The only way out is to print more and more money.

This is an issue I have been looking into for a while. How can the US ever manage to to payoff its debts ($12.7 trillion and counting) and continue to run trillion dollar deficits for the foreseeable future. This year the national debt to GDP will equal 100% and could hit 150% in the next 7 years. The historical method for managing the national debt has been to debase the currency by 3-4%(official numbers) through inflation. This technique has worked very well over the years as most people lack a general understanding of inflation. However the sheer amount of debt and the rate it is piling would require double digit inflation for years. Below is a chart of the best case estimate of how the national debt will increase over the next few years.

Remember this is an optimistic projection and likely underestimates the true numbers. Marc Faber estimated that the US will run trillion dollar deficits forever. Why? Because Social Security has now fallen into deficit. This means that for the first time in history, the government is paying out more in benefits than it takes in from payroll taxes. The US government has used Social Security as a piggy bank for years in order to finance the government. It was a great racket while it lasted. But instead of being able to freely spend Social Security's surpluses, the Treasury now has to make up the deficit by borrowing billions more.

This brings us to the next problem: servicing the interest on the national debt. The US will spend north of $400 billion during 2010 to just pay the interest on the debt. And this is with historically low interest rates. At a certain point interest rates will rise and the cost of servicing the debt will skyrocket putting more pressure on federal budget.


Historically there are only four solutions to the current debt problem.

1. Grow your way out. If the US could grow at 6-7% for the next 20 years without a single recession we could theoretically grow our way out of this problem. Yes the debt would still increase but it would represent a smaller percent of GDP and thus more easily serviced. If you believe in this scenario all I can say is good luck.

2. Simply defaulting--This is not a possible outcome as it would have devastating affects for the US. It is also politically unacceptable and could spark riots and even a revolution. I highly doubt the US will ever officially default.

3. Reduce Government Spending--HA HA HA!!

4. Print Money and lots of it--This in my opinion is the most likely scenario because it is so easy. The only problem is that the US would likely have to print $1-1.5 trillion a year to achieve the desired outcome. Printing this amount of money would lead the high rates of inflation in the future. The only downside to this is the potential for a large backlash from the general public who become unable to afford their lifestyle. Imagine having to pay $10 for milk $14 for a gallon of gas while your wage stays relatively flat. This is the conundrum facing the Federal Reserve central planners. The people are oblivious to 3-4% inflation but become enraged at 10-30% because it is more easily recognizable. Another problem with high rates of inflation is that the bond market will simply refuse to purchase government bonds (except at egregiously high rates). This in turn forces the Federal Reserve to print even more money which creates a viscous cycle of ever increasing inflation.

How to protect yourself

Since inflation is the most likely scenario, you have to find a way to protect yourself from this eventuality. It is really simple--you have to get your money out of paper assets. Paper assets include bonds, stocks, money markets, etc. I know most people will tell you that stocks protect you from inflation but this is somewhat misleading. Stocks do well during periods of low inflation (around 2-5%), but do poorly during periods of high inflation(above 10%). This is especially true during hyperinflation. Take a look at the following chart which shows the nominal price of the Dow between the Great Inflation between 1966-1980.

At first glance it does not look so bad--the market was roughly flat over this period. But remember that this does not include inflation. When you adjust for inflation the market lost over 50%. Not very good it is.

The only way to protect yourself is to have hard assets which retain their value in real inflation-adjusted terms. It does not matter which hard asset you choose, be it gold, silver, oil, copper, etc. All commodities will hold up under inflation.

Good luck

Black Swan Insights


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