Executive Summary

The function of the economy is to economize – that is, to do more with less. Increasingly since the early 1980s, the US has been doing less with more, using more and more of the global supply of financial assets while steadily producing less per dollar utilized, until finally the US has reached the point where it is doing virtually nothing at all while borrowing trillions of dollars just to keep standing still. Very recently (July/August 0f 2009) U.S. Treasury Secretary Timothy Geithner is being faced with the increasingly difficult task of marketing US government debt because the federal deficit has soared beyond $1 trillion. He recently traveled to Europe and the Middle East to persuade investors to continue purchasing Treasuries. It is turning out to be a very big task. Our concerns that the global financial system may not be able to handle the twin financial insolvencies of both Japan and the US appear to be well founded. Of more concern is that the US may have to resort to the printing press unless it chooses to deal with its solvency crisis with unknown consequences for the value of the US dollar, the global economy overall, and the very ability of any economic expansion to take place for some unknown but lengthy period of time. It is all so unnecessary.

In the third quarter of 2007, the solvency condition of the United States, as measured by its GDP/Debt Ratio, fell into what we at Strategic Analysis Corporation (SAC) designate as a ‘second-order insolvency’. And it was precisely at that juncture that the debt markets, first of the US, and then the globe, began to seize up and did so in subsequent months with stunning speed. The US Federal Reserve Board reacted as it has done for more than 20 years whenever a slowdown threatened. This time, however, given the severity of the freeze, as well as lowering interest rates and pumping in additional credit, it started using what has become known as “quantitative easing”, which included purchasing bad debts on bank balance sheets, and began pressuring other nations to join in a general attempt to get American (and global) credit markets functioning smoothly once again.

The true central issue is, however, that when the debt accumulation reaches a critical juncture, additional debt merely creates an impediment to further activity. This occurs when the marginal efficiency of debt in terms of generating additional GDP per dollar of incremental debt plunges towards zero, and renders much of the new debt issuance effectively sterile in terms of producing a significant net additional economic work (GDP).The US has reached that point in the mathematics that underlies the analysis that SAC performs, as is evident by the drying up in domestic and global debt markets which has occurred and which the US Federal Reserve Board is desperately trying to undo.

We can put the problem into numerical perspective, using the Atrill Solvency Curve. The Atrill Curve measures the maximum amount of activity (debt plus GDP for purposes of this discussion) that can be generated at various solvency ratios (per dollar of the cost of maintaining state, which is our unique variant of the ‘cost of capital’). If the US were still operating in its usual historical and efficient solvency range close to the peak of the curve, the total requirement for US indebtedness would be in the general area of $21 trillion, or approximately $1.45-1.50 per dollar of GDP (the reciprocal of .689 on the graphic above which measures GDP per dollar of debt). Instead, total US indebtedness amounts to more than $52 trillion, an excess of over $31 trillion, and is escalating in 2009 as present US government plans for coping with the ‘crisis’ are realized. Escape from this condition calls for a radical change in fiscal and monetary strategic policy: simply put, save for the very dubious short term palliative effects due of quantitative easing, this solution to recessions, which has been employed with increasing vigour and decreasing effect over the past 20 years, can no longer work on any kind of self-sustaining basis. That means that from here on in, with no change in policy, US monetary and fiscal authorities, and the US economy, are on a treadmill going nowhere.

When the curve is inverted, the Y Axis, rather than measuring the dollar amount of total activity which can be generated, can now be used to determine the “cost of maintaining state”, that is, holding the balance sheet together, our own unique variant of the ‘cost of capital’ measure. Under increasingly insolvent conditions, the cost of holding a balance sheet together escalates very rapidly. This means that the total activity of the economy is less than it could be, and it is much more costly to keep going (regardless of nominal interest rates).

Practical evidence of this is very clear. Japan entered this precisesame solvency condition 11 years ago and has not been able to escape its grip, even after all this time. Japan has resorted to ultra-low interest rates, loose monetary policies, and massive government debt issuance for more than a decade. To date, during which time total government indebtedness rose from roughly 40% of GDP to 200% of GDP, the GDP of Japan has remained essentially dead flat. The Atrill Curve shows that the US is unlikely to be able to achieve any better results – and even that outcome is open to question. That is because, if nothing is done except to attempt to soldier on as very much appears to be the case at the present time, the US government must borrow trillions of dollars in the years ahead under the current ‘stimulus’ programme, and the rest of the globe may simply not be able to handle the burden.

There are two “sides” to the Atrill Curve. On the right hand side of the peak at .689, an increase in debt can lead to an increase in activity (GDP). On the left hand side, a decrease in debt leads to an increase in activity (GDP). At .689, there is an optimal balance between the generation of activity and the generation of debt. As today, the US is far over on the left hand side, trying to push more debt onto its citizens and the country as a whole is doomed to failure. At the current solvency ratio for the US, which we term a ‘second-order’ insolvency, about the only thing that added debt generates is even more debt – as the Japanese have already discovered over the past 10 years or so. In practice, what occurs when governments attempt to push out additional debt is that the private sector reacts by decreasing its own debt load through an increase in savings and an improvement in balance sheet leverage.

The solution to this insolvency is no different than from any insolvency, namely eradicating debt from the (national) balance sheet by paying down debt through various means including sale of assets. As with any insolvent, further debt issuance will only compound the problem, even assuming it can be done. Those who might fear that the massive paydown of debts would drastically slow down the US economy clearly do not grasp the nature of insolvency and its aftermath. When a person or company is deeply insolvent, lifting the burden of debt frees them to get back to those productive activities which generate wealth rather than plodding along servicing the dead weight of increasingly sterile debt. The Atrill Curve mathematics shows that far from being hurt by debt reduction, the GDP of the US could be some 22% higher than it is today if it were solvent within its historic parameters.

The US government itself can make a strong start to the solution by paying down the debts of [all] US governments through the issuance of what we have termed Phoenix Trust units. These consist of a 30-year forward “sale” of US tax revenues, the classic solution to debt crises that governments have used since time immemorial, although we will put it in a very modern dress. This will need to be followed up by placing American banks (indeed, all banks, domestic and global) back under Basle I rules, the erasure of most of the speculation-oriented derivatives down to those levels actually required to conduct normal-course business, and the mending of household balance sheets. Speed is of the essence, however. No successful restructuring of an insolvent balance sheet has ever been carried out over 8-10 years, or even 4-5 years, without risking further severe loss. The ultimate reward for this exercise is to create the financial parameters which will permit more rapid US and global growth in general, and a better distribution of growth and wealth into the emerging countries as well as the mature industrialized ones. From a US point of view, the Atrill solvency structure will help to bring about optimal growth and employment without the necessity of excess leverage. It will also help to create a framework by which governments everywhere can ensure that the financial excesses of the past few years never recur again.

We at Strategic Analysis Corporation are concerned that the failure of the United States to take comprehensive action to clean up its horrific national balance sheet – along with its current pursuit of policies already proven to result in, at best, economic stasis – will result in a very poor domestic growth outlook which will spill over into the global arena, as the US government continues to tap into global savings to feed its debt habit. This in turn will lead to a volatile but overall long term poor stock market outlook, probably unduly low interest rates which will penalize saving, and a weak domestic and global investment climate. Hence, we have made an effort to deploy our solvency theory work to suggest an exit strategy for the US and its government.

Those who are bullish on the economy in the more or less standard interpretation of a (normal) recession/recovery scenario – even the recovery is muted – argue that the Index of leading Indicators is turning back up, even if it still in negative territory, and that there are signs that the rate of descent of the US economy is slowing, with the implication that it will soon be turning up again. It has been a bit of a scary ride but all’s well that ends well. It is not that we, too, wouldn’t like everything to work out so nicely. It is more a case that the evidence underlines a key point that this time is different. The US has reached the same solvency condition that Japan entered 11 years ago, and has yet to recover from. The US government is going hat in hand, around the world begging for alms (or a trillion dollars, which ever comes first), an unprecedented event in modern times. It is time to try something new and radical, as we believe that the evidence shows that the borrow-and-spend policies of the past are bankrupt.

Even if nothing comes of our efforts and we wind up having merely tilted at windmills, at the very least we firmly believe that we will have provided a framework for our clients to understand the malaise that is infecting the globe today and in the future, and thereby improve their own investment performance in the future.

We expect that there will be one of two outcomes for investors if nothing is done to clean up the two major sovereign insolvencies. The first is a Japanese-like outcome in which the equity markets “drift” slowly lower over time, albeit within in a very volatile framework. That may well be a ‘good’ result under the circumstances. Americans being Americans, however, with little patience for “non-results”, their monetary and fiscal authorities may well push for something better. That could result in the use of the printing press if, as we suspect, the rest of the globe refuses to – or more likely cannot – go along with the US attempt to co-opt global savings to keep the US economy bumping along. The outlook for the US dollar (and the US economy) in this case would be horrific.

