Is the US Economy out of the Dark Woods –

Think Again……

The US economy has improved in the 1st quarter 2012, with stock markets returns being more than stellar. The Dow Jones Industrial Average was up 7%, S&P500 up 11% and NASDAQ leading the way, up 17%. Clearly confidence had improved and ‘risk on’ investing was back. Now it is the economies turn. The challenge of the hypothesis that the economy would follow the lead of the stock market is questionable at best. There were some marked improvement in consumer confidence and spending; manufacturing seems to be coming to life; and most importantly the economy was creating jobs. As much as this picture sounds rosy, the details reflect a somewhat different picture.

Mild improvement did occur in a number of economic indicators but one has to recognize that they were improving from a horrible baseline. A minor bounce was due in the economy given the trillions injected into it by both the Federal government and the Federal Reserve. Federal Reserve Chair Bernanke has pushed up his balance sheet (creation of money into the economy) to about $3 trillion.

This kind of monetary creation is unprecedented in history. Also, during the bull run from the 2003 to the high in 2007, the two central banks (Feds and European Central Bank) were fueling both the stock market liquidity and the real estate bubble with growth in their balance sheets. Bottom line is they were printing money, a lot of it to liquefy the system. President Obama has shown no belief or need to lower the deficit to a more manageable level – he clearly has taken a path of protecting and adding to entitlements and safety nets in the difficult economic environment the US has been stuck in. Clearly he inherited a great deal of deficit policies and momentum through the Bush administration as well as the weakest economy since the great depression of the 1930’s.

The Federal Government debt will hit $16 trillion this year, going up by about $6 trillion dollars during

the Obama administration. This deficit and debt growth is unsustainable. During the 2011 year, there was a major shift in buying trends for US government debt. Major international purchases have historically been led by China (held $1.15 trillion US treasuries at end of 2011) and Japan ($1.04 trillion balance on December 31st, 2011). Both Asian nations appear to be shifting and moving away from being primary buyers of US bonds. China actually sold off $16 billion of bonds in the last six months of 2011. Also, the last two years have seen little growth in China purchases of US government debt. Japan has to re-patriot funds as they have a deteriorating economy, with a debt to GDP ratio of more than 200%. Where will future buyers come from? Well in 2011, 61% of all new issues of US government debt were purchased by the Federal Reserve, clearly a trend that cannot go on forever. In theory, the government is required to pay back the Feds, but that is highly unlikely. Monetizing debt creates two devastating economic situations – high inflation and a depreciating dollar.

Leading Foreign Holders of US Treasury Securities as of January 2012

Economic Areabillions of dollars (est.)

ratio of owned US debt to domestic GDP (est.)

percent change since January 2011

Mainland China 1,159.5 16.6% +0.4%

Japan 1,079.0 18.4% +21.8%

Oil exporters1 258.8 n/a +20.1%

Brazil 229.1 9.1% +19.8%

Caribbean Banking Centers2

227.8 n/a +37.8%

Sources: International Monetary Fund, World Economic

Debt in billions

OutlookRecent and Budgeted* US Federal Debt Source US Government Spending.com

Government debt and Central Bank money creation has been the reason for the artificial rallies in the stock and commodity markets since the financial fallout 2007-09. The real economy has seen minor improvements and appears to be rolling over to the downside once again. Real estate continues to stagnate and there are signs that it may further deteriorate in late 2012 onward. This is due to prices continuing to fall, demand soft, and foreclosures to increase significantly in 2012. "Perhaps a million foreclosures could have been pursued last year but weren't," said Rick Sharga, executive vice president for real estate investment company, Carrington Holdings. But that's all about to change, he said. "We're going to see an increase in the speed of foreclosures and a higher number of foreclosure starts." The stimulus is the $26 billion mortgage settlement agreed to by the nation's five largest mortgage lenders. This is expected to speed up the foreclosure process by providing stricter guidelines for the banks to follow when repossessing homes.

Let me also add that municipal defaults are gaining momentum. As per Moody’s, the ratio of bond defaults from 1970-2009 was 2.7% per annum. The level for the 2010-11 periods has increased to 5.5%, nearly doubling the prior periods default ratio. Given these enormous challenges, how is the Government going to fund its debt, keep the economy from falling into a depression, and doing what it can to help many more municipalities from bankruptcy. Well many would simply say, let the Feds keep printing money. They may just do so and unfortunately defer the problem and make it larger. We must remember that the monetization process of the Federal government creates inflation and deflates the US dollar, both terrible for living standards of most Americans.

