fyi, FWD "The Bankrupting of America - John Mauldin's Weekly E-Letter"

-----Original Message----- From: John Mauldin 
[SMTP:wave@frontlinethoughts.com] Sent: 2003/06/06 17:06

Subject: The Bankrupting of America - John Mauldin's Weekly E-Letter

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The Bankruptcy of America And the Number Is? Where are the Profits?
Inflation 
and the Fall of the Dollar Meet me in New York and San Francisco

from John Mauldin June 6, 2003

Today we have a guest writer for Thoughts From the Frontline, as I am in 
Puerto Vallarta sipping margaritas by the beach. I asked my friend,
Porter 
Stansberry, to give us his take on the recent (and very important) study 
which shows the US government is $44 trillion dollars in debt. I think
you 
will like his easy reading style, even if the analysis is sobering.
Then, to 
end on an upbeat note, I asked him to

give you a free link to a recent study by David Lashmet, one of his
analysts 
from the Pirate Investor, on new cancer treatment breakthroughs just 
announced last week at an industry meeting. We have all lost friends to 
cancer. There is real hope we may lose fewer in the near future. Now
let's 
read Porter's thoughts:

The Bankruptcy of America By Porter Stansberry

"There's nothing unprecedented about interest rates beginning with the
numbers 
1,2 or 3. They were the rule rather than the exception in the days of
the 
gold standard. But, as far as I know, no rates such as those quoted
today 
ever appeared in a monetary system unballasted by gold or silver." --
James 
Grant, Forbes 6/9/2003

America is bankrupt.

This from Jagadeesh Gokhale and Kent Smetters.

No, these men are not a Saudi terrorist or Southern right wing extremist 
respectively. Instead the former is the Senior Economic Advisor to the 
Federal Reserve Bank of Cleveland, and the latter is a full professor at
the 
Wharton School of the University of Pennsylvania.

Credentials notwithstanding, the men's conclusion would seem
preposterous. 
America has never seemed more prosperous. Even this recession has been
minor.

On the other hand, their source seems reliable: Gokhale and Smetters got
their 
data from the U.S. Department of Treasury. And they performed their
present 
value calculations on the order of then Secretary of the Treasury Paul 
O'Neill. Smetters was, until recently, on staff there, as the Deputy 
Assistant Secretary for Economic Policy. The Treasury needed new numbers 
because the Office of Management and

Budget's numbers have almost no connection to reality. (For example,

OMB projects a constant 75-year average lifespan in its Social Security
and 
Medicare cost estimates even though the average lifespan in America is 
already 78...and increasing at the rate of three months every year.)

When you look honestly at our government's future obligations, the
numbers in 
the red quickly become so large they require entirely new measures to 
describe them. Gokhale and Smetters invent the term "financial
imbalance," to 
measure Uncle Sam's impending bankruptcy. Financial imbalance means:
"current 
federal debt held by the public plus the present value of all future
federal 
non-interest spending minus the present value of all future federal 
receipts."

Or, in other words, Gokhale and Smetters use FI (financial imbalance) to 
estimate how broke Uncle Sam is when measured in constant dollars,
today. FI 
is how much Uncle Sam owes now and will garner in the future versus how
much 
he is on the hook for now and later.

And the number?

"Taking present values as of fiscal-year-end 2002 and interpreting the 
policies in the federal budget for fiscal year 2004 as current policies,
the 
federal government's total fiscal imbalance is equal to $44.2 trillion."

Huge numbers like $44.2 trillion don't mean much to anyone without a 
comparison. So, consider: Uncle Sam's "financial imbalance" is 10 times
the 
size of our current national debt.

In order to achieve current solvency, the government would have to raise 
payroll taxes by 68.5%, beginning today. Alternatively the government
could 
cut Social Security and non-Medicare outlays by 54.8% immediately and 
forever. (How do you think either policy would go over at the polls?)

It's unlikely that either huge tax hikes or huge Social Security cuts
will 
occur. Most likely nothing will happen. And so, the government's
insolvency 
will grow much larger. By 2008 FI will reach $54 trillion. To reach
solvency 
at that point, taxes would have to increase by 73.7%.

Looking at the government's finances in a serious way is like expecting
a 
Ponzi scheme operator's numbers to add up. They don't. And they never
will; 
that's the game. Making political promises is easier than paying for
them. 
Theoretically these debts could be inflated away by printing more
dollars. 
But legally this would require the repeal of the 1972 Social Security
Act, 
which pegs benefits to inflation.

And that will not be a simple matter.

Worse, these financial imbalances stem from direct wealth
redistribution, from 
one generation to the next. They're a disincentive for saving and
investment. 
They hinder current growth today while bankrupting America tomorrow. But 
politically they're sacred cows.

