The sky will fall on many people, but there is hope for some.
Henry K. Hebeler at www.analyzenow.com
10/8/08
Let’s start with some of the known problems before we go to the consequences and actions needed to protect individuals from something I believe is inevitable for the U.S. as a whole.
At the federal level, we have amassed at least $55 trillion of national debt and unfunded obligations for Social Security and Medicare. That’s $184,000 for every man, woman and child in the country. Some estimate our federal obligations to be over $60 trillion now or over $200,000 per person.
This does not include international balance of payment deficits nor state, county and municipality debts nor their unfunded future obligations. It does not include company indebtedness that we pay for with reduced stock returns and higher product costs. Nor does it include personal debts such as home mortgages, home equity loans, reverse mortgages, student loans, auto loans and credit card debts. Whether it’s been greedy companies buying other companies, individuals on a consumerism binge, importing more than we export, government overspending or employers/government promising far more employee future benefits than they can pay, the debt obligations are horrific.
Now we see that the credit markets are in dire trouble, so the government is anticipating a $700 billion bailout after already paying about $300 billion to salvage Bear Sterns, Fannie Mae, Freddy Mac, AIG, Lehman Bros., Merrill Lynch, and Washington Mutual. This is supposed to cover unsupportable home loans including ARMs and option ARMs which were destined to be disastrous from the beginning.
This is only the beginning. The AIG $85 billion credit default swap infusion plus another $38 billion more today is a drop in the bucket compared with what some estimate as $58 trillion of unregulated derivatives like credit default swaps in the rest of the finance industry. There are other derivatives that will start showing their ugly heads too. Consider Exchange Traded Notes, ETNs, the cousin of Exchange Traded Funds, ETFs. These notes don’t even have to own the securities implied by their description. Or how about the high-risk part of the tranches of Collateralized Debt Obligations held by many seeking higher returns? Or those who bought factored loans? Some estimate that 90% of derivatives don’t have any collateral and are just casino bets.
It’s certain that pension trusts now are much below the amounts required to sustain future payments. Furthermore, the pension trusts’ projections have depended on ever-hopeful forecasts of returns from future glorious stock market returns as well as bonds that won’t lose value. Because of Accounting Board Standards, this means that states, government and industry are going to have to start pumping lots of cash into pension trusts—and many industries like the auto producers just aren’t going to be able to do this—and will come begging to the government. Pension fund trust failures are supposed to be insured by the Pension Benefit Guarantee Corporation, but the insurance often falls far short of people’s expectations and the Corporation itself is on very shaky financial grounds.
Then there is the as-yet-unquantified number of people that will be added to the government payrolls to investigate and administer as-yet-undefined procedures for the bailout and broad health-care changes. All we can say for sure is that this can be more costly to taxpayers than the overhead of Medicare that can outweigh the costs of the actual medical treatments and can take years to get payments to doctors. Further, we know that the average person in government is compensated about 50% more than the average person in private industry, in part due to lavish government COLA pensions and extensive health insurance benefits. So government will grow by leaps and bounds. As those of us who spent a lot of time working in the defense industry know, surveillance cost are high both for the government and the companies that have to respond to the mandates, data and reviews imposed by the government.
Let’s just make the terribly oversimplifying assumption that the average person’s share of this country’s debt and unfunded obligations is $250,000 per person or $1 million for a family of four. Considering all of the above, this is probably a huge understatement. If we don’t do anything to retire any of the debt and obligations, and only pay interest at say only 4%, that’s an interest burden we bear a cost of $10,000 per person per year. If, in addition to paying the interest, we set about to retire those debts and obligations in 30 years, we would each have to contribute $14,500 each year. So a family of 4 would have to make annual payments of $40,000 each year just for interest or almost $58,000 a year if we don’t want to leave any of this problem to our grandchildren.
Some think that we can pay for this by relegating the payments to the top 5% of our population. If that’s so, every family of 4 supported in that top 5% would have to pay $800,000 just for the interest and $1,160,000 to pay for interest and principal. That’s PER YEAR for 30 years. So even without any additions to social programs, there is no way that those who make under $250,000 a year will not see higher taxes. This is a problem that is going to be solved ONLY if people start saving money and everyone pays something in higher taxes. Sometimes people forget that higher taxes on one segment of the economy migrate to others. Put more tax on businesses and they have to raise their prices, so we see the tax as an increase in inflation.
We are clearly talking about the end of the consuming generation of reckless spenders. These include people at all levels that have their own image of being able to live like the Jones. Low income people just can’t enjoy the benefits of higher income people, and higher income people just can’t afford to live like royalty. It was a mistake to develop policies that tried to make it possible for everyone to own a home. A home is a huge financial obligation and very illiquid. For many people renting is not only better financially, it offers mobility so workers are not constrained to finding jobs in nearby, perhaps even distressed, communities.
The end of consumerism has a huge impact on the economy as we know it now. When we become savers, we have to stop spending as much. If we would start a full fledged recovery program right now with the objective of having individual finances get back to where savings rates were a little over two decades ago, and if we wanted to recover the lost savings during those two decades in the next 20 years, our national savings rate would have to exceed 20% per year--plus we’d still have to pay at least the interest on all of the debt we and our government have incurred. Consumer spending constitutes 70% of our gross domestic product so that if we use 20% of our income to pay off the national obligations, our economy will contract sharply.
