THE RIDE THAT NEVER ENDS

   

                    Source: Shutterstock 

    Ray Dalio, CEO and former co-chief investment officer at hedge fund Bridgewater Associates, has spent decades researching and writing about the political and financial cycles that have recurred throughout history. His book "The Changing World Order: Why Nations Succeed and Fail" is not just for historians. It is essential reading for investors. He finds that the rise and fall of major powers follow a predictable template. Armed with this knowledge, we can plot where we are in the current cycle.

   He describes these repeating cycles as follows: 

Throughout time and in all countries [the elite] are the people who own the means of wealth production.  In order to maintain or increase their wealth, they work with the people who have the political power, who are in a symbiotic relationship with them, to set and enforce the rules [laws].  This has happened similarly across countries and across time.  This dynamic leads to a very small percent of the population gaining and controlling an exceptionally large percent of the total wealth and power, then becoming over-extended, and then encountering very bad times, which hurt those least wealthy and least powerful the hardest, which then leads to conflicts that produce revolutions and/or civil wars.  When these conflicts are over, a new world order is created and the cycle begins again.

He graphs one loop of this cycle below. It begins with a new world order, progresses into a period of peace, prosperity and growth of productive debt, followed by the growth of unproductive debt and increasing wealth gap, a debt bust and economic downturn, a period of desperate money printing and credit, revolutions and wars, debt and political restructuring, followed by a new world order. Take some time to consider where on this graph your nation finds itself. Doing so allows you to anticipate and prepare for what comes next.

                                                           Source, The Changing World Order, Ray Dalio

    During the last 500 years eleven leading powers have risen and fallen.  His clear warning is that the US and much of the West have crested the top and are in the "printing money and credit" stage - with predictable consequences.  

History shows that when an individual, organization, country or empire spends more than it earns, misery and turbulence are ahead. History also shows that countries that have higher percentages of people who who are self-sufficient tend to be more socially, politically and economically stable. 

   For example, we can readily observe the unprecedented growth of debt in the US (personal, corporate, local, state and national government). It is obvious to anyone who is paying attention - as is the public's growing financial dependence on the government. For decades, both political parties have devoted an ever-growing percentage of the nation's GDP to "transfer payments" (social benefits) to the population to buy their votes and keep them quiet, so that those holding political power can remain in office. While Republicans delight in holding themselves out as the party of "fiscal conservatives," the facts refute that claim. The US two-party system has been non-denominational in terms of fiscal irresponsibility. Here are their contributions to the national debt: 

        Johnson - D           $42 billion

        Nixon - R              $121 billion

        Ford - R                 $224 billion

        Carter - D              $229  billion

        Reagan - R            $1.9 trillion

        Bush I  - R            $1.6 trillion

        Clinton - D           $1.4  trillion

        Bush II - R           $6.1 trillion

        Obama - D           $8.3 trillion

        Trump - R            $8.2 trillion

        Biden - D             $ to be determined        

     To be able to function properly every economy needs sound money. It "measures" the value of your labor and assets and the cost of everything you consume. It is supposed to act like a ruler. The problem is that governments always manipulate the ruler – it starts out being 12” long and then it shrinks to just 10” or 6". Everyone finds it increasingly difficult to know what to demand for their own labor, how much to save for their retirement, how much to invest in plant and equipment, and how much to pay for any good or service.  

    With today’s fiat money (i.e., having no intrinsic value) no one really knows what its value is today, will be tomorrow or how much of it they will need in thirty years for their retirement. History proves that governments always end up debasing their currencies to the great disadvantage of the working classes.  The elite who own most of the assets are enriched by their rising prices, at the expense of the many who labor and own few of the assets.   

    As the percent of the population that is no longer self-sufficient grows, the government must increase its outlays to them in order to stave off social unrest. But directing an ever-growing percent of the national GDP to social benefits means there is less money to devote to capital improvements that are necessary to increase the production of goods and services. This results in declining productivity that, in turn, leads to falling international economic and geopolitical power.  

History is replete with government defaults

    Europeans are well versed in government defaults. They have experienced many of them. Americans however, scoff at the notion that the US would ever default, naively declaring that "we are the richest country in the world!" They have no comprehension of what it means to have a national debt of $31 trillion - and counting - and  $170 trillion of unfunded obligations. It is axiomatic that current debt and future promises that cannot be paid in sound money will not be paid in sound money. The Federal Reserve Bank has partnered with the US Treasury to continuously debase the dollar through excessive money printing and by setting interest rates below the level of price inflation. They do this in order to make the government's growing debt more manageable in the near term. That is to say, inflation is not a "bug" in the US financial system. It is a "feature." The dollar has been devalued by 97% since the Fed was created in 1917. There has been an ongoing "soft" default by the US government for decades. It pays its debts with devalued money.