Phoenix Rising

A Proposal to Eliminate the Global Debt Malaise

Introduction

For more than two decades, whenever there has been a slowdown – or even the threat of a slowdown – in the world’s largest economy, that of the United States, the Federal Reserve Board’s solution has always been to lower interest rates and pump a lot of credit into the economy. But each time around has required a little more stimulus and even lower interest rates. Even as that “time-tested” solution appeared to work so well, it hid a massively growing problem of accumulating debt on that nation’s books until one day in late 2007, the solvency chickens came home to roost. Even then – meaning right now – the powers that be, led by the chairman of the US Federal Reserve Board, Ben Bernanke, persists in attacking the problem as just another exercise in cutting rates and pumping in credit. The challenge is, however, that when the debt load reaches a critical extreme as it now has, the solution is no longer more debt but less, drastically less. Herein, we will make the case for a major sea-change in policy thinking in dealing with the current (and burgeoning) debt load, away from “stimulus” of credit pumping, and towards stimulus of another – that of freeing the US, and the world, from the dead weight of virtually sterile debt. Instead of adding to the debt load, we advocate that it be drastically and rapidly reduced instead, thereby providing renewed financial freedom for entrepreneurship. Regretfully, rather than building resilience into the financial system, what normal and natural resilience there was has been systematically undermined by encouraging and abetting the circumstances whereby more and more debt has been loaded onto the US, actually drastically increasing overall riskiness in the financial system instead. Furthermore, it is clear from the “stimulus plan” that is in process of being put in place, that it will involve a huge increase in government intrusion into the affairs of the US. If the record of Japan is any indication, this intrusion will widen and deepen over the years to come, not fade away “once the crisis is over”.

Right now, the monetary and fiscal authorities seem to want to return to “normal economic conditions” as they were in the very recent past years, and then and only then “something may be done”. The central problem to this approach to recovery is that right up to the recent past years, the US had been accumulating more and more debt without any concern about the consequences, and the consequences have finally resulted in a debt freeze-up and savage recession. Our solvency approach to the debt issue shows that there is no possible way to return to the recent past as it is the actions of the recent past that has brought about what Isaac Asimov termed a Seldon Crisis. Taking on massive new indebtedness, the source of the problem, is no longer the solution to attaining renewed American, and probably even global, growth.

We will start with the proposition that when the problem is debt, the answer is not more debt. Yet the “solutions” being offered (by governments at any rate) to solve the current credit malaise all lie in the attempt to get households and corporations even more into debt. Compared with what has been the norm for most of the past 100 years, we calculate that at the present time the United States of America is carrying roughly $31 trillion in excess indebtedness and rising on its ‘national balance sheet’, and that number will grow rapidly if the more aggressive of the “stimulus plans” take place. While there is no doubt that the new American administration is fully prepared to throw as much stimulus (for which we should read “additional credit/debt”) into the system as is deemed necessary to jump start the currently weak economy, a permanent solution to this problem will not and cannot be found in that direction as is already clear from the evidence from another highly over-indebted country, Japan.

If the stimulus does not work to return the US economy to a growth condition, as we expect, there is no contingency plan to fall back on. Indeed, evidence that the stimulus is not working comes from the reality that US households are not using ultra-low interest rates to borrow but are paying down their debts and starting to save once more – a major sea-change in thinking. Banks are reducing lines of credit, including credit card limits, and tightening their loan criteria substantially (as well they might). Increasingly, there is talk of ‘deleveraging’ going on, as the private sector at least, appears to understand that additional debt is anathema.

We will introduce the reader to the Atrill Solvency Curve, a unique approach to measuring ‘solvency’, which is based upon the mathematics underlying the theory of Accounting Dynamics developed by the late Dr. Verne Atrill, and which Strategic Analysis Corporation has been employing for years in the analysis of corporate debt and equity, as well forecasting currency and stock prices, to show clearly why the proposed stimulus spending is the diametrically wrong approach to use. As well, we will offer a solution which could lead the US, and the globe, out of its present financial morass. We will use Dr. Atrill’s theory of solvency to show that the systematic reduction of debt will not only work far better than additional stimulus, but also will work far faster in getting to the heart of a permanent and lasting solution. Far from damaging the future economic outlook, debt reduction at this juncture will serve to stimulate growth instead.

Our proposed solution will not be painless, nor will it be implemented without substantial protest, most notably from those who have benefited the most from the debt explosion. Both pain and protest will occur. But…not nearly as much pain – and over a much shorter period of time – than if our solution, or a facsimile thereof, is not implemented. The payoff will not only be of major benefit to the United States and Japan, the twin loci of the global debt crisis, in terms of renewing the impetus to economic growth, but also it will serve to provide the necessary financial resources to improve the economic outlook for the rest of the globe and speed up the development of the emerging nations. Not only will this solution relieve the global markets of the credit-driven breakdown from which it is currently suffering, but it will also relieve the pressures on the capital markets and allow them to get back to their normal functional modality. Given the loss of wealth in the capital markets alone that has occurred thus far, this will be a huge relief to everyone.

We will challenge the notion, popular in some quarters in the US, that the free market will find the solution to this economic problem. It clearly has not, will not, and cannot. Only strong central government action will work, including better regulation and future monitoring of general solvency trends and developments. An overly free and increasingly unfettered market has been allowed to flourish, abetted by changing government regulation, and has brought us to this impasse. But now the so-called free market has now effectively thrown up its hands and is waiting, even counting on, the necessary political leadership to get us back out. Even so, many of its participants are trying to have it both ways, government bailouts but few consequences for those whose actions have taken us to where we are at today.

The bottom line as far as the US is concerned is that current attempts to deal with the US (and global) recession through so-called quantitative easing, lower interest rates, and stimulation in general are doomed to failure. We make this forecast on both theoretical grounds and from the practical evidence from Japan. Bernanke’s assertion that the Japanese “did not try hard enough” to escape their own insolvency is based on his total lack of a fundamental framework with which to understand the mathematics (let alone the practical workings) of the balance sheet in general, and the nature of insolvency in particular. Herein, we will rectify that grave lack of knowledge which has led the US into such perilous waters.

While the precise details of the debt elimination plan that we have generated here may be altered as other astute minds focus on this solution, the underlying purpose and our approach to the debt malaise cannot be circumvented if there is to be a permanent recovery. However, once government debt – all government debt – has been eradicated, then dealing with the gross excesses of private sector debt will be more manageable. Decisive leadership is always a prerequisite of success.

Finally, we will observe that underlying our solution to dealing with government excess indebtedness is an approach that is as old as government itself. There is nothing new under the sun when it comes to dealing with debt problems, save the imagination and the will to deal with them – with finality.

Is There Life After Debt?

The US, and now the entire global economy, has been hit by a debt crisis, and the epicenter is the US economy itself. The US national balance sheet had been steadily worsening for years (becoming more “insolvent” in the credit analysis terms of SAC) – yet no one in a position of responsibility and authority had ever acknowledged that even a hint of a problem might be impending. In late 2007, as the solvency of the US balance sheet became critical, the US credit system began to ice over. This rapidly spread, and by the second quarter of 2008, a global credit deepfreeze had set in. Though it ignored these potential problems for years, the US now faces a solvency challenge that it must deal with firmly, effectively, and finally, so that it never recurs. We offer a solution early for the new Democratic administration so that the US and, hence, the global economy, can get back on a renewed growth track. While the Pavlovian (Greenspanian?) response to the “sudden” credit crisis seems reasonable based on what that country’s central bank had been doing (‘successfully’) for years, that is, pump in additional credit as hard and fast as possible, no one in charge today seems to grasp the true nature of the problem nor how to deal with it so that it does not recur. This may be because the way out calls for a repudiation of everything that “worked” over the past 25 years. The approach of Obama administration so far will only make the problem more intractable. Partially that is because many of the architects of the current catastrophe, which include the current chairman of the US Federal Reserve Board, remain in power and continue to “wrecktify” the problem by steering the American ship of state into steadily more turbulent waters. Partially, that is also because there is no sound, disciplined framework to make the key decisions necessary to finding an exit strategy.

Providing additional credit and hoping for the business cycle to turn up is not going to work this time. While such notables as Nobel prize economist Joseph Stiglitz has called for confidence-raising measures, including regulatory reform, stemming foreclosures, and passing a “stimulus package that works”, this is akin to throwing a pail of water to a drowning man. The US business cycle cannot turn up in the traditional sense, so laden is its US balance sheet with debt. And the rest of the world has become so tied to the US and its balance sheet that we are all in trouble as well.

What we need is a solution that will eliminate the source of the problem, too much debt, as quickly and as much as possible. This solution should accomplish three things:

1. Eliminate the excess debt.
2. Honour as many of the financial and social contracts as possible.
3. Create the financial pre-conditions for future growth.

Finally, in the spirit of “something for everyone”, all global participants should benefit from this solution. Though this may appear to be a tall order, as we will see, it is an order that can be met.

Defining and Measuring the Issue of ‘Solvency’

The origins of the current malaise really starts with the simple-minded “Laffer Curve”, which purports to explain the tradeoff between taxation rates and the amount that can be raised under any set of tax rates. The idea behind it is, in essence, to direct financial resources to the private sector, which presumably will make better decisions than governments and thereby grow the economy faster. This will in turn raise total wealth, taxes will rise, and the cycle will continue onwards and upwards. With this “free market, fee economy” idea in mind, Reagan, despite ongoing federal deficits, began a spate of tax reductions to boost the US economy out of the aftereffects of the recession of the early 1980s. But the problem with the Laffer Curve is that it is one-dimensional. It may have had some effect (and certainly appealed to the wealthy who benefited mightily from it), but there were no limits on its application. And, because it did seem to work well for many years, “tax reduction” has become virtually a mantra of American politics. But like the strictures laid down by Lord Keynes many years ago, American governments since 1980 conveniently neglected the “other side” of the Laffer Curve (had there been one), namely, that tax reduction must be accompanied by expenditure reduction until the hoped-for strong economic growth (the promise of the Laffer Curve) allows additional government spending to occur safely and affordably. While the Reagan administration reduced taxes, it kept spending at a high level, and total US indebtedness relative to the growth in GDP began to rise well above its long-term norms. Save for the Clinton administration which did manage to rein in the government’s balance sheet, total US indebtedness relative to GDP has risen ever since. In recent years this growth has increased to alarming proportions, reaching the tipping point in late 2007, as the US generated huge amounts of debt and virtually no GDP.