Ironically, the people most threatened by this hydra-headed financial
and 
political monster are the very same people these programs were designed
to 
benefit: the middle class.

Your typical 50-year old, middle class American isn't prepared to retire 
without a lot of help. In fact, most baby boomers will never even pay
off 
their mortgages. Lawrence Capital Management notes in the last 19
quarters 
total mortgage debt increased by $3 trillion (+58%). To put this in 
perspective, prior to 1997, it took 13 years to add $3 trillion in
mortgage 
debt. Or, said another way, before 1997, around

$50 billion a quarter was being borrowed against homes. Today the run
rate is 
near $200 billion per quarter, or four times more. Household borrowings
now 
total $8.2 trillion in America and they continue to grow at near
double-digit 
rates.

And it's not just mortgage debt that's problematic...

According to the Federal Reserve Bank of St. Louis, US household
consumer debt 
is up more than 12% from last year. Debt service, as a percentage of 
disposable income, is above 14%. Only twice in the last 25 years has
debt 
service taken as large a chunk of America's income - - and that's
despite the 
lowest interest rates in fifty years.

When you look at these numbers you quickly see the problems our favorite 
weekly scribe, John Mauldin, hopes we can "muddle" through:

The government is making promises it can't keep without bankrupting the 
nation; the individual American has made promises to his bank he can't
keep 
without bankrupting his family. And we haven't even looked at the
biggest 
borrowers yet - corporations.

Corporate America has been on a borrowing binge for most of the last 25
years. 
Even the very best companies are now loaded up with debt. GE, for
example, 
has been a net borrower since 1992.

And IBM borrowed $20 billion during the 1990s, while at the same time
buying 
back $9 billion worth of its stock on the open market. Why would you
take on 
expensive debt while buying back even more expensive stock? It made the 
income statement look good, converting debt to earnings per share. And
that 
made Lou Gerstner's bank account look good, because he got paid in
options 
whose value was influenced by earnings growth. Meanwhile the balance
sheet 
was covered in the concrete of debt.

Then there's Ford - one of America's greatest companies. Debt on the
balance 
sheet is now 24 times equity.

Lower interests rates aren't necessarily helping, either.

Yes, firms can restructure debts and improve earnings thanks to lower
interest 
expenses. But these lower interest rates are also keeping companies that 
should be bankrupt, alive. Consider Juniper Networks, which shows a 
cumulative net loss of $37 million after ten years in business. Despite 
having over $1 billion in debt, Juniper was able to close a $350 million 
convertible bond deal that pays no interest coupon two weeks ago. The
company 
is borrowing $350 million dollars until 2008 for free. Bankers say
similar 
deals are closing at the rate of two a day.

Why? Because investors once burned by stocks are now plowing into bonds. 
Through April of this year, investors sank $53.7 billion into bond
funds, 
compared to only $4.5 billion into stock funds.

The money isn't going into new capital investment. Instead, this "free"
money 
is paying off more expensive, older loans. Corporate America is
repairing its 
balance sheet. The ratio of long-term debt to total liabilities now
stands at 
68.2%, the highest level since 1959,

according to economist Richard Berner of Morgan Stanley. And cash is
staying 
put: corporate liquidity (current assets minus current liabilities) is
at its 
highest level since the mid-1960s. The combination of cash and extended
debts 
is easing the credit crunch. Bond yield spreads have narrowed between 
investment grade bonds and government treasuries, from 260 basis points
in 
October 2002 to only 108 basis points currently.

You can also see this new debt isn't creating new demand by looking at 
capacity utilization. If businesses were spending again, capacity
utilization 
would be up. It's not. Across the board in our economy, capacity
utilization 
has fallen from around 85-90% in 1985 to below 75% today, according to
the 
Board of Governors of the Federal Reserve System. The data makes sense:
areas 
of our economy that had the biggest investment boom show the biggest
decline 
in capacity utilization today. Capacity utilization in electronics, for 
example,

has declined from 90% in 1999 to under 65% today.

In the long term, debt restructuring does absolutely nothing to improve 
America's economic fundamentals. Lower interest rates aren't spurring
new 
investment or new demand. More debt only postpones the day of reckoning. 
Thus, the current bond market mania is just the corporate version of the 
consumer's home equity loans: We're buying today what we couldn't afford 
yesterday...

Where are the Profits?

What we need are genuine profits. But there aren't many real profits

in the leading companies of the baby boom generation, the generation

that's approaching retirement with a bankrupt social net and no net
savings.

Consider Adobe Systems, a leading software firm, headed by a baby boomer 
(Bruce Chizen, CEO, was born in 1956). Sales are rebounding. Earnings
are up. 
But profits genuinely available to shareholders have all but
disappeared.

In the last five years, Adobe's net income has grown from $105.1 million
to 
over $191 million. But stock based compensation in the same period grew
from 
$50 million a year to over $184 million a year. Taking into account
options 
expenses, net income shrunk from $54 million to only $6 million. Adobe,
a 
firm valued by Wall Street for $7 billion can only produce $6 million in 
genuine net income.

Without profits, an entire generation of Americans will see their
retirement 
savings wiped out. Moving into bonds instead of stocks will not save
anyone - 
interest payments must come from corporate profits. Even with zero
coupon 
loans, principle must be repaid.

And there are still bigger threats to corporate profitability.

As was reported this week in the Wall Street Journal, New Jersey State
Senator 
Shirley Turner, upset that a firm hired by New Jersey would use cheap
Indian 
call-center workers, introduced a bill requiring state contractors to
use 
U.S.-based employees. As a result, New Jersey wound up paying 22% more
for 
the $4.1 million contract -- $100,000 per job it saved. Politicians in
five 
states - New Jersey, Connecticut, Maryland, Missouri and Washington -
are now 
partnering with the AFL- CIO to craft new laws against using cheaper
offshore 
workers for service sector jobs like accounting, programming and
customer 
service.

The goal, of course, is to prevent service sector jobs from leaving the 
country, like we lost manufacturing jobs. And as with Social Security 
financing, the politicians believe they can simply legislate economic 
reality. They won't save jobs, but they will force more investment
capital 
away from America and make American professional service firms less 
competitive.

Meanwhile, new FASB guidelines regarding stock options -- rules meant to 
encourage genuine profitability -- are in danger of being stymied

by Congress. Congressman David Dreier (R, California) and Congresswoman
Anna 
Eshoo (D, California) have written new legislation that would impose a 
three-year ban on the new rules. The FASB wants to force companies to
count 
options grants against earnings, where excessive executive compensation
would 
impact the bottomline (as it should). Unfortunately, super-rich
technology 
executives, who have fed at the stock option trough for ten years are
the 
main factor in California political fund raising.

Legislation like these two recent items and the never-ending stream of 
consumer protection laws, environmental laws, SEC regulations etc., will
all 
combine to dampen any lasting economic growth and to discourage 
entrepreneurial risk taking.

It's more to muddle through. All of which is reason to doubt corporate 
profitability will rebound substantially before corporate debts, home
loans 
and America's retirement crunch begins in 2010.

And I haven't even mentioned the problems lower interest rates are
causing for 
insurance companies (annuities) and life insurance companies...

So...what will happen? What's the financial endgame? What are the
consequences 
of America's bankruptcy...?

Inflation and the Fall of the Dollar

Like John, I'm sure we'll find a way to muddle through. In the end -
even if 
there's more deflation in the short term - our government will end up 
monetizing its debts. Greenspan and others at the Fed have already
mentioned 
they're prepared to buy large amounts of long-dated Treasury bonds.
Retiring 
Treasury obligations with dollars the Fed prints will cause a weaker
dollar. 
That means, sooner or later, inflation will be back -- and in a big way.

This is the real endgame, as I see it. Let me explain.

One of the smartest and best investors I've ever met, Chris Weber, says
we're 
entering the third dollar bear market. And if there's anyone worth
listening 
to when it comes to the currency, it's Chris Weber. Starting with the
money 
he made on a Phoenix, Arizona paper route in the early 1970s, Chris
built a 
$10 million fortune, primarily through currency investing. He has never
had 
any other job. When I met him seven years ago he was living on Palm
Beach. 
Now he resides in Monaco. I saw him two weeks ago in Amelia Island,
Florida.

According to Chris, the first dollar bear market began in 1971. It ended
when 
gold peaked out at $850 an ounce in 1980. This inflation helped ease the 
debts the U.S. incurred fighting the Vietnam War while wasting billions
on 
the "war on poverty."

The second dollar bear market began after the Plaza Accord in 1985. This 
inflation helped pay for Reagan's tax cuts and the final build-up of the
Cold 
War. (You should remember the impact the falling dollar had on stocks.
They 
collapsed in 1987 on a Monday following comments over the weekend by
Treasury 
Secretary Baker who said the dollar could continue to weaken.)

And Chris thinks this - the third dollar bear market - will be much
worse than 
the last two. This time the falling dollar might lead to the end of the 
dollar as the world's only reserve currency. He's not the only one who
thinks 
so. Doug Casey sees this happening too. And I believe it's not an
unlikely 
outcome.

Why? Because the imbalances inside the U.S. economy have never been this 
large, nor has our current account deficit ever been this big and never 
before has the United States been more dependent on foreigners for oil.

This possible move away from the dollar as the primary reserve currency
for 
the world is high-lighted by a recent comment from Dennis Gartman (The 
Gartman Letter):

"At what has been promoted as "The Executives' Meeting of East Asia-
Pacific 
Central Banks" (The EMEAP), those attending took the preliminary steps
toward 
creating an Asian bond market fund to be managed by the central bank's 
central banker, the Bank for International Settlements (The BIS).
According 
to the Nihon Keizai and The Japan Daily Digest, the EMEAP is a
co-operative 
of eleven regional central banks and it intends to create a fund with 
contributions from its member banks and to use the money to invest in
dollar 
denominated government debt... initially. Then from our perspective, the
fun 
begins. Given that the idea works in practice, the fund will proceed

to increase its size and to start buying debt denominated in local
currencies, 
moving away from the US dollar. The idea according to the Nikkei is to
give 
the Asian central banks a place to invest the dollars their economies 
generate in something other than U.S. Treasuries. The intention is
ultimately 
to keep the foreign currencies that these economies generate available
in the 
region for investment. They are apparently weary of washing these
earnings 
back into the US

dollar, and that weariness has become all the more emphatic in light of
Mr. 
Snow's ill-advised comments over several weeks ago. President Bush's
comments 
over the weekend might have assuaged those concerns somewhat, but they
are 
still looking above for other avenues of investment. Were we in their
shoes, 
certainly we'd be doing the same. The EMEAP's member central banks
include 
Australia, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia,
New 
Zealand, the Philippines, Singapore and Thailand. Other's may join,
making 
the effect even more material. Snow's comments created a veritable
blizzard 
effect."

If this happen, it will accelerate the drop of the dollar predicted by
both 
John and myself for some time.

For investors, while we muddle through this mess, it will pay to
remember: 
America is bankrupt. Another big inflation is coming. And that's bad for 
equity investors. From 1968 through 1981 the Dow lost

75% of its value, in real terms.

What should you do? Imagine the 1970s, but on an even bigger scale. Doug
Casey 
says fair value for gold right now is $700 an ounce. And he expects it
to go 
to $3,000. It's hard for me to imagine that he's right. But then I look
at my 
fellow American's finances, at Uncle Sam's balance sheet and the mockery 
corporate America has made of accounting standards...and suddenly gold
looks 
pretty good.

Dr. Sjuggerud compiled this list of the annual returns of various asset 
classes from 1968 to 1981, during the last major collapse in the dollar:

19.4% Gold 18.9% Stamps 15.7% Rare books 13.7% Silver 12.7% Coins (U.S. 
non-gold) 12.5% Old masters' paintings 11.8% Diamonds 11.3% Farmland
9.6% 
Single-family homes 6.5% Inflation (CPI) 6.4% Foreign currencies 5.8% 
High-grade corporate bonds 3.1% Stocks

Chances are pretty good that you don't have a big position in these
assets 
(with the exception of housing). It might be time to consider moving
some of 
your savings out of stocks and bonds and into things more attuned to the 
declining value of the dollar.

We'll muddle through...the way we always do.

Your filling-in-for-my-friend analyst,

Porter Stansberry
* * * * * * * * * * ** * * * * * * * * * *
Editor's note: Porter Stansberry is the founder of Pirate Investor 
(www.pirateinvestor.com), a publisher of independent financial
newsletters. 
Pirate Investor titles include: Porter Stansberry's Investment Advisory, 
Steve Sjuggerud's True Wealth, Extreme Value and Diligence, a small cap 
research service for high net worth investors.

Here is the link I promised you on the cancer treatment e-letter: 
http://www.pirateinvestor.com/BiotechBlast.html

Meet me in New York and San Francisco

I will be in New York speaking at the Hedge Fund Forum June 23-25. I

will have some time to meet with clients and prospective clients. You
can 
check this out at www.iirusa.com/hedgefundforum. Attendees who use the
code 
XUSPKR get a 15% discount. I will also be in San Francisco August 13-17
at 
the 2003 Agora Wealth Symposium (as will Porter Stansberry). This should
be a 
very interesting conference for active investors. You can learn more by
going 
to http://www.agora- inc.com/AGW03/home.cfm?code=18. Again, I will set
aside 
time to meet with investors. You can email me if you are interested in 
meeting.

As you read this, I will be in Puerto Vallarta for a long weekend with
my 
bride and two youngest sons. I predict margaritas, golf and some quality 
family time. I will be back in the office and writing next week's letter
on 
Tuesday. Enjoy your weekend. And remember, just because the economy will 
Muddle Through does not mean that we have to do so in our personal
lives. 
Make sure you live it to the fullest.

Your can't wait to get on the plane analyst,

John Mauldin John@FrontLineThoughts.com

Copyright 2003 John Mauldin. All Rights Reserved
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