    As to the commonly held belief that the US has never expressly defaulted on its monetary obligations, that too is mistaken. During the final stages of World War II most nations were in deep financial crises due to huge debts incurred to fight the war. In order to bring some resolution to erratic exchange rates between the national currencies, forty-four countries met at Bretton Woods, New Hampshire in July 1944.  They agreed to a new monetary framework where the US dollar would be pegged to gold at $35/oz. and other currencies would be pegged to the dollar at set exchange rates that were to be maintained within a 1% band. This agreement succeeded in reducing exchange rate volatility and allowed for loans and grants between nations and from the World Bank, greatly facilitating trade among the participants and reconstruction after the war. In order to give the participating countries faith in the new system, it was agreed they could freely exchange US dollars they received in trade for US gold at the set rate.

    The US dollar was chosen to be the base currency for a very practical reason. By supplying countries fighting Germany in two World Wars with arms, materials and food, the US had accumulated the largest gold hoard in history and other nations' gold holdings had been dramatically reduced. The US held over 20,000 tons of it. The Bretton Woods Agreement worked well for several decades.  It came to an abrupt end on August 15, 1971 when US President Richard Nixon announced that the US would no longer exchange its gold for US dollars. He did so out of necessity - albeit a necessity created by the US government's gross mismanagement of its own economy.  

   The US imported goods from around the world and sellers of those goods were comfortable holding the dollars they received and investing them in US Treasury bonds. But by the late 1960's it became apparent to some (especially French government officials) that the number of dollars in circulation had vastly expanded and the value of those dollars was shrinking. Lyndon Johnson's "Great Society" consisted of vastly expanded social benefits and the US' quixotic war in Viet Nam was extremely costly. The US was paying these expenses by selling US bonds (creating debt) and printing dollars. As a result, foreign governments began to turn in their dollars for gold - first in dribbles and then in a flood.  US gold holdings fell from 20,000 tons to just over 8,000 tons. Nixon understood that if US gold holdings were further depleted the dollar would suffer a loss of confidence and that would mean loss of international status and rapidly rising prices for imports. So, on August 15, 1971, he directed the US Treasury to default on the promise to exchange dollars for gold at the price of $35/oz.  

    However, defaulting on its obligation to accept dollars in exchange for gold did not solve the problem of the US' ever-growing debt and increasing difficulty in managing that debt. The US national debt has grown from next to nothing in 1970 to over $31 trillion today:

                             

History shows that once a nation ceases to peg its currency to a real asset, it inevitably prints money with abandon, grossly devaluing it. The chart below shows the dollar's ever-declining purchasing power.

This devaluation of the dollar results in rising asset prices as people flee the dollar and buy assets to protect purchasing power. By way of example, the price of gold has soared from $35/oz. in 1971 to near $1,800/oz. today. Gold is not any more "rare" today than it was in 1971. The price change reflects the flood of increasingly worthless dollars printed since then. 

    Rising asset prices benefit the elite who own most of the assets. The next chart shows that the top 1% of Americans own one-third of all assets in the country. This is consistent with the history reported by Mr. Dalio. The elite always manage to dominate a nation's wealth. In the US they do this by hiring lobbyists to press those holding political power into passing laws that favor them - and they seal the deal with political contributions that allow those holding political power to remain in office (the "symbiotic relationship" referred to by Mr. Dalio, above). 

And the bottom 50% of the population?  How big a piece of the pie do they have? Just over 3%.

    Progressives like to argue that this proves the "inherent flaw" of capitalism that can only be cured with more socialism. They are able to make this argument only by studiously ignoring the world around them. Putin and his oligarch supporters have cornered most of the wealth in Russia. President Maduro and his cronies hold the vast wealth in Venezuela. Castro and his supporters are the rich elite in Cuba. In all of these countries, those who get the short end of the stick are the middle and lower class workers whose wages always trail rising prices caused by the insider's debasement of the currency. The lesson to be learned is that it is not the form of government that causes wealth disparity. It is the presence of a strong centralized government that enables it. 

    The next chart compares US wage growth (black lines) with price inflation (purple lines). Bear in mind that the price inflation reported below is the CPI inflation rate calculated by the government.  It dramatically understates real inflation and the growing burden on the working classes.  

