in the media claims that the deficit was reduced to $319 billion in 2005.  However, the Financial Report issued by the Department of Treasury says it was $760 billion, or over twice as large.  “But how come?” you may wonder. It is fascinating to note that the US budget process meant for general reporting uses accounting procedures that ignore long-term, future obligations such as Social Security and Medicare.  The US keeps two sets of books, only wanting the world to see one of them.  The “President’s Budget,” issued by the Office of Management and Budget and used to develop the annual budget, is based on cash-accounting. The other set of accounts, the “Financial Report of the United States,” issued by the Department of the Treasury, uses a more realistic accrual-basis accounting.  It is interesting to note that the US Federal law requires ALL businesses with revenues in excess of $5 million to use accrual accounting, yet the budget figures released to the public don’t follow this rule. Take a look at Figure 2, which summarises the Financial Report issued by the US Treasury taking into account the future obligations of the federal government.  According to this report, the US budget deficit is now at a record-high!

Figure 2: The real US budget-deficit!

Source: Department of Treasury, US

Next, let’s review the strange US unemployment numbers released in the media.  Since the end of the recession in November 2001, reported employment growth is up moderately, which makes it the worst performance during any post-war economic recovery.  However, closer inspection reveals that even this small reported growth in employment is an absolute joke.  The reported official unemployment figures don’t include those people who’ve given up looking for a job (due to non-availability of jobs), joined a university or taken a part-time job since they can’t find full-time employment.  When you add all these people, the real rate of unemployment is closer to 10%.

Finally, the biggest “Cover-Up” award must go to the officials who determine the Consumer Price and the Producer Price Indices (CPI and PPI).  These “inflation-barometers” are a total fraud!  Remember, the Federal Reserve’s biggest motive is to conceal the ongoing inflation and manage the inflation expectations, or else the viability of the Federal Reserve itself may come into question.  Therefore, both the consumer and producer prices are massaged, seasonally and hedonistically adjusted to keep inflationary fears under check.  So, by keeping the CPI and PPI artificially suppressed via voodoo accounting and understating the inflation menace, the Federal Reserve maintains the public’s confidence in the US dollar as a great store of value.  After all, as long as the masses continue to believe in the “inflation-controlling” powers of the Federal Reserve and the other central banks, the more inflation and credit they can create!

In summary, the US economy isn’t in good health and eventually the monetary stimulus and injections of liquidity will fail to revive this terminally ill patient.  Accordingly, I advise you to minimise your exposure to American assets.  On other hand, tangible assets (especially precious metals) and mining stocks represent a great opportunity for the medium to long-term investor.  Despite the recent pull-back, the long-term bull-market is still intact and I anticipate a rally over the coming 6-8 months.  Accordingly, this is an ideal time to add to your positions in precious metals as well as mining and commodity-producing companies.

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Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication available at

An investment adviser based in Hong Kong, he is a regular guest on CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.