How Much Debt is Too Much?

We note with interest that an “agent model” is currently being developed by a three-man team (Yale economist John Geanakoplos and two physicists, Doyne Farmer and Stephan Thurner), to help determine how the level of credit in a market can influence its overall stability. They start with the proposition that credit in general is good because it leads to creative economic activity, but that “too much credit” can be dangerous. In their model, market participants, including hedge funds, do what they do in real life – seek profits by using increasingly higher leverage to amplify investment gains. Of course, increased leverage ties market participants into ever-tightening ‘chains of financial interdependence’, which can cause market instability (as is shown by the team’s simulations) because it becomes more likely that trouble in one place (for example, the failure of one investor to cover a position) will spread more easily elsewhere.

Though this in itself is not surprising, the model also shows that instability in the credit market does not grow gradually, but arrives suddenly. Beyond a certain threshold, their “virtual market” abruptly loses its stability in a “phase transition”; (think of water turning to ice). At this point, a collective financial “seizure” becomes a certainty. Needless to say, modern equilibrium thinking is not attracted to, nor is it mathematically equipped to deal with, this possibility, but is precisely what occurred in late 2007.

While Geanakoplos et al. have stressed that their work is speculative and is not meant to be completely realistic, it does illustrate the kinds of things that occur in actual markets. It also suggests that the explanations we hear in the aftermath of every credit crisis – how it started and spread, who’s to blame, and so on – lead economists to miss the actual underlying cause.

The reason that this “new” analysis caught our attention is that it supports the mathematics of the theory of ‘Accounting Dynamics’ and has been used in daily practice by SAC and its clients under the general appellation, Structural Valuation Analysis (SVA). The mathematics underlying the theory were developed by the late Dr. Verne H. Atrill (also a physicist by training) over a 25-year period prior to 1978 and has actually been in public view since that time.

The Atrill Solvency Curve

What would be very useful under current (and, indeed, all circumstance) would be to have a rigorous way to describe and measure the limits of indebtedness which is both predictive and prescriptive. At this juncture, therefore, we will introduce the Atrill Solvency Curve which does define and measure the tradeoff between economic activity and the solvency of an entity, whether it be a company, household, government or, as it turns out, an entire country. The Atrill Solvency Curve presents a powerful curve-linear relationship, which, unlike the Laffer Curve, has coordinates and constraints that are measurable and highly useful for forecasting. While herein we will only briefly explain how this Curve operates, its concept has been laid out in Dr. Atrill’s book, How ALL Economies Work (1979) and The Freedom Manifesto (1981). The theories were also encapsulated in an article Will the Real Laffer Curve Please Stand Up? in 1983.

On the Atrill Curve graphic, the X-axis measures the solvency of a financial entity and is measured as the ratio between “dynamic receivables” divided by “dynamic payables”, the total debt of the entity. For the entire economy, the historical evidence shows that those two values can be aggregated as the ratio of GDP to the total debt in the economy. The Atrill Curve measures the total activity per dollar of cost of capital that can be generated at each solvency ratio on the Y Axis, this being defined at the sum of the dynamic receivables plus the dynamic payables. In the case of an entire economy, as it transpires, that sum is GDP plus the total debt. The solvency curve shows that there is an optimal level of solvency at which total activity of an entity, in this case the economy, is maximized. Thereafter, on both sides of the peak, what we think of as “activity generation potential” (GDP here) falls away.

There are two ways of looking at the Atrill Curve. The first shows the tradeoff between solvency and total potential activity. In the second, inverse mode, the curve measures the cost of financing per dollar of activity (GDP plus total national debt in our example), and can be thought of as the “cost of maintaining state” (that is, the cost of supporting its current solvency condition). The point of maximum financial efficiency, the apex of the solvency curve and the nadir of the cost of capital curve occur at a solvency ratio of .689, the point at which an entity will generate a little over $52 of activity per dollar of cost of financing. This means that the least cost of capital (the “least cost of maintaining state”) and the most economic activity occur at that ratio, obviously an ideal devoutly to be wished from a political perspective for any government wishing to maximize GDP potential at minimum cost and hence maximizing employment opportunities. In practical terms, this means that when operating at what could be considered as “maximum financial efficiency”, the overall economy uses about $1.45 of debt to produce $1.00 of GDP.

As a balance sheet gets weaker (takes on increasing amounts of debt), the cost of supporting the debt load rises, increasingly rapidly. (Note that the cost of supporting a balance sheet also rises as balance sheets become increasingly strong, demonstrating that increasing indebtedness adds value to the economic process when insufficient leverage is utilized). If we map this relationship using a log scale on the X-axis, both appear as symmetrical U-shaped curves.

In its broader application, the total activity can also include the market value that can be generated (i.e., the price of an entity’s securities and the pressures on it). This has major and forecastable consequences for any financial entity, including governments and the value of their currencies, when countries become insolvent as SAC measures it. Besides the peak value of the curve, there are two key solvency breakpoints which are relevant to this discussion, being the first-order and second-order insolvency conditions. A first-order insolvency occurs very slightly below the ratio of .5 (.5 being the point at which the debit float of an entity just equals its credit float). Beyond that, the entity starts to go into chronic overdraft (deficit). The second-order breakpoint comes at a ratio of .289. This is the point at which an entity must borrow 100% of the service costs required to meet its current debt obligations and therefore will usually be required by its creditors to sell assets to meet its debts. In the realm of physics, these two breakpoints are the First Constant of Radiation (.499) and Wein’s Constant of Radiation (.289) respectively.

A Solvency History of the United States – 1920 to 4Q 2008

The peak efficiency ratio of .689 has had considerable relevance for the US economy. For most of the 20th century before the Reagan years, the entire US economy, acting as a single entity, operated very close to this optimum (save for the Great Depression when the US GDP collapsed). This should not be surprising, because the forces within the economy should operate so as to minimize the overall cost to its financial resources. It turns out, therefore, that the Atrill Curve is not just an interesting theory, but has practical relevance to the real world. US Federal Reserve records provided the basic data necessary to determine what levels of debt have prevailed annually (and, more recently, quarterly) as well as the GDP for the same time periods. The chart above shows the GDP-debt ratio (as many of our readers have undoubtedly seen in other places). The chart below (the reciprocal of the first) shows the number of dollars of debt required to generate a dollar of GDP.

From a current solvency point of view, the US is now slightly below the second-order insolvency breakpoint (at or below .289), represented by the dotted line on the graph; at no other time in the last century has the US reached this condition. Among other things, this means that Fed Chairman Bernanke’s assertion that he has studied the Great Depression and knows what to do this time around has a very hollow ring about it. The solvency conditions of these two events bear no resemblance to one another at their respective outsets. Even at the worst of the Depression, the US was not as insolvent as it is today.

We can see in the inverse chart that the amount of debt required to generate one dollar of GDP has increased from the efficient requirement of roughly $1.40-1.60 to more that $3.50. Indeed, with GDP currently starting to slip into moderately negative territory, that ratio is now more than 10:1. And, assuming as we did that the US would be in recession into 2009 with negative GDP growth, this ratio can reach infinity. (Note that this precise situation has prevailed in Japan for over 10 years, as we will show!)

The second-order insolvency breakpoint holds very serious implications. In the world of physics, this is a ‘state transition’, the point at which an atomic structure kicks off a particle (the ‘click’ on a Geiger Counter) because the centripetal forces holding a nucleus together are barely balancing the centrifugal forces. When a financial entity such as a company reaches this point, it is the company’s ability to hold its balance sheet together and meet its debt obligations that has become so weak that it must “kick out” something to stabilize its finances. Such a company’s financial workings would likely show that its creditors have abruptly stopped extending it credit, and that it must sell assets and pay down debt to relieve financial pressures. As Dr. Atrill liked to say, it has sold everything on the shelf and now must sell the shelf itself to survive. Failure to do so inevitably means, in corporate life, that the advent of bankruptcy, the legal recognition of insolvency, is approaching as creditors will start to call their loans.

Our corporate solvency work has shown that this ratio is inviolate (except where a company routinely, as part of its business modality, sells assets to meet its debts, mainly real estate developers), and is often enforced by a plummeting stock price (a powerful market signal that something is amiss). Usually, an examination of the balance sheet will reveal that the company is overwhelmed by debt. Though the US doesn’t have a “stock price” per se, its dollar has depreciated as its insolvency worsened.