    

Price inflation, "is always and everywhere a monetary phenomenon," as explained by economist Milton Friedman. By that he meant that price inflation inexorably results from increasing the money supply faster than the supply of goods and services. While it is true that prices can rise due to temporary shortages of certain goods, in a free market those prices quickly correct as production rises to meet the demand. When shortages result from government interference in or domination of the economy, they frequently persist because those markets lack entrepreneurs who are incentivized to meet the demand. 

    Price inflation curses the working classes throughout much of the Western world. If not corrected, it will lead to the social unrest described by Mr. Dalio. For the time being, the working classes in the US are meeting the financial crisis by "dis-saving" (red line, below) and taking on debt, mostly credit card debt (blue line), that carries punitive interest rates (19%+). Note that savings briefly spiked with the two sets of Covid "stimmie" checks that workers used to pay down credit card debt but those funds have been exhausted. Consumer debt is again spiking and will become increasingly unmanageable. It is likely that there will be increasing vocal demands for more "stimulus" distributions, that if passed, will simply cause further price inflation. 

The Shrinking Labor Force

    To add fuel to the price inflation fire, the US is also confronted with a shrinking "labor force participation rate" (pink line below) and rising number of people no longer in the labor force (black line). The latter are no longer contributing to the economy but continue to consume from it. There are now nearly 100 million adults who do not work. Fewer workers produce less goods and services and this results in a stagnant or shrinking real GDP.  Mies van Der Rohe's "less is more" concept may succeed in the field of architecture but it fails in the world of economics.

      

The Shortfall Between Government Revenues and Outlays 

   This chart shows the US government's sources of income (receipts: light green) and classes of expenses (outlays: dark green). The yellow bar at the bottom on the receipts side reports the shortfall between the two. The deficit shown is $336 billion dollars. This deficit must be covered by increasing the debt (selling government bonds) and/or printing more money, further debasing the dollar. Recently released data reports that the November 2022 deficit alone was $249 billion. That annualizes to nearly a $3 trillion deficit. 

        

    The "official" November inflation rate is said to have dropped to 7.1%. That is a lot better than the 9% reported several months ago and is giving investors hope that the Fed will soon "pivot" and start lowering interest rates resulting in a rising stock market. We have previously noted that the US government "adjusted" the way it calculates price inflation and, not surprisingly, the new method results in a lower reported inflation rate. John Williams at ShadowStats.com continues to calculate inflation as the government used to do it. He reports that price inflation is 15.23%. Ask any wage earner which inflation figure more accurately reflects the costs of her housing, goods and services. Also consider that the government is highly incentivized to understate the rate of inflation it is causing by devaluing the dollar so as not to cause alarm among the voters.   

    There is a potential new way for your government to address its monumental and un-payable debt. It is by imposing a CBDC (central bank digital currency) on its citizens. Under this scheme, paper currency will be eliminated and you will be forced to use a digital account set up for you at your central bank. Your government will then know what you spend every dollar on and may eventually bar you from buying items deemed by it to be "undesirable" or traveling to "unapproved" destinations or engaging in "forbidden" activities. Should you fall afoul of your government overseers, for example with your political beliefs, your account can be frozen leaving you destitute. Charles Gave comments on this dystopian future.

Global banking giants are starting a 12-week digital dollar pilot with the Federal Reserve Bank of New York. Citigroup Inc., HSBC Holdings Pl, Mastercard Inc and Wells Fargo & Co are among the financial companies participating in the experiment alongside the New York Fed's innovation center, they said in a statement. The project, which is called the regulated liability network, will be conducted in a test environment and use simulated data, the New York Fed said. The pilot will test how banks using digital dollar tokens in a common database can help speed up payments.

One should recognize that the CBDC creates new opportunity for monetary policy. If we all had CBDC accounts instead of cash, in principle it might be possible to implement negative interest rates simply by shrinking balances in CBDC accounts. 

What this essentially means is that any choice that remains and any degree of financial sovereignty that is left in the present system could be easily wiped out by CBDCs. And it's not only financial freedom that’s at stake: these centralized digital currencies can be used by governments to monitor, to control and even to directly punish dissenters, by blocking transactions, freezing their accounts or seizing they assets. Some might find that farfetched, but those are probably the same people who thought that China’s “Social Credit System” was implausible too, right up to the moment it was actually implemented.  

The Investor's Dilemma

    If you, like many, are invested in a traditional 60/40 stock/bonds ratio, 2022 has been a disaster as this chart shows. While that strategy works much of the time, it comes with no guarantee and a few big negative surprises.