As you can see inflation as per John Williams, Shadow Government Statistics, inflation is significantly higher than what is being reported. Adjustments in the formula to hide key factors of inflation in 1980 and 1990 have resulted with inflation levels being far worse than reported. The adjusted models come in the 6% and 10% range. These are dangerous levels and destroy the middle class and working class further. Now let’s take a look at the US dollar:

Inflation is rising dramatically and the US dollar has been on a steady ride down. Further quantitative easing will further exacerbate this problem. Time is running out for the US to fix this interconnected economic and fiscal disaster in the making.

The US has been the world’s economic and military power throughout the nineteenth century. They have been the savior of last resort when the world goes astray. Well now the tide has turned and countries like China and Brazil have reserves and economic power that the US has lost. The developed Western world is in economic shambles and who is left to pick up the pieces. European nations are in recession which is deepening (17 nation GDP in 4th quarter 2011 was (0.3%); joblessness is surging in many countries (unemployment rate is at 10.8% among the European Union, the highest level since 1997); and manufacturing has had 8 straight months of decreased activity. Sovereign debt concerns are starting to reel their ugly head again. Spanish 10 years bond rates have hit 6% again and Italian yields have rocketed up to 5.5%. Their debt/GDP level is 120%, not manageable and is just a fiscal mess waiting to happen. Their debt problem is far from resolved even though the European Central Bank has injected over a trillion Euros since the beginning of 2012, with total injection into the system of $3.02 trillion. These are monstrous numbers and together with the Fed and the other six major world Central Banks (Japan, Germany, China, England, France and Switzerland), the total balance sheet

assets that have been injected into world economies is $15 trillion. Our fiat currency system is alive and well but appears to be on life support. Debt based currencies have failed throughout history and with the course we are on, we will probably follow suit.

Many argue that China can be the financial savior to the world. Forget this idea, as yes they have significant reserves but the trend we are seeing is that much of their reserve funds are moving to gold, out of government bonds as well as stimulating their own stumbling economy. I think they see the situation for what it is and plan on being on the right side of the table when the fallout occurs. Also, China, Japan, India and other emerging economies are slowing quite significantly. Clearly there is interconnectivity in the world today that cannot be ignored.

Irving Fisher, a great US economist recognized why the great depression occurred in 1932, too late but he formulated a very arguable thesis. He identified the monetary pressures behind every prolonged depression “"In the great booms and depression, each of the above-named factors has played a subordinate role as compared with two dominant forces, namely over-indebtedness to start with and deflation following soon after... In short, the big bad actors are debt disturbances and price level disturbances." So therefore the question must be ‘who are the bad actors’. Intellectually most understand how the Federal Reserve is most guilty, followed by our politicians and bankers/brokers. They have created a toxic environment that has benefitted few (primarily themselves) and hurt the majority as well as future generations to come.

If the problems are not deep enough, the United States also has unfunded liabilities in excess of $100 trillion. The bulk of this is in social security, Medicare and Medicade. These will be all but impossible to honor and they are getting worse by the day. As an example Federal healthcare spending as a percentage of the Federal budget has gone up from 7% in 1970 to 24% currently. It is projected to go up to 28% by 2015. These uncontrollable expenses will cripple the US economy for decades to come.

How will this major fiscal imbalance be resolved – difficult to say but if prudence does not come forth quickly, look for sovereign defaults throughout the world. Even the great US will be at risk of defaulting. Many of its local government and states are in serious trouble now. Expect further collapses there and the dollar to continue to depreciate at a rapid pace once the world starts to flee from the US dollar to perceived safer ground or a preferred world monetary standard. Austerity is inevitable – higher taxes and cutting of government expenses – but unfortunately it will do nothing but further the problem by creating further economic weakness resulting in fewer taxes collected and more demands on society’s safety net. The next number of years should result in economic fallout worldwide. The key will be ‘who is positioned to come out of the ashes stronger’. The past cannot be fixed, but the future can be planned and positioned to ensure future success.