The solvency breakpoint, .289 is a “state transition” – like the point at which water turns to steam – which is relevant as we know that such a transition requires a burst of energy. One of the SVA functions tells us how much debt needs be used at exactly this point to enable a balance sheet to maintain state (and/or get even more deeply insolvent). As it turns out, this amount is a multiple of the normal amount of financial debt required to maintain that solvency state. So if the US “balance sheet” were to cut through that .289 state transition breakpoint and kept going without addressing its debt problem, it will find itself having to use a multiple of the amount of additional debt (financial energy) that it was using to keep going prior to the breakpoint transit. And that’s precisely what happened.

Recall that heading into this ratio, the US needed increasing amounts of additional debt for each $1 of GDP generated. At .289, the number would reach 3.46:1. But if the Atrill solvency theory is correct, we should see that the actual numbers should experience a rapid escalation – a spike – which should occur as that solvency ratio is approached and exceeded. Since the end of 2006 to the second quarter of 2008, as the US solvency ratio was approaching .289, US GDP grew by $853.3 billion and total US indebtedness grew by $5.967 trillion. This works out to a ratio of about 7:1. Since then, GDP has now actually declined, and the ratio of added debt to GDP ‘growth’ has, in effect, become infinite. As we will see shortly when we turn our attention to looking at the Japanese economy when it first fell in the same solvency condition that the US is now suffering from, even with the explosion of government debt issuance, there is no guarantee whatsoever that GDP will – or, more to the point, even can – respond positively.

Few corporate entities have been able to operate below this breakpoint, and the US itself is having similar difficulty. It is highly dependent on obtaining financing, but its usual source of financing, other global banks and central banks, are becoming nervous about the solvency state of the US. And Europe, considering just one source of financing, is very concerned that meekly falling into line behind the current US drive for “quantitative easing” is nothing but a means of taking their stimulus monies and using them to bail out the US, a fear which we suspect would turn out to be all too true. It is alarming that the US government plans to run multi-trillion dollar deficits to address this challenge, which promises only a mild bump (if any) in overall economic (GDP) activity, assuming that it even can work at all given decreased consumer confidence, along with a new and alarming propensity for households to save rather than spend.

In closed economies (e.g., Weimar Germany, Zimbabwe), the method of financing was the printing press alone. In the US, the government and the Fed are resorting not only to borrowing but also the printing press and the support of other central banks, which so far have supported the US out of fear that a US recession will spread throughout the globe. The result is that those countries are supporting a deeply insolvent entity at the risk of their own stability, severely damaging their own growth prospects in the process. Of course, there is some apparent validity to their actions. Having invested (i.e., lent) so much in the US already, the value of their US holdings depends entirely on the US being able pay it back, or at least stay afloat; they must help the US avert a recession, because a serious recession/depression could trigger a potential default (one way or the other).

However, as the intrinsic value of US assets held around the globe is called into question, the global financial system has gone into a funk. Banks are concerned about lending to other banks for fear that those banks may be in trouble. Even normal course global trade is affected, as customary letters of credit (which have facilitated international trade for just about forever) are not willingly accepted by other banks. The US consumer is now retrenching (and even starting to save!) as sources of new credit, housing prices, and stock market values are well down. Central banks are cutting interest rates and providing massive support to domestic banks to keep credit flowing, but it appears that the global financial system may be unable to cope with the US insolvency, so massive is it in scope and impact.

Precisely how serious is the US solvency situation? Here are the hard numbers. If the US were operating at the same maximum efficiency that it did for much of the 20th Century, its total debt requirements would be roughly 1.45 times its GDP. As US GDP was $14.3 trillion as of our latest quarterly numbers, its total indebtedness should be approximately $20.8 trillion; instead, it is $52.6 trillion, an excess of more than $31 trillion. And every day that the US soldiers on at or lower than this ratio, the mathematics of the Atrill Curve tells us that the cost of just maintaining its current solvency state will continue to rise, and therefore so will its debt, no matter what happens to GDP. Current estimates are that the US deficit, which must be financed abroad (or the money simply printed), is now running at a half-trillion dollars a quarter. With US GDP growth numbers falling below zero, and the annual deficit is projected at $1.8 trillion.

It is interesting to observe in the GDP/debt ratio chart (above) that the US reached the .289 ratio in the last half of 2007, precisely when the credit markets began to cramp up seriously. As the US tried to punch through that level, the global markets followed by seizing up. In other words, using the precision of the Atrill Solvency Curve, the team from Yale was on the money when their models predicted that things would keep carrying on and then abruptly freeze up. And the freeze has occurred where it always occurs (in our corporate solvency work), at .289.

Parenthetically, few seem to have observed that in administrations which most contributed to the explosion of debt, the decline in the international value of the US dollar in percentage terms almost perfectly offset the growth in nominal US GDP. This is called “spinning your wheels”.

The Curious Duality of Debt

SAC’s approach to the mathematics of balance sheet economics (SVA), includes two relationships that go a long way to explaining why the global financial markets are currently in a conundrum. These are the bonding function and the directness function, alluded to, but not measured by, Geanakoplos et al.

To begin with, a debt is both a liability and an asset. Its character stems from the obligation that arises between two (or more) parties. For analytical purposes, when we at SAC refer to the debt structure of one entity we lump all creditors of that entity into a single counter-entity (which we term the “trading connections” in the transaction). In a two-person world, the reasoning is very simple to follow because the balance sheet of the borrower is perfectly mirrored by that of the lender. If you owe me money, your balance sheet shows a liability and mine shows a corresponding asset (namely, the loan that I have made to you).

The weaker your balance sheet, the riskier my balance sheet becomes because the value of my asset is increasingly dependent on your being able to repay it; we are increasingly bonded together as your balance sheet becomes increasingly heavily indebted to me. From your perspective, the more you owe me, the more important your relationship with me becomes because you risk losing everything if I call your loans. Equally, however, as my balance sheet becomes highly extended because of loans to you, if you cannot pay me back, my wealth is also jeopardized. The bonding function, which describes and measures our relationship, therefore looks very much the same for both of us. Because I can call the loan and, if nothing else, take whatever assets you may have, I am not quite as tightly bonded to you as you are to me, but the relationship is still uncomfortable at the weak (insolvent) end of the spectrum. This is nicely captured by Geanakoplos’ description of it as “the chains of financial interdependence”.

The directness function measures on the Y-axis how quickly a dollar flowing into an entity leaves that entity to meet its obligations, and is directly tied to its solvency.

This measure is vital to the health of an organization because the longer a dollar stays within it, the more work it can do (the more it can earn), even if it is only earning interest. Banks are the most aware of this function because they can only lend by borrowing; the longer a dollar on deposit stays with a bank, the more times it can relend that same dollar. The borrower, of course, borrows by lending because once he has been lent that dollar, it is deposited into his account at the bank (lent back to the bank). If the bank is at all fortunate, it can then relend that same dollar to someone else. The ability to hold on to money and make it work (‘stickability’) as it flows through the organization is the essence of economic activity.

As an entity enters insolvency, every incoming dollar will flow back to its creditors faster and faster, until finally, at a second-order insolvency, that dollar flows directly out without doing any work at all (the entity’s credit float becomes negative at that point). In essence, the debtor is paying off [some of] his obligations at one window and then rushing to another window to borrow the money right back – plus a bit more to meet the increase in servicing costs. The organization is spinning its wheels, borrowing to meet its debt service but contributing virtually nothing to economic activity. As we will see in practical terms, it is now easy to understand why Japan’s GDP has gone exactly nowhere since it reached that condition in 1998 and why the US, now currently in that exact same condition, is unlikely to be any different.

Creditors, the ‘trading connections’, of such an entity will usually try to call their loans and it should come as no surprise when we hear that China, among others, is musing about its current level of holdings of US debt. The only change from period to period in highly insolvent entities is that their total indebtedness rises but there is no net contribution to the economy, no added growth, no addition economic “work”. In such cases, all that its creditors/lenders see is a spiraling demand for money, and will therefore use all means to slow down their lending, usually attempting to reverse the flow of money away from the debtor’s balance sheet and thereby put their money to productive use elsewhere. And is this not precisely what US foreign creditors are saying right now (led by China)?

The bonding and directness functions help us see a curious duality concerning the nature of debt when entities are in highly insolvent states. On the one hand, the bonding function between creditor and debtor rises increasingly rapidly as it becomes more vital to the creditor that the debtor not default, even if that means that the creditor must continue to lend more to the debtor. On the other hand, with no useful economic work being done by the debtor, the directness function warns us that creditors do not want to lend the debtor any more; they just want their money back so it can be put to productive use somewhere, anywhere, else.

The US, with nearly 25% of global GDP, requires much more of the world’s financial resources just to tread water than Japan did before it. The US is the largest economy in the world, and it is also the largest consumer of global financial resources. With every nation now stretched thin because of the US insolvency, we wonder whether it will be possible much, if any, longer for the US to tap into anything but its own printing presses to get the needed financing. Certainly any hope that the US could go one way as the rest of the globe “decouples” and goes on its own separate growth path should be largely dispelled.

