Game Plan

by Kevin D. Freeman

  The only question is why anybody would be surprised by this. The governments of country after country defaulted on their debt in the 1980s, a mere generation ago. In a longer view, Carmen Reinhart and Kenneth Rogoff count 250 defaults on government debt from 1800 to the early 2000s. As Max Winkler wrote in his instructive 1933 book, “Foreign Bonds: An Autopsy”: “The history of government loans is really a history of government defaults.”41

  Another form of default was suggested by Lord Monckton, a former advisor to Prime Minister Margaret Thatcher of Great Britain. He suggested that the U.S. government could simply replace the dollar with another currency.42 It has been done before. Debts denominated in dollars would become worthless, but other assets could be priced in the new currency. Either direct default or a currency replacement would shake the system to its core. That’s why the Chinese, and even the Japanese, so seriously warned America not even to flirt with default.43

  America’s global economic dominance is being called into question. Default may no longer be unthinkable. And the implications for investors are serious.

  What Happens if the Fed Loses Control?

  Even if the government pays its debts on time and keeps the currency in place, there is another risk. What happens if the Fed can no longer hold everything in place? Jim Rogers believes that this will happen. At some point, he suggests, bondholders might stop caring about what the Federal Reserve is doing. So far, the Fed remains “god” of the markets. A sentence in a press release can move markets up or down. But the Fed’s weapons, ultimately, are only paper. They either increase or reduce the supply of dollars. If the dollar loses its value, the Fed loses its weapons. Likewise, if the Fed loses control, the dollar could collapse.

  The Federal Reserve has almost single-handedly propped up the global financial system since 2008. The Fed supported banks around the world and has pumped trillions of dollars into economies. The Fed could do that because the world desired and trusted dollars. The Fed could electronically inject dollars into a bank in Italy, making it instantly solvent. If the dollar lost value, however, this intervention would be meaningless. The Fed would not be able to help anyone. The result would be massive inflation, tremendous bond losses, and a knockout of support for everything the Fed has held up—in other words, chaos. Prices would be volatile for almost every asset class, even as the dollar collapsed. In this unprecedented calamity, inflation and deflation would occur almost simultaneously—food and other necessities would skyrocket in price, while other assets could collapse. The economy would be a ship in a sea, rocking from one extreme to another in short order. Some currencies might skyrocket while others failed, so we would see hyperinflation in some areas and deflation in others. Even the strongest metal will ultimately fail from stress if repeatedly bent back and forth at a rapid pace. To quote Zero Hedge: “[I]f and when Bernanke finally loses control, there are simply no words to describe what would ensue, as a situation like that—one where not just the Fed but every single central bank has gone all in on reflating the world’s biggest asset bubble—has never been encountered before.”44

  Certain asset classes could survive a Federal Reserve crackup, but maintaining ownership would be challenging. Bonds denominated in dollars would likely be hit the worst.

  If the system stabilizes and you are smart about how you allocate capital (based on your age, the yield curve, and so on), bonds can be an important part of a well-balanced investment portfolio. If we enter deflation and the dollar retains its reserve status (where the world continues to appreciate dollars), bonds will be tremendous investments. This assumes the Fed retains control and investors maintain confidence.

  But if we enter a serious inflation or the currency collapses, with or without a financial terror attack, bonds will be the worst investment. Even if we simply see a return to a normal interest-rate environment, bonds will be hurt.

  You need professional help from advisors who understand all the risks of economic warfare.

