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The Buy Side

Why Eric Sprott isn't right Add to ...

One of the monthly letters I read devotedly is Eric Sprott's. It is irreverent, pithy, brutally honest - and very often right.

The latest piece (written with David Franklin) is no exception. Titled "The Solution … is the Problem," it makes clear (via detailed tables) that there isn't enough free and willing cash anywhere to roll over U.S. government debt.

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Therefore, "the future solvency of the U.S. as a nation-state is currently in jeopardy." In other words, the U.S. government is broke. Messrs. Sprott and Franklin then invite the reader "to explain to us how this debt crisis will resolve itself without significant turmoil."

Why am I quoting the letter? Because although I agree with its excellent analysis, I think its definition of "turmoil," being (probably) financial and political, is a bit narrow. I'm convinced that, at this point, one must conclude that war is the likeliest way out. Why is this quibble important?

Because Mr. Sprott's analysis might push one to both buy gold and short bonds, whereas my quibble would support the first conclusion, but be wary of the second.

Here's why: History shows that empires that desperately need money but cannot get it willingly will take it by force from the powerless, then invent reasons why this taking was necessary. Think indebted Mafia dons: Does their credit rating really matter?

The more apt historical analogy is the British Empire after the Napoleonic wars. Once these ended (Waterloo took place in 1815), the British government, like the United States today, was horrendously in debt and practically bankrupt, as all its revenue sources had been used up to vanquish Bonaparte.

But there was one wealth source hitherto untapped: India. India was rich, India was large, India was defenceless. However, India was the "property" of the East India Company (EIC), a concession of the Crown.

So following the Napoleonic wars, little by little the indebted British government seized control of the EIC to grab India's wealth directly. Even as early as 1813, two years before Waterloo, Britain renewed the EIC's charter but terminated its monopoly - perhaps to prepare for future control - and after Waterloo, Britain charged the East India Company an enormous tax to pay for "military services."

And yet even the taxed EIC was still considered "safer" than the British Crown, as evidenced by the yield on its "funds" (bonds). Only by 1823 did the yield on EIC "funds" cross over that of British government ones - in parallel with the takeover of the EIC (and India) by the British government - which also made the pound strengthen. And thus bankrupt Britain fixed its finances by grabbing India's wealth.

Why is it relevant? Because, at the time, the money was in India. Where is it today?

Mostly in sovereign funds, pension funds and other public fiduciaries, as per Mr. Sprott and Mr. Franklin's fine tables. But none of this wealth can - or wishes - to pay for U.S. government debt. So a civilized analyst would conclude: In a world of purely voluntary wealth transfers, one should short U.S. bonds because the U.S. must issue more, and no sane investor would buy them. And one should also buy gold, since it's an asset the U.S. government cannot inflate away.

Gold aside, the above argument assumes that all major wealth transfers are voluntary. But what if the assumption is wrong? In Palermo it is dead wrong, just as it was in the EIC's India.

What if today's world goes (partly) the same way? For example, one of the largest global wealth transfers is the $700-billion (U.S.) annual payment for oil, made by the U.S. to often-primitive and dangerous dictatorships. Will this continue?

Now mind - this is not a matter of "should," only of "probable." I am not suggesting the U.S. would grab the oil in war, nor - as Britain did in India - give prize money to generals who vanquished maharajas and grabbed their wealth for the Crown. But I am suggesting that in the case of countries who use their oil wealth to make life hard for the bankrupt U.S., arguments would be invented to take their wealth to help make the U.S. solvent, or at least make more oil flow so as to cut its price: The resulting financial relief would be so large (let alone the decline in risk premium worldwide) that it would pay for many speechwriters composing justifications. Empires go where the payoff is, and invent reasons later. Like Britain of old and its EIC grab.

So: I agree with Messrs. Sprott and Franklin that the United States is in a hopeless spot. But I half disagree with the (implied) conclusion that U.S. bonds are a short. I think the U.S., like Britain of old, will adhere to the old Wild West rule - when your opponent holds all the cards, overturn the table.

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