As a footnote to the discussion above, it is of more than passing interest to find out where that $31 trillion of excess US indebtedness actually went. That is to say, the US debt it is someone else’s “asset” and the size of it is such that it cannot possibly be a trivial bookkeeping entry elsewhere in the world. Other balance sheets must be affected and in a major way. Therefore, we have taken a look at the “national solvency” of a few other nations including Canada and the United Kingdom to ascertain where all that money came from which the US is using. It did not take us long to find out that a staggering amount of that debt is showing up in the balance sheets of – most notably – the global banking system (not to mention sovereign wealth funds). Indeed, in many countries we have found that bank debt as a percentage of the GDP can be a huge multiple. In the UK, for instance, bank assets as a percentage of GDP stands at 400%. Since there is an equal amount of liabilities on the other side of those “assets”, by the measure that we have used herein it would mean that that country is “massively insolvent” as well, in fact apparently worse so than the US. By our measure, Canada would also be in poor shape as Canada’s national solvency ratio stands at .28, exceeding our threshold number for being a second-order insolvent of .289. We think, however, that a closer look at the national numbers shows that the debt/GDP ratio must be carefully analyzed before jumping to any such conclusion.

Without having delved into the specifics of each nation so affected, in the cases that we have looked at, the “Foreign Indebtedness” totals for the UK and Canada are running at a multiple of GDP, as is Financial Indebtedness. In comparison, for the both US and Japan, Foreign Indebtedness is a tiny fraction of GDP. Only Financial Indebtedness is a major part of overall debt in both cases. Since many countries have followed a policy of monetizing their holdings of US obligations obtained in the course of trade and/or investment, we believe that this “indebtedness” is due to that factor and are not necessarily associated with excessive internal borrowing within the country at all. Hence, their internal solvency is not necessarily affected.

One should not be too glib about passing off those high debt/GDP ratios as not being a danger to those countries. The danger may not come from their own internal over-indebtedness, as is the case with the US and Japan, but from the risks associated with that massive pile of external US (and Japanese) debt assets so acquired. The risk of default is not one which can be minimized, especially insofar as some of those debt assets acquired consist of US securitized loans which have come to grief. Tiny Iceland, with 10 times its GDP in Financial Indebtedness, was an accident waiting to happen. Hong Kong, with 32 times its GDP in Financial Indebtedness has either been very lucky or has done nothing but invest in sovereign debt.

Some Implications Which Follow From This Analysis

There are a number of things which follow from the mathematics which underlie the Atrill Solvency Curve analysis and can serve as a sort of forecast of likely events to come should nothing be done about the current US debt situation, save more of the same. Here are some highly probably outcomes which logically flow from this work.

1. There is highly unlikely to be any growth in the US economy going forward, and certainly not any growth which springs from anything but massive government spending. When a company finds itself in a second-order insolvency, we say that it is no longer in the business of whatever-is-on-the-door, but is in the business of selling assets if it is going to survive. For an entire country, if Japan is a reasonable model – and we believe it is – the “business” of the US is servicing its debts, not moving forward. Any “growth” due to the stimulus package (if “growth”, as opposed to stasis, is even possible) will quickly die as soon as the stimulus is taken away.
2. As a corollary to the above, if the US somehow stays the stimulus course, US government debt will, in all likelihood, grow about as fast as that of Japan. This means that in 10 years – if such a term is even possible, which we already seriously doubt – US government indebtedness will be, as it is in Japan, somewhere in the order of 2 times US GDP, not the ‘one times’ as we have heard bandied about as of late by certain US authorities who may simply be trying to hide the really bad news.
3. Global resentment of the US financial situation is bound to keep increasing, especially now that that initial global freeze-up has occurred and more and more countries feel that the US is out of financial control. Already, the leaders of several countries have observed that they want to have no part of “quantitative easing”, feeling, correctly as we have already pointed out, that QE is simply an exercise whereby the US manages to get its hands on additional foreign funding, obviating the necessity of using their own printing presses.
4. Many if not most US states, which are suffering from chronic under-funding due to collapsing tax revenues and escalating costs, will find a way to borrow once again, despite those balanced budget amendment restrictions that many states are operating under. California is currently using what it refers to as “IOUs” to make some payments. The difference between raising additional debt and an IOU is ??? Sooner or later, some state is going to find another such loophole and then all will follow suit – in spades.
5. It is difficult to see a strong rebound in household and business borrowing in the US, given the overall financial situation. As Japan clearly demonstrates, just because interest rates are low (and money apparently available) does not guarantee that people and businesses will borrow. As we have stated so many times in this monograph, when the problem is debt, the solution is not more debt. Households and businesses are not as blind to reality as the Fed now, and the Bank of Japan before it, apparently thinks that they are. As households in particular have themselves become so very extended, so now must the long process of retrenchment set in. Overcoming cyclical forces is one thing for the Fed to combat but overcoming balance sheet forces is another issue entirely. Unless the Fed comes to grips with this issue and faces the implications squarely – and actively helps to speed and resolve the process – then household balance sheet rebuilding will take a long time to accomplish. Just ask Japan. Thus far, the unfortunate Mr. Bernanke doesn’t appear to have a clue that he is on the wrong track, the victim of his own mis-analysis.
6. Estimated US loan losses vary all over the map, depending on who is making the forecast. Nouriel Roubini has to date been the most aggressive in this area, looking at something in the neighbourhood of $3.5-8 trillion. With total excess US indebtedness of more than $31 trillion to deal with, that number would allow for roughly a 10-11% rate of writedown losses. We would expect that this number is too low. For a major balance sheet reorganization following an insolvency, that would be a very modest write-down rate, we would aver.
7. As for the outlook for the US stock market, it is difficult to foresee anything except a similar outcome to that of Japan. If nothing is done, then zero growth (or worse), a shrinking industrial base, and a retrenching consumer sector cannot spell anything but slowly ebbing market values. Due to massive government spending, however, such a decline will be highly volatile, as it was/is in Japan.
8. The question as to the future value of the US dollar is an open one, especially if the US does nothing to get its balance sheet under control. When we discussed the Directness Function, we observed that the worse the solvency, the more that others will try to avoid US obligations, which would strongly suggest downwards pressure on the US dollar. The Bonding Function, however, suggests equally strongly that everyone else has a powerful vested interest in maintaining the value of the US currency, so massive are US foreign debts. No one should mistake the US dollar as being any sort of “safe haven”, however.
9. Whether the world will move away from using the US dollar as a key reserve currency is an interesting question. It should, if its fiercest critics have their way, but the US has a powerful vested interest in preventing this from occurring and will do all that it must to stop this movement from gaining momentum because ready access to global financial resources is vital.
10. The global outlook will depend on two things. The first is how quickly the rest of the world adjusts to the new American consumer reality. The second is what happens to the value of that $31 trillion mountain of excess US debt. On balance, however, those global markets that find themselves on the right hand side of the Atrill Solvency Curve can do no better than to foster stronger and more flexible banking systems with a strong emphasis on consumer lending.

What is the probability that sooner or later the US will follow our prescription for what ails it and actually begin the process of eliminating the excess indebtedness which now hobbles it, thereby tipping the scales back to sound global growth? We would expect that they are higher than one would think, looking at the magnitude of the problem, even considering the general political unwillingness to do the different and difficult. For one thing, despite those current Republican-leaning advisors from Wall Street at the highest levels of the US government, Americans are a very pragmatic people. Already the ground swell of opinion that quantitative stimulus is wrong is building strongly. Heaven forbid that things unfold as we expect under the current programme for another year, and the only positive on the horizon is even more stimulus spending.

What Should the US Be Doing?

A prime tenet of Dr. Atrill’s solvency theory is that the economy economizes – this is its function – and it so works as to continually do more with less. From Reagan on, however, the Laffer Curve horror and the resultant so-called “supply-side economics” has brought us a new approach to economics which does less and less with more and more of the world’s financial resources. A sort of theory has emerged in the US that their economy is somehow unsinkable and unstoppable – or at the very least, that government (and the Fed) can keep it afloat no matter what. This kind of thinking has led us to the present malaise and it will have to end for a true global recovery to set in, let alone a US resurgence.

While we must understand what went so dreadfully wrong in the past, it is imperative to look forward and deal with the future. Perhaps of course, the US is about to find out that its solvency condition cannot get worse, as the rest of the world decides that it will not, or cannot, lend the US more money. Certainly to this end, Europe, led by such notables as Angela Merkel of Germany and the central bank of Spain, but with China first and foremost, are questioning the efficacy of quantitative easing as they understand – correctly – this is equivalent of bailing out the US at staggering cost but with little if any economic benefit. In the chart below, we show the marginal efficiency of using an additional dollar of debt to produce additional GDP and one can see that at a solvency ratio of .289, the added value starts to plunge almost vertically. Here an additional dollar of debt leads to just 40% of the incremental amount of GDP which would occur if the economy was at .689. Indeed, those countries are quite correct in their inference that quantitative easing in the US is producing very little at huge cost, a stunning economic inefficiency for the global economy.

In this criticism, which is becoming increasingly strident as the costs of a “bailout” increase exponentially, those critics are being joined by a number of thoughtful Americans who also do not see that there is any lasting (if any) benefit at all in the current plans afoot. However, it seems perfectly obvious to many countries as to why the US authorities led by the chairman of the Fed are exhorting other countries to stimulate as well: that is actually money needed by the US to purchase additional US debt so that the US itself will not have to resort to the printing press.

To go to the heart of the issue: when the problem is too much debt, the answer cannot be more debt. If we know what the US is doing is wrong, then what should it do to make things right? To help to find the answer (and to ascertain what we already know won’t work), let’s visit another massive modern sovereign insolvency, Japan.

Japan Redux?