  CHAPTER EIGHT

  Beyond the Dollar: Why Money in the Mattress Is a Bad Idea

  A Chinese woman thought the best way to protect her substantial nest egg was to keep her four hundred thousand yuan in a plastic bag at home. Thieves didn’t steal it and she didn’t lose it. But termites got to it and ate a substantial amount—about sixty thousand yuan, a loss amounting to almost $10,000.1

  A Queens woman hid her family’s life savings in a refrigerator without telling her husband. He replaced the fridge and dumped it at a recycling center, losing thousands of dollars. Cash literally became trash.2

  An Israeli woman hid $1 million in her mattress. Her dutiful daughter replaced the lumpy, worn-out mattress and left it on the curb. A scramble to find the most valuable mattress in the world ensued at the Tel Aviv dump.3

  Christ teaches, “Lay not up for yourselves treasures upon earth, where moth and rust doth corrupt, and where thieves break through and steal: But lay up for yourselves treasures in heaven, where neither moth nor rust doth corrupt, and where thieves do not break through nor steal: For where your treasure is, there will your heart be also” (Matthew 6:19–21).

  Destruction by insects and the risk of theft was as real in Jesus’ time as it is today. There’s a lot in the Bible about money, and in the parable of the talents Jesus warns against hoarding it out of fear. Don’t bury it in the backyard, He says—put it to work, or at least draw interest:

  For the kingdom of heaven is as a man travelling into a far country, who called his own servants, and delivered unto them his goods.

  And unto one he gave five talents, to another two, and to another one; to every man according to his several ability; and straightway took his journey.

  Then he that had received the five talents went and traded with the same, and made them other five talents.

  And likewise he that had received two, he also gained other two.

  But he that had received one went and digged in the earth, and hid his lord’s money.

  After a long time the lord of those servants cometh, and reckoneth with them.

  And so he that had received five talents came and brought other five talents, saying, Lord, thou deliveredst unto me five talents: behold, I have gained beside them five talents more.

  His lord said unto him, Well done, thou good and faithful servant: thou hast been faithful over a few things, I will make thee ruler over many things: enter thou into the joy of thy lord.

  He also that had received two talents came and said, Lord, thou deliveredst unto me two talents: behold, I have gained two other talents beside them.

  His lord said unto him, Well done, good and faithful servant; thou hast been faithful over a few things, I will make thee ruler over many things: enter thou into the joy of thy lord.

  Then he which had received the one talent came and said, Lord, I knew thee that thou art an hard man, reaping where thou hast not sown, and gathering where thou hast not strewed:

  And I was afraid, and went and hid thy talent in the earth: lo, there thou hast that is thine.

  His lord answered and said unto him, Thou wicked and slothful servant, thou knewest that I reap where I sowed not, and gather where I have not strewed:

  Thou oughtest therefore to have put my money to the exchangers, and then at my coming I should have received mine own with usury.

  Take therefore the talent from him, and give it unto him which hath ten talents.

  For unto every one that hath shall be given, and he shall have abundance: but from him that hath not shall be taken away even that which he hath.

  And cast ye the unprofitable servant into outer darkness: there shall be weeping and gnashing of teeth. (Matthew 25:14-30)

  Despite this two-thousand-year-old warning, people are people, and in tough times they become paralyzed and hold on to money. They certainly did it in the aftermath of the 2008 collapse. Everyone was buying stock before the crash. Now everyone seems to be hoarding cash, as the AP reports:

  Five years after U.S. investmen
t bank Lehman Brothers collapsed, triggering a global financial crisis and shattering confidence worldwide, families in major countries around the world are still hunkered down, too spooked and distrustful to take chances with their money.

  An Associated Press analysis of households in the 10 biggest economies shows that families continue to spend cautiously and have pulled hundreds of billions of dollars out of stocks, cut borrowing for the first time in decades and poured money into savings and bonds that offer puny interest payments, often too low to keep up with inflation.4

  The reality is that even if your life savings is safe from termites, if you keep it all in paper money, you are running a huge risk. The average life expectancy for a fiat currency is twenty-seven years, and our dollar has been off the gold standard since 1971.5 DollarDaze’s study of 775 fiat currencies found that no fiat currency has ever held value—12 percent were destroyed by hyperinflation, another 21 percent by war, 12 percent by independence, and 24 percent by monetary reformation. The rest are awaiting their deaths. The most successful fiat currency in history is the British pound sterling, which has lasted since 1694—but even that currency is a shocking 0.5 percent of its original value.6 No wonder Stephanie Pomboy, the founder of MacroMavens, says that currencies unbacked by gold or other assets will collapse. Inflation, she says, isn’t the solution:

  Some believe that, with another round of quantitative easing, we move forward, emerge from the morass, and the need for further intervention will dissipate. But the Fed is really the only natural buyer of Treasuries anymore. It will have to continue to monetize Treasury issuance at the same time all the other major developed economies—from the Bank of Japan to the Bank of England to the European Central Bank—are doing the same. Pursue that to its natural conclusion, and you see the inevitable demise of fiat money. To look at our policies and not be concerned about the risks to our currency would be dangerously naive.7

  Lord Monckton, a former advisor to Margaret Thatcher, has suggested that it is time to reset the United States dollar. He’s not kidding. In fact, he has argued that a complete reset of the monetary system may be required:

  “Forget the dollar. It is finished. America needs a sound currency. The easy option would be to adopt the Canadian dollar, for hard-headed, common-sense Canada avoided the foofaraw of nonsensical credit-default swaps and dodgy derivatives that brought down the sillier banks. . . .”

  Monckton doesn’t stop with suggestions of Canadian monetary integration, however. He suggests a complete “reset” of the American financial system.

  “There is a more dirigiste solution, which I prefer much less than the free-market solution. . . . It is possible simply to cancel all public and private debt and tell everyone to start again. One takes a deep breath, presses the RESET button and reboots the entire system,” he said.

  “The Emperor Augustus did this in ancient Rome, and the result was 400 years of prosperity, notwithstanding the flashy and often spectacularly incompetent absolute tyrants who succeeded him,” he said. “Again, the more recent precedent is in postwar West Germany in 1948, when Mr. Erhardt, then the finance minister, waited until the occupying Allied commanders were away for a weekend’s shooting and called in the Reichsmark, replacing it with the Deutsche Mark. Everyone was given 50 new Deutsche Marks and told to get on with it.”

  Financial analysts are aghast at the idea, but Monckton dismisses such concerns, again reaching into history: “‘When Gen. Clay, the U.S. commander of the occupying forces, got back after his weekend and found out what had been done [in Germany], he called at the Finanzministerium and said, ‘Herr Erhardt, my advisers tell me you’re making a terrible mistake.’ Erhardt’s famous reply: ‘Don’t worry, general: mine tell me the same.’ Again, the rest is history. Germany, even after enduring the staggering cost of rebuilding East Germany upon the happy reunification of the nation, remains Europe’s economic powerhouse.’”8

  If Monckton were right, what would happen to the greenbacks being hoarded now? This is a sobering thought and should give pause to anyone who believes that cash is the safest investment.

  Even if you believe the dollar will survive as a viable currency and retain its status as the most important reserve currency of the world (in spite of economic warfare against it), history has proved that those who hold paper will lose purchasing power even in the best of times. From 1913, when the Federal Reserve was created, to 1933, the dollar lost almost 30 percent of its value. By 1944, it had lost another 10 percent of its value. By 1971, the dollar was about 30 percent of its 1913 value, and today it represents just 5 percent of its original value. According to the Bureau of Labor Statistics’ inflation calculator, it takes one hundred dollars to buy today what cost $4.24 in 1913. And that calculation is based on the consumer price index, which many think understates inflation.

  If you factor in the risks of a currency attack or collapse, it is easy to see that keeping all your wealth in paper is a bad idea.

  What about Banks?

  Banks are wonderful things. They serve important functions in our economy. But, while far better than a mattress, bank deposits are not the only place to store wealth.

  There are many reasons not to stick your cash in a bank. First, banks may offer very low rates for savers, often below the rate of inflation. Catherine Rampell of the New York Times explains,

  The fact that interest yields are so low in so many parts of the world is no coincidence. Rates are determined not only by markets, but also by government policy. And right now many governments say they have good reason to keep their own borrowing costs as low as they possibly can. . . . Though bad for people trying to live off their savings, low interest rates happen to be quite good for anyone borrowing money, like governments themselves. Over time, interest rates below the inflation rate allow governments to refinance, erode or liquidate their debt, making it easier to live within their budgets without having to resort to more unpalatable spending cuts or tax increases.9

  So you can thank the U.S. government for making sure that you make no money on your deposits.