There has only been one time in our modern history when people had a national savings rate of 20% in this country. That was during World War II when almost everything was rationed from gasoline to sugar, there were no new cars, store shelves were empty, all able people worked at a job, and it was patriotic for everyone to save war bonds—even school children. There’s more on this in my book, Getting Started in a Financially Secure Retirement published by John Wiley & Sons, 2007.
The only people who may come out of this situation with some semblance of the American Dream are those who have already saved and those who will start saving and stop spending NOW! That’s true if we don’t have something like the revolt against imperial Russia where real estate ownership disappeared, homes were shared by many families assigned by the government, and savings were taken away and consumed largely by the government.
Those that will save, and those who already have saved, will be asking, “Where shall we put our money?” I certainly don’t see the financial market future any better than anyone else, so I can only tell you what I am doing. I effectively divide my investments into three parts. The first part assumes that I want to be able to live through the Great Depression II. The second part assumes that it will take people a number of years to wake up to the problems, so this part is very conventional mix of stock and bond funds. The third part assumes that we will have hyper inflation. Only the Great Depression II and hyper inflation provide environments to solve the huge debt problem: the former by defaulting on loans and the latter by so cheapening the value of the payments that debt payments are a small part of a huge income denominated in almost worthless money.
The largest part of my own investments is conventional, but the amount I have in the hyper inflation portion and Great Depression II are sufficient to get me by, especially if the conventional part ends up having some value and not wiped out entirely. Those who would do similar splits would end up with the sizes of the three parts dependent on the extent of their savings, age, employment security, expectations for the future and probably lots of other factors.
Understand that I don’t pretend that I am wise about what to do in either of these extremes. Still, my own choices for a hyperinflation scenario include candidates like leveraged real estate, stocks, I Bonds, TIPS and inflation-adjusted immediate annuities. I have been thinking about this for years and so built up my supply of I Bonds when you could buy large amounts at interest rates of over 3% plus inflation. I know that others more venturesome than I am would now add commodities as well as metals such as gold and platinum. Very wealthy people often gain inflation protection by saving valuable art and rare collectibles. Art and collectibles are beyond my financial capability, just as some of my choices are beyond the capability of other people. For example, a young person probably doesn’t have the resources to buy an immediate annuity and should never buy one in the first place. However, when the prices of stocks stop falling and the weak companies with bad management are gone, stocks may be one of the best investments for a younger person in an inflationary environment.
It’s common for most people to sell stocks when the market falls and buy stocks as the market nears a peak. That’s why the average person does far worse in the stock market than a buy and hold investor. Even better, those that have regular savings deposits benefit from dollar-cost-averaging because they buy more shares when the stock prices are low and fewer shares when the stock prices are high. Unfortunately, retirees have just the opposite effect and lose because they take regular withdrawals rather than make regular deposits. (For more on this, see J. K. Lasser’s Your Winning Retirement Plan, Wiley & Sons, 2001.) Retirees often would do better to sell fixed income investments for expenses rather than cashing in stocks in bad markets and vice versa. But it’s counterintuitive in down markets.
There are great benefits from establishing a minimum and maximum percentage allocation for stocks in a retirement portfolio. When stocks (or stock funds) get below the minimum, it’s time to rebalance to increase the percentage of stocks. When stocks get above the maximum percentage, it’s time to trade them in for fixed-income investments like bonds or bond funds. I’ve found that a spread of 10% between the minimum and maximum means that I don’t have to rebalance much, often not for two years. Our personal minimum percentage is 100 minus my wife’s age, and our maximum is 10% higher. There’s more on this in Getting Started in a Financially Secure Retirement, Wiley & Sons, 2007 as well as on www.analyzenow.com.
The Great Depression II portfolio is much more difficult. My choices here would include money markets, CDs, EE Bonds, treasuries and debt-free real estate. I know that my parents would add another category. My parents were struggling young adults during the great depression and gave us children strong encouragement to learn at least one musical instrument so we could earn something even if we lost our regular jobs. I played the piano, flute and trumpet—not knowing what I might need. I learned something about diversification even then.
Perhaps the best protection during the Great Depression II outcome would be strong and varied work skills. Even non working spouses and older children should learn some work skills that could bring income if necessary. Think Rosie the riveter during World War II as opposed to soccer mom. Learning to be frugal combined with doing as many home, car and clothes repairs yourself is important in a depression environment as could be supplementing your food supply with a home garden. You might want to store some vegetable seeds for next year.
The nation’s debt problems are so large that the sky will fall on the majority. I firmly believe that to survive, people will have to save—lots. They will also have to invest it well. We can’t tell which direction the economy will turn, but we know it has to make drastic changes. Hence, in addition to having good work skills and savings lots, it’s important to be well diversified and include some things that might help in the Great Depression II or hyper inflation.
Of course, we could also have both Great Depression II combined with hyperinflation, sort of stag-flation cubed. Don’t wait to start your own defensive actions. Do them now! The reductions in future benefits will be small if the economy would turn around quickly (which I doubt), but the benefits from taking action now will be huge otherwise.