Many years ago, the great futurist Herman Kahn once predicted global economic dominance by Japan. He called it the “Japanese Miracle”, rising as Japan did from the ashes of World War II to become the dominant economy in the 1970s and ’80s. But a funny thing happened on the way to global hegemony: Japan got massively over-extended from a credit point of view and crashed and burned in the 1990s, suffering what has become known as the Ushinawareta Junen, or “lost decade”. Since then, it has not raised its economic head in anything but fiscal shame.

One reason that examining Japan might bring some insight into the US situation is that Japan’s great expansion terminated abruptly and began a long downward spiral (as far as its capital markets were concerned); it has not managed to gain any forward momentum since that time. This kind of outcome suggests to us that a deeply entrenched insolvency must be at work (without even looking at the numbers themselves). The debt and GDP data for Japan over that time supported this theory (see chart).

The great boom in Japan was similar, although earlier than that in the US, and was built as much on increased issuance of debt as anything else. Many will remember that at the peak of the Japanese expansion (1989–91), the Nikkei Dow reached a record 39,000. Since then it has fallen continually, and currently stands approximately 78% below the 1989 peak. Of particular interest is that Japan’s GDP/debt ratio reached the .289 second-order insolvency ratio in about 1996–97 at which time its GDP completely stalled out. Given what the Japanese solvency condition means (as described earlier) that Japan has “sold everything on the shelf and now must sell the shelf itself”, it came as no surprise to learn that, as Japan did nothing about its solvency condition except just hang on, there would be sufficient debt grit in its economic machine to prevent it from moving forward. And this is precisely what has happened.

First off, we observe that Japan’s GDP has gone virtually nowhere since 1998.

Japanese GDP reached almost ¥458 trillion in 1989 with a solvency ratio of .32. It was able to advance to the ¥500 trillion mark, albeit at a slower pace, until 1996–7 when its national solvency ratio hit .289. From that time, its GDP virtually stalled out, reaching ¥515 trillion in 2007, a growth rate of 0.27% per annum. That compares with an average growth rate from 1980 through 1991 of 6.05% a year.

Looking at the private sector, household credit has barely held its own, and business credit has declined by roughly 33%. We know which sectors did not participate in the growth of the Japanese economy since 1996. Household debt growth has been mostly in flat to negative ground, and corporate debt growth has been in a fairly steady decline. Indeed, after tripling in size between 1980 and 1990 alone, Japanese corporate debt has declined by more than a third since 1996. Because the Japanese GDP has been almost dead flat over the period, and corporate debt has fallen, we can conclude that the business climate has been in a steady retreat. (We can safely assume that Japanese business has not been using equity instead of credit for the majority of its financing requirements, because the stock market has declined drastically from its peak 18 years ago. However, we would not be surprised if Japanese companies used the equity markets to exchange equity for debt and thereby reduce their balance sheet risk.)

Clearly the equity “capital formation” process in Japan has taken a massive hit since the 1989–91 peak and, save for sporadic rebounds, has not managed to get on track since. Nor has the banking system been a source of growth. After its great surge, again peaking in the 1989–91 period, the overall growth in financial debt has been so anemic as to be hardly worthy of mention beyond the fact that it mirrors the household sector.

Now, if GDP has leveled out, household and financial debt has gone nowhere and corporate debt is declining, one might think that the Japanese GDP/debt solvency ratio was set to improve (if modestly) to a point that might permit expansion again. But this is not the case. Rather, the Japanese government has kept the pot boiling (insofar as there is any heat in that economy) by the continued issuance of government indebtedness, with the result that, while the Japanese GDP has crept forward at a 0.27% annual rate of growth since 1996 (before the recent plunge), the growth of total government debt has nearly quadrupled over that time, for an annual rate of growth of 10.7%.

The numbers show that almost all the heavy lifting in Japan to keep that economy at least flat (rather than downtrending) has been borne by the federal government, although total debts of state and local governments have grown by 57% over the 12-year period. The total indebtedness of all levels of government in Japan, which was a fraction of Japanese GDP as late as 1996, is now a multiple instead.

No matter what the nominal reasons offered to support the actions of the Japanese government during this period, nothing has ever been done to halt the erosion of national wealth overall. Japan has become unable to advance on the global economic stage. The steady downtrending decline of the Japanese stock market and its real estate prices were part of the same bubble that infected the US years later, and arose because of the same unrestricted expansion of debt that first blew the country into a second-order insolvency and then brought it to its knees. As private sector activity waned, and waned, and waned, the government moved in and has kept moving in, just like the US government is planning to do today. By steadfastly refusing to deal with the fundamental problem, too much debt, Japan has been stuck in a debt warp, a mire from which it cannot escape without taking imaginative action. After 12 years of close to zero interest rates and massive government credit expansion, Japan remains on government-financed life support, its economic pulse virtually flat-lining.

Mercifully for Japan, the country has been aided and abetted by the rise of hedge funds and the development of the carry trade. Borrowing in one currency, the yen, and lending in another where there are higher interest rates for a nice spread has been very profitable, and all the more when the yen was weak. This has created an ongoing demand for the yen, which has probably kept it very much higher in international markets than it should have been.

Financial debt has virtually flat-lined during the entire period. Japanese banks have been loathe to call their bad loans and put those weak organizations into bankruptcy and so clean up bank balance sheets. And with a regulatory environment which does not force any mark-to-market accounting, presumably this can go on for some time. Unfortunately, it fails to get to the solution of the overall problem which is a surfeit of nonperforming or underperforming debt. As of mid-year, 2009, there is still not one scintilla of evidence that any of the attempts by the Japanese authorities to get their economy moving again are paying off – in the slightest. In fact, almost the opposite seems to be occurring in that, if anything, things appear to be getting worse. Like the US this year, those same authorities keep saying that things are turning around but the figures keep belying their assertions. In answer to those who ask whether Japan can avoid another “lost decade”, having done absolutely nothing about their debt problem, the answer is, unfortunately, a resounding ‘no’.

Is this to be the fate of the US as well? Goodness knows the American monetary and fiscal authorities seem to agree on the Japanese course of action: cut interest rates as close to zero as possible, goose the economy with massive infusions of (government) credit, and bail out the corporate losers who have demonstrated remorseless greed or shown little foresight and a pathetic inability to adjust to changing global realities. Already, as of the time of writing, the US Fed has opened the door for a very lucrative carry trade for those financial organizations who are eligible (which apparently also includes hedge funds), by offering Fed loans at close to zero percent cost and allowing the recipients to lend elsewhere at a handsome and risk-free spread.

At the same time, there are no plans to erase any more debt than is deemed necessary as those same US authorities want to prevent the short-term pain that they fear, erroneously, must inevitably come from those actions. The new Democratic government seems bent on pursuing the same course of action as Japan – only more vigorously – under the faulty guidance of Fed Chairman, Ben Bernanke, who claims to be “an expert on Japan” but who clearly demonstrates no understanding of what the problem is. There is an old saying that is as true today as when it was first coined: those who do not learn the lessons of history are doomed to repeat the same errors.

If Interest rates stay very low, however, how much trouble can a country get in anyway? Surely with low costs of supporting the national debt, one can afford to wait until a broad recovery finally sets in. Let’s take a last look at Japan to see how well this thesis has managed to hold up.

From John Mauldin’s market letter (“Buddy, Can You Spare $5 Trillion”, July 10, 2009), comes this excellent chart showing how all the costs of all that government debt issuance has finally caught up with Japan. Japan’s central government interest expense as a percent of its annual budget has reached 18% and is rapidly rising. Japan has been lucky in that it has been able to keep rates down, but if that should change, that country would still be issuing massive amounts of government debt to keep Japan from a horrific recession – or worse – at the same time as its cost of servicing the debt escalated. All rates would have to do would be to go to 2% (!) and all hell could break loose. With the US thinking that it can emulate Japan, only more forcefully, to escape its problems, that would mean that two countries were competing for scarce global capital just to hold off recession.

How Did Japan Ever Get Into Its Credit Malaise in the First Place?

The Atrill Curve provides a profound insight into why Japan managed to get itself into the credit morass that it has been in for some time. Thus far, herein we have been dealing with the left side of the peak of the Atrill Curve, the side that shows the slide into insolvency and the inevitable compounding of indebtedness that this brings. But we have not looked at the right side of the Atrill Curve, to what one might think of as the Siren’s Call of Debt.

The right of the peak of the curve is where we find those entities (companies, households, and countries) that can benefit from carrying more debt on their balance sheets. The more solvent the entity in excess of the maximum efficiency ratio of .689, the bigger the ‘bang for the buck’ (yen, yuan, mark, or whatever) in terms of generating more dollars of economic activity per dollar of additional debt. Referring back to the graph on page 27, we can see that at very high solvency ratios (very little or no debt), a small amount of additional debt produces a lot of additional economic activity (GDP). From this, it is easy to grasp why China, for instance, can grow so quickly. As a [former] communistic country, it was starting from a very low energy state far to the right of the efficient peak, in a condition that we term “supersolvency”. Once the credit generating machine (an honest currency, an increasingly efficient banking system, and even a decent auction market) gets into gear, the rate of change of economic growth will greatly outstrip the rate of change in debt, although slowing gradually up to the efficient peak at which time the process starts to reverse (that is less additional economic work is done per addition unit of debt).