  Banks also charge a variety of fees for holding your money. IRA fees, for example, may be up to fifty dollars per year. On a $5,000 deposit, that fee would wipe out a 1-percent interest rate.10 Banks commonly charge fifteen or twenty dollars per month to maintain checking accounts below a certain minimum balance (as high as $15,000). “Nothing in banking is free anymore,” reports the Associated Press.11

  One reason that banks can get away with charging such high fees is that they are flush with deposits. In fact, some banks now try to discourage deposits because they don’t have good places to put all the cash. According to Reuters:

  “Banks were fighting each other for deposits in 2004, 2005, and 2006, but since then, deposits have become easy. I’ve had bankers tell me, ‘I can’t turn the deposit faucet off,’” said Scott Hildenbrand, a strategist at investment bank Sandler O’Neill who advises banks on their assets and liabilities.

  Some banks have tried to turn down the faucet. In August 2011, during a U.S. debt ceiling crisis, Bank of New York Mellon Corp announced a plan to charge some corporate and fund management clients a fee for adding too much to their deposits, although it never acted on that threat. It thought about making a similar move last year amid euro zone turmoil.12

  It’s not all good times in the banking business, however. More than five hundred banks have failed since October 2000, some big, some small. Many others were bought and merged away. Virtually all of those failures have occurred since the beginning of the Great Recession.

  But your money is safe even if it’s in a failed bank, right? Wrong. Federal Deposit Insurance Corporation guarantees have limits. During the financial crisis, the limit per account was raised to $250,000,13 but it can be adjusted. The insured amount varies by type of account. Savings accounts, trust accounts, money-market deposit accounts, individual retirement accounts, and certificates of deposit are insured up to the $250,000 limit, but mutual funds, annuit
ies, life insurance policies, and the like, are not. Limits have ranged from $2,500 to $250,000. Some non-interest-bearing checking accounts enjoyed unlimited coverage during the crisis, but this ended in 2012.

  The FDIC’s reserves are limited. At the end of 2011, its backstop fund was about $12 billion, and it predicted that it would need $12 billion to cover bank shutdowns through 2016. The FDIC said that it would take until 2018 for the fund to recover fully; the fund actually had a deficit of $20.9 billion at the end of 2009, when the banks began to collapse.14 The deposit fund grew nicely in 2012 to almost $33 billion, as member bank assessments far exceeded bailouts.15

  Sounds like they have it covered—as long as the dramatic slowdown of failures from recent history continues. From 2007 through 2012, the FDIC paid out almost $100 billion, according to the Los Angeles Times, while taking in less than $1 billion: “Since 2007, 471 U.S. banks have failed, nearly depleting the FDIC deposit-insurance fund with $92.5 billion in losses. . . . Overall, the FDIC collected $787 million in settlements by pressing civil claims related to bank failures from 2007 through 2012—a fraction of its total losses.”16 At the start of 2013, assets insured were something like $9 trillion. That’s right—the total amount insured is measured in trillions of dollars, while the insurance fund is measured in tens of billions. Barring a major catastrophe, the FDIC should be able to continue to guarantee deposits up to $250,000. But in the case of a massive failure from an act of economic warfare, there would be a problem. There’s no way to cover $9 trillion in deposits with less than $50 billion on hand. And with a $17 trillion federal debt, it’s hard to see how even the government could bail out $9 trillion of deposits in the event of a systemic collapse.

  Government default is not all that uncommon, unfortunately. Germany and France have both defaulted eight times since 1800, the United States has technically defaulted before, and Russia defaulted as recently as 1998.17 Obviously, in the event of a default, government help beyond the FDIC limits is, shall we say, unlikely.