    The problem is: if you get out of bonds what to do with the proceeds? Despite recent setbacks, stock prices remain elevated making equity investments a risky undertaking.  The next chart shows the Buffett Indicator (equities to GDP ratio). Its still high reading suggests muted future returns.

                                

    Will the hapless Fed miraculously save the day? It is faced with bad choices.  Mohamed El-Erian, the chief economic adviser at Allianz writes,

Rather than fall to 2-3 per cent by the end of next year, US core PCE inflation will probably prove rather sticky at around 4 per cent or above. This is what happens when an inflationary moment is allowed to get embedded into the economic system [due to Powell's gross misreading of the inflationary environment]. The world's most powerful central bank is now confronted with two unpleasant choices next year: crush growth and jobs to get to its 2 per cent target or publicly validate a higher inflation target and risk a new round of destabilized inflationary expectations.

    We presume that next year Powell & Company will cave to political demands to stop raising rates and begin to lower them ignoring the long-term consequences of doing so. We base this belief on his complete misreading of inflation early on, delayed efforts to do anything about it, fear of crashing the economy and going down in history as the Fed's biggest monetarist failure.  Does this mean the US is on the precipice of revolution or civil war?  It does not.  It took the mighty Roman Empire roughly a century to collapse. We recall the famous lines from Ernest Hemingway's The Sun Also Rises.  Mike, "How do you go bankrupt?" Bill, "Two ways. Gradually, then suddenly."  The US is somewhere on the "gradually" spectrum ("economic downturn and printing money and credit" per Mr. Dalio's chart).  Where do you plot your nation's position on the curve?

Promising News on the Science Front

    Fusion power has been long been held out as an energy game-changer. At the Lawrence Livermore National Lab, a recent fusion experiment managed to generate some 2.5 megajoules of power output from 2.1 megajoules of power input.  It used 192 giant lasers to heat and compress a tiny hydrogen pellet that imploded, fusing hydrogen atoms into helium atoms and releasing both heat and pressure. While that experiment represents a fairly small "ROI" (return on input), it was the first time a positive result was achieved.  In tech talk, it represents a "Q factor" of 1.2. The accepted rule of thumb is that the Q factor needs to reach 10 for the process to be of any commercial use. Huge obstacles remain to be overcome before this can be achieved

 

    The New York Times reminds us that this exercise involved a single fusion. To be useful, a generating system requires sustained and rapid-fire fusions and efficient conversion of the heat to electrical energy. There are other problems as well. Omar Hurricane, the chief scientist of the LLNL project, says his team has learned that the 500 billion atmospheres of pressure at the core of the implosion amplifies the slightest impurity in the target capsule that leads to wildly fluctuating results. Overcoming just that issue will not be easy. 

    Before we abruptly shut down our oil and gas fields in expectation of the imminent development of bountiful fusion power, note that the LLNL facility costs $15 billion and took many years to construct, it takes up three football fields of space, and it achieved a single event of positive, but nominal, output. It is reported that commercial use will require lasers to recycle and fire up to 10 times a second at rapidly and precisely inserted hydrogen targets. If this proves to be impossible or the cost of doing so vastly outweighs the value of the energy generated, it will simply go down in history as a very interesting experiment.  

    We are cautiously inclined to bet on the ingenuity of scientists to pull it off - but not for years and at a huge cost to advance the technology.  The final energy impact of the process is unknowable at this time.  The West has spent some $4 trillion developing alternative energy sources (e.g., solar, and wind) to reduce our reliance on fossil fuels.  That has succeeded in lowing their use for electrical generation from 82% to 81%.  While that is not nothing, it is pretty close to it. It is foolish to choke off cap-ex money for oil and gas development by pressuring banks to restrict loans and imposing "windfall profits taxes" on the industry. Massive ongoing capital investments for fossil fuels are essential to get us through to better (greener) times.  Without reliable oil and gas we will find ourselves in the shoes of Europe, the UK and California looking at rolling power blackouts during periods of peak loading.  While climate activists may love the idea of forcing us to live like the characters in Little House on the Prairie, governments will be met with an armed rebellion if the people are forced to do so because of short-sighted policies. 

If you would like to receive these reports, you may do so by clicking on the "Subscribe" tag on the left side of the opening page and entering your email address.  

Important Message: The foregoing is not a recommendation to purchase or sell any security or asset, or to employ any particular investment strategy.  Only you, in consultation with your trusted investment advisor, can select the strategy that meets your unique circumstances, investment objectives and risk tolerance.  © All rights reserved 2022