The four Greeces in the US

Nick Hubble

Back in 2007, stockbroker Peter Schiff was hounding the financial news channels with his apocalyptic predictions of a subprime crisis. He was ridiculed by his fellow interviewees at the time. “Peter Schiff was right” compilation videos on YouTube still make for excellent viewing.

Schiff’s stockbroking firm Euro Pacific Capital boomed as the crisis crashed. But there was a major fly in the ointment. Peter was extraordinarily prescient about the crash. But his advice for what to invest in during that crash was far less successful.

Schiff believed that the subprime crisis was an American problem. Therefore, the US was going to be in trouble while other places like Asia and parts of Europe would fare better.

This was only half correct

Because it missed a key feature of our financial system. The US is the safe haven for capital during a crisis. Whenever a financial crisis occurs, even one in the US, money is sent to the US for safekeeping. This makes the US dollar surge.

Schiff had, according to the media anyway, positioned his clients for a tumble in the US dollar by investing in other places. It’s bizarre to think that the US dollar would surge during a crisis that originated in the US. But it happened. And so currency losses hurt Schiff’s clients badly.

There are many things to learn from this. Today I want to focus on just one of them. It’s to do with the sea change that might be the most important of your investing lifetime.

The basic idea is that Schiff will be proven right in the end. Eventually a financial crisis in the US will see capital flee elsewhere. You see, his basic premise is correct. The US is in financial trouble for all sorts of reasons. But it remains the world’s financial safe haven. Any American crisis still leads to a surging dollar. For now.

If this were to end, the financial system as we know it would end with it. If the euro or another currency or combination of currencies were to replace the US dollar as the safe haven, it would rip out the carpet from underneath the US financial system and economy. The implicit backing that the American financial system gets during a crisis would disappear. The dollar would crash.

Given the founders of Capital & Conflict’s publisher spent many years trying to warn of this moment, you can imagine it’s a very well explored idea.

Well a new sign that the times are a changing just popped up.

The other Greece

Greek GDP is around US$200 billion. The US state of Illinois is about four times the size. Their governments are both in dire financial straits for the same reason, but we only hear about Greece. I think Illinois will prove far more important to you in the end.

Illinois hasn’t had a budget for two years. The governor of the state declared it to be a banana republic thanks to its government’s complete lack of credibility. Debt ratings agencies have downgraded Illinois bonds eight times in recent years. The state’s treasury is refusing to pay its basic bills, with the unpaid amount over US$14 billion.

But Illinois’ debt-to-GDP ratio is below 20%. So what’s the problem? Well US states don’t collect anywhere near as much tax as the federal government. But more important are pensions. The state owes impossible amounts to former and future employees. But these aren’t counted in the official debt statistics.

It’s a typical example why modern economics is useless. The figures are dodgy, the methods are iffy and therefore the conclusions are wrong. But the markets know better. And they’re getting worried about Illinois’ pensions. That’s why the bonds are steadily getting downgraded.

Illinois’ Supreme Court ruled that existing pension liabilities are not a political policy matter. They’re a legal debt that must be paid or defaulted upon. Puerto Rico chose default recently. But it’s much smaller. And there are states in even worse positions than Illinois. Three in particular – Massachusetts, Connecticut and New Jersey.

It’s not much better overall though

According to the Government Accountability Office, state tax revenue as a per cent of GDP won’t be back at 2007 levels until 2047!

What makes US states so interesting is that they’re like Greece, not Japan. They can’t print their own money. This makes default and financial accountability far more real.

If you put the legal nature of pension obligations together with this inability to print money, you get a startling conclusion. Taxpayer funds will have to make up the difference to pay out all those pensions. And researchers from the Hoover Institution recently did the maths on where that leaves US states overall:

Even under states’ own disclosures and optimistic assumptions about future investment returns, assets in the pension systems will be insufficient to pay for the pensions of current public employees and retirees. Taxpayer resources will eventually have to make up the difference.

In aggregate, the 564 state and local systems in the United States covered in this study reported $1.191 trillion in unfunded pension liabilities (net pension liabilities) under GASB 67 in FY 2014. This reflects total pension liabilities of $4.798 trillion and total pension assets (or fiduciary net position) of $3.607 trillion. This accounts for roughly 97% of all public pension funds in the U.S. Taking into the account the pension funds’ penchant for manipulating (in their favor) the discount rates, the unfunded public sector pensions liabilities rise to $4.738 trillion.

Constantin Gurdgiev from the TrueEconomics blog puts the maths in understandable terms:

[…] what is really going on is that the governments create a binding contract with their employees to loot – at some point in the future – the general taxation funds to cover the shortfalls on these contracts. How much looting is on the pensions liabilities? Take the unfunded liability estimate of $4.738 trillion. And consider that in 2014, total revenues collected by state and local governments stood at $1.487 trillion. Pensions deficits alone amount to 3.2 times the [governments’] income. In household comparative terms, this is like having a full 100% mortgage on a second home, while still running a full 100% mortgage on primary residence (day-to-day expenses).

US states and their pension systems could be the crisis that ends the US’ safe haven status. And with it, the end of financial stability.

A bank failure isn’t a crisis any more

Strange how times can change. These days a major Spanish bank can fail and it’s not even front-page news. Only a few years ago, just the potential of a failure would cause panic.

Spanish bank Santander agreed to buy its rival Banco Popular for a token price of €1 yesterday. I wouldn’t have paid as much.

The failure of the bank isn’t even treated as important by the news. All the attention is on whether the new EU rescue mechanism for banks works. The New York Times’ headline read “Santander Rescues Troubled Rival in Test of Europe’s New Rules”, Reuters said it was the “ECB Triggers” that set the bailout in motion, and the Guardian claimed “Santander rescues” Popular. Seems like half of Europe is in on the deal…

The details are interesting. Popular has €37 billion in toxic real estate loans, which Santander says it needs €7 billion to recapitalise. That’s typical banking maths. Santander will raise the money from the markets. Which begs the question why the ECB, the EU and all its institutions needed to be involved at all.

As far as I can tell, the new bank rescue institutions of the EU are there to declare a bank insolvent before it is officially so, so that the rescue can happen before any defaults happen.

The ECB’s Single Supervisory Mechanism ruled Popular was likely to go broke imminently, which allowed the EU’s Single Resolution Board to set up the sale to Santander.

At least the rescue deal isn’t too kushy

Popular’s senior bond holders get their money back while shareholders and junior bonds get wiped out.

But it’s all a practice run for the main event – rescuing Italy’s banking system. The toxic real estate loans there dwarf Spain’s.

But one man isn’t worried at all. He doesn’t even ponder whether all the bad news is priced in or not. Instead, markets move independent of the sorts of news we focus on so much.

It’s a remarkable idea. But it’s hard to argue with the evidence. And if he’s right, you stand to make a lot of money…

Until next time,

Nick Hubble,
Capital & Conflict

Category: Economics

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