Just because the process starts to reverse does not mean that the participants in that particular economy have not seen and come to appreciate the connection between added debt and added growth even after it ceases to ‘add value’ in terms of overall economic efficiency. This is certainly true of those who stand the most to benefit from “more of the same”, the financial system and the politicians. As the US has experienced, the populace at large also appears to benefit from excess debt growth as the economy ‘benefits’ from price bubbles (which is how excess indebtedness often is transmitted through an economy). The impulse of a central bank to take away the punch bowl just when the party is in full swing can be overtaken by the urge to keep generating even more activity through the simple expedient of permitting increasing amounts of debt issuance well beyond what have been “normal parameters” in the past. The process by which increasing economic activity generates an increase in debt becomes reversed, as debt is actively used to generate activity instead. This was clearly Greenspan’s dilemma: keep the expansion going at an ultimate cost of “irrational exuberance”, or stop it ‘now’ and risk the ire of everyone, public and politicians alike.

Clearly, this impulse took strong hold in Japan – and seemed to work and work very well for some period of time. Both the stock market and real estate prices soared to the very heavens themselves. That same impulse also took increasingly strong hold in the US following the election of Ronald Reagan, and was reinforced by the economics of unfettered capitalism of the time. What no one could have foreseen was that GDP would find a limit, the limit at which the economies of both Japan and the US reached the second-order insolvency condition and the credit process abruptly seized up.

We think that it is equally clear from the economic history of the United States, in the immediately aftermath of the Great Depression, that the reverse also holds true. When an economy finds itself in a deeply insolvent condition, a decline in total indebtedness due to writedowns or writeoffs relative to the GDP can also serve to increase total GDP at a very rapid rate (although at the time, people may not have thought of it quite in those terms). Lifting the burden of debt provides the renewed freedom to expand once again. This will become one of the cornerstone arguments in favour of the solution that we propose herein, erasing debt off the US (and Japanese) national balance sheets as quickly and efficaciously as possible.

One of the fears that economists throw up who are unfamiliar with the economics of debt is that the massive reduction of debt that is necessary to “get back to some semblance of normality” would ‘cripple’ the country and shatter its ability to move forward. What the Atrill Curve (and the aftermath of the Great Depression) show is that the rapid erasure of debt has just the opposite effect – it stimulates activity by eliminating the dead weight of debt on the shoulders of the nation and its citizens, and frees it to become healthy and productive again. The coordinates of the Atrill Curve indicate that a return to the level of maximum efficiency at .689 would result in an increase in US GDP of roughly 22% as the dead weight of over-indebtedness is lifted off American shoulders, allowing the US to move forward again with confidence.

Before we leave this particular subject, there is one minor point to be made of potential relevance to the future. As the emerging economic powerhouse nations such as China grow due to an increasingly efficient banking system and GDP growth continues apace, it will be useful to have a “credit governor” in place, similar to those mechanical governors on steam engines which slow the flow of steam into the engine once a certain speed has been attained. As those nations approach the optimal national leverage ratio of .689, it will be useful from a global perspective not to keep running into the kind of excesses that have been visited upon the global economy by Japan and now the US.

Looking for a Way Out

The US has already discovered that at a GDP/Debt ratio of .289, financing the US balance sheet becomes very difficult and problems erupt. Below that (where we are now), the financial system can virtually go into stasis. Obtaining financing through normal course channels becomes very difficult, if not impossible, and a resort to quantitative easing increasing likely. If that fails, next comes the printing press. A quick look around the world, not to mention in the US itself, has already brought this message home.

In looking at the US debt breakdown, it is useful to note who are the largest contributors to the overall levels of indebtedness. One method of identifying those areas is to examine the general levels of participation in the debt generation process prior to 1980, the last time the US enjoyed a healthy solvency ratio. The following graphs chart the progress of the two major sources of US excess indebtedness, the household sector and the financial sector. We have taken their “share” of the national debt from the 1970s as our reference level. We then determined how much “excess” indebtedness can be attributed to them if they had remained around the same percentage of overall debt relative to US GDP.

We will start with the household indebtedness number which makes for some interesting reading. With the open encouragement of financial institutions and greatly relaxed credit regulatory standards, the US consumer hugely increased his debt levels since the 1970s and earlier. By this measure, as of the latest data for the 4th quarter of 2008, American households are now carrying $6.332 trillion more in debt than they would have had they stayed within the parameters of the 1970s and earlier. This is out of total household indebtedness of $13.821 trillion. Even if our precise figure of 46% over-indebtedness is open to [some] question, it is completely safe to declare that the US household sector is indeed carrying far too much debt.

The financial sector has grown even more rapidly than the US consumer, very quickly in absolute and relative terms, that is, as a percentage of GDP. If we compare the current level of financial debt relative to 1975 levels, the financial sector is carrying $11.9trillion more than was the norm 33 years ago. Back in the 1970s and before, financial debt was about 12-15% of non-financial debt for the US economy, today it is 50% of total non-financial debt. Further, its annual growth rate has been stunning, and worse, it was still running at a very heady growth rate in 2008 although towards the end of the year, the growth rate has slowed down.

For purposes of computing the numbers for this chart, we very charitably pushed up this “base” percentage massively from 12-15% to 25% of GDP to account for “new and improved” financial instruments which could be considered to “add value” to financial markets – perhaps overly charitably given the damage that those instruments have wreaked in practice. (If we used the old norms prior to 1980 of less than 15% of GDP, the actual number for “efficient US financial indebtedness” would be a maximum of $3.2 trillionand the excess financial indebtedness would be $14 trillion.) The real point of departure from longer-term norms occurred in the Reagan years, notably under the “watchful guidance” of Fed Chairman Alan Greenspan, who aided and abetted in this debt generation process as head of the Fed during almost the entire period of the degeneration of the American solvency condition. His was truly the “Age of Hubris”, when the Fed felt that it could suspend, even cancel, the business cycle. As a result, his continuing “counter-recessionary” policies led to the under-estimation of credit risk on a broad front. This in turn led to excesses of greed and risk taking over time that over time had to be bailed out with ever higher credit infusions each time a new recession was in the works. And yet Mr. Greenspan persisted!

We all remember Alan Greenspan’s mantra that “the rest of the world are savers and the US is a consumer nation” (which he repeated as late as November 2008 at a Toronto luncheon well after the eruption of the credit crisis, and – heaven help us all – we still see this incredible myth being reiterated by senior US authorities), his cheerful rewriting of the ants and grasshoppers fable. When the US was becoming so deeply insolvent, it did so by dint of loans from others. The mechanism was simple. US obligations to foreign countries were monetized by their central banks, and the proceeds re-lent to the US. Excess global saving, no. Excess monetization being recycled to the US, yes.

Since the rest of the world was (and is) a principal source of that debt, if it had not supported the US with endless loans, the US would have ended its insolvency streak long ago. But then, many feared that the US would still have entered a recession, and probably a severe one. Essentially, the rest of the world entered into a Faustian bargain with the US. The US consumed and its GDP grew faster than it should, and the other nations exported to it, recycling the proceeds into additional US debt. No “excess” saving was involved. It was in effect “finance or perish”, however wrongheaded this notion has actually turned out to be. The one person who should have known better, the nation’s chief banker, was the chief tub-thumper for all of it.

We have to wonder why the powerful rise in Debt/GDP ratio didn’t ring bells in Greenspan’s mind. Though he did not have the Atrill Curve mathematics at his disposal, the sheer magnitude of the increase in the Debt/GDP ratio over the years must have been a dead giveaway that something was severely out of kilter. We quote Anna Schwartz (of the University of Chicago – Milton Freidman era) for some possible insight:

Alan Greenspan has issued an epilogue to his memoir, The Age of Turbulence, and it's about what's going on in the credit market. He says, “Well, it's true that monetary policy was expansive. But there was nothing that a central bank could do in those circumstances. The market would have been very much displeased if the Fed had tightened and crushed the boom. They would have felt that it wasn't just the boom in the assets that was being terminated.” In other words, Mr. Greenspan absolves himself by saying that there was no way you could really terminate the boom because you’d be doing collateral damage to areas of the economy that you don't really want to damage. I don’t think that that’s an adequate kind of response to those who argue that absent accommodative monetary policy, you would not have had this asset-price boom (and bust). In general, it’s easier for a central bank to be accommodative, to be loose, and to be promoting conditions that make everybody feel that things are going well. Policies based on such thinking can only lead to a far more damaging bust when the mania ends, as they all do and this one has.

Worse (if things could be worse), his successor, Ben Bernanke, has a deeply flawed understanding of the entire situation. Considering Bernanke’s “insight” into the current problem, we wonder whether he is one of those pure academic economists who considers the profession of accounting as “being in trade” (as the British upper class used to refer to it, with a sniff). As the saying goes, to a hammer, everything looks like a nail. His PhD Depression Model thesis as applied to current circumstances bears no resemblance to what is needed, nor does it respond to the issues. Frankly, in light of better research into the Great Depression, we are not even sure that he understood that period either. A glance back at the US solvency ratio shows that it is now worse than at the extreme trough of the Great Depression. Creating even more credit/debt as a “solution” to the current credit burden malaise is hardly likely to help in any way, though that is what he advocates. Anna Schwartz agrees that “today’s crisis isn’t a replay of the problem in the 1930s [today is far worse, as we showed]. However, the US central bankers have responded by using the tools they should have used then; they are fighting the last war. The result has been failure”. She concluded that they have not “achieved what they should have been trying to achieve. So my [her] verdict on this present Fed leadership is that they have not really done their job.” That was the understatement of the year.

If the US were a company, its bankers would have already cut it off from additional credit and it would now be selling its assets to pay down at least some of its debt (sell the shelf itself). Or it might raise “equity” by converting its debt to equity. However, faced with possible bankruptcy, and/or a collapse of the value of the US dollar, current debt holders may be willing to convert into equity if the new “equity” appears to be able to earn a solid return.

It is now patently obvious (to us, at least) from the evidence from Japan and the current financial machinations of the new Administration, that if the US is to escape its financial problems, it will have to reduce its indebtedness, and the quicker the better. It is not that the US will become “bankrupt”; that would be a nonsensical assumption. However, countries with deep solvency problems have been known to print money and issue more and more credit, thereby using inflation to massively debase the value of its currency. While we are not about to accuse the US of doing such a thing in cold blood, increasingly we do not see much distinction between what Dr. Bernanke is doing and any of the more sordid historical examples, save for the probable scale of the US operation.

The new administration may be cause for optimism. With the success of the Clinton administration on its mind in reducing the deficit and producing a surplus, we would hope that similar policies are more likely than not if such policies were put to it. The big challenge now, however, is that when Bill Clinton was elected, the US was standing at a first-order insolvency condition. Clinton turned around the finances of the US federal government, which can be seen on a chart of the GDP to total non-financial debt. In the Clinton years, one can see that the solvency line flattens out and even improves marginally as federal government indebtedness essentially froze and allowed GDP to move forward unimpeded by government deficits.

As it transpired, however, he was being steadily undermined by Alan Greenspan’s E-Z credit policies. This can be seen in the second chart showing the overall solvency ratio, which merely slows its rate of descent in that period. When the Republicans returned to office in late 2000 that surplus disappeared, and the current catastrophe continued to be orchestrated by the man they used to call the “Maestro”.

From these graphs, we understand why Clinton took the measures he did as the pressures of the national insolvency were already being felt by the US government (i.e., it had entered a first-order insolvency condition, or “chronic overdraft”). This insolvency condition does not need to be measured to be confirmed, as one can feel it in many ways, not least the decline of one’s international currency value, which in the US had been falling for years. Indeed, much of the GDP gains of the Reagan/Bush administrations were essentially wiped out through US currency value losses.

One of the tenets of our foreign exchange forecasting methodology is that price follows solvency. With a Democratic administration newly elected, we suspect that the foreign exchange markets thought – hoped – that the saner fiscal policies of the Clinton administration might return to the United States and the US dollar had indeed enjoyed a fairly decent rally. Unfortunately, for the moment at least, the fiscal policy making of the Democratic administration is being run by Republican holdovers. The US dollar may have rallied from its Bush lows in anticipation of better Democratic policies but is now slipping back towards those lows as it is becoming obvious that things have not changed for the better in Washington.

Looking for Solutions

Given the massive size of total US debt (and in particular the excess indebtedness of more than $31 trillion), it is impossible to move from deep insolvency to maximum financial efficiency in one jump. However, the US does need to escape its insolvent condition, which requires it to reduce overall indebtedness to about $28–30 trillion, or just back over the first-order insolvency condition where the natural compounding of debt is no longer an issue. That means that some $20 trillion in debt must be eliminated, and as quickly as possible in order to prevent the self-compounding nature of debt once insolvency occurs.

There are several ways to do this, and others may think of more. First, the US government could simply declare a default. This would violate our second principle of achieving a sound solution (honouring all contracts, or at least as many as possible), and would be unthinkable for the US, arguably the most morally righteous nation on earth.

Second, the US could increase the price of its gold bullion reserves to pay down at least the federal government debt. Given the size of the official bullion reserves at Fort Knox, our own calculations suggest that this would mean a price target for bullion of $30,000+ an ounce. We view this as unrealistic, unenforceable in sustainable market price terms, and akin to defaulting in another way (i.e., foisting artificially overpriced assets onto creditors as ‘payment in full’).

Third, the US can stick with what is currently being done, pump more credit into its economy and hope for the best. This approach has indeed kept the US economy going for some years now, albeit at a stunning and rising cost. Japan is evidence that this is not a realistic option when the overall economy is operating at or below the point of a second-order insolvency condition, at least in terms of propelling the economy upwards. It is possible that at .289 or worse, the US solvency situation cannot get any worse, meaning that its bankers (the rest of the world) may be tapped out themselves and won’t, or can’t, lend it any more (as the Directness Function strongly suggests). Indeed, given the dead weight of two major national insolvencies, Japan and now the United States, perhaps we are at the point where the current global economy is simply too illiquid to continue moving forward.

Fourth, perhaps the US will simply print dollar bills and redeem its funded debt for cash. Under US law, this is perfectly legal. While in theory, this would not change the US Debt/GDP Ratio as currency is as much a government obligation as its bonds (with the advantage to the government that it would not have to pay any more interest!) we suspect that an flood of actual dollars themselves might have highly disruptive effects, not only domestically but also internationally.

Fifth, just as insolvent companies often resort to selling assets and paying down debt, so the US government could also do so. It is unlikely that sufficient actual “hard assets” are available to bail out the entire US system. However, the US government does not have to carry the entire debt load on its own shoulders. While it cannot deal directly with much of the excessive household debt, it does have a powerful clout over the financial sector due to its bailout support for the banks and near banks. The excesses of these two sources together dwarf the total US government sector.

Having made this observation, any major reduction and paydown of household debt can probably occur only in modest stages. Though it is tempting to suggest that the US government via the banks could force a pay down of the massive mortgage-related debts by forcing asset sales, the outcome of this would likely be mass consumer bankruptcies and an even faster collapse of property values, together with huge social dislocation. Accordingly, we are inclined to be cautious here.

The two areas that can be dealt with readily are government and financial indebtedness. Certainly, President Obama cannot allow the US to flounder for another year. By then, the financial crisis may no longer be considered to be a problem inherited from the Republicans. By the next presidential election, that will certainly be the case. The new administration must therefore act quickly and decisively. The alternatives are inflation on the one hand by continuing the Republican policies of rapid credit expansion, or resolution of the problem by taking firm action to return the US towards the efficient GDP/debt solvency level.

No Free Market Solution

One thing is clear. There is no “free market” solution to this crisis. Or perhaps we should elaborate and observe that, of course a free market solution is available – as long as everyone can wait for things to get dire enough to force one on those who brought us this credit misery. Truth to tell, however, it was the overly free market approach that got the US here in the first place, a lesson that the US seems doomed to relearn every 2-3 generations or so. In the 19th century, it tried totally free enterprise and had to dismantle the business trusts that preyed on everyman. It tried again in the 1920s, which led to the Depression, and again in the years post 1982, resulting in the current financial meltdown. Unfortunately, at this solvency level and below, the credit excesses are not self-correcting, but self-reinforcing.

If this problem is to be tackled head-on, it is extremely likely that all forward momentum will be removed from the US economy, and that a severe recession will set in. Although the ultimate payoff will make this short-term cost inconsequential, political courage of the highest order will be necessary. Unfortunately, the US has shown more of a penchant for quick fixes over sound and permanent long-term solutions.

And so we come to the central part of our thesis, applying the Atrill Solvency Curve to clean up the credit excess as quickly as possible, thereby helping mightily to speed the recovery process. We shall invoke the Occam’s Razor Principle that the best solution is the most obvious one, namely paying down debt. The point of the exercise is to exorcise the US economy of the dead weight of its massive excess debt and thereby allow the economy to realize its full potential. Furthermore, by cleaning up its balance sheet, the US will effectively release its tied-up excess financial resources to be used elsewhere on the globe.

Creating The Phoenix Trust

The first issue associated with selling assets to pay down debt involves assessing whether there are sufficient assets to sell. We suspect, for instance, that the sale of Yosemite National Park to, say, Chinese buyers, would neither sit well with Americans nor be terribly appealing to the Chinese (even with mineral rights!). State and local governments are already selling toll roads and other capital sources of revenue, so strapped are they for ongoing funding. What we want to do is to find a single asset worth the total value of the national debt, plus all state and local debt (because when all is said and done we want to have fresh-start accounting for all governments). On the surface, that seems a tall order, as we were looking at $8.3 trillion as of the fourth quarter of 2008 (and over $10 trillion into 2009).

This is not the first time a government has been insolvent. This sort of thing happened all too routinely with ambitious kings and emperors, many of whom came up with the same solution, namely sell the right to tax. In olden days, the purchaser was a wealthy person who would purchase the right to tax some specific region of the realm. They would then, of course, go at the citizens of the region with a taxing vengeance to earn as much as possible before the right expired.

Now, we are not about to recommend selling the taxing rights of, say, California to foreign investors, or, indeed, any holders of government indebtedness. But there is nothing wrong with selling off the same thing: a slice of the US GDP as a replacement for that debt, with the government paying into a trust a set percentage of the national GDP every year (quarterly) until the trust units (converted debt) are paid down in their entirety. All growth in the GDP (i.e., the set percentage) would accrue to the holders of the trust units and be discounted by a predetermined base rate of return. All gains and returns would be tax-exempt (after all, the government is selling its rights and should have no residual claim on any of the returns generated). The tax-exempt basis would also result in a lower required rate of return than would otherwise might be required. The spreadsheet in Appendix A shows how this could work in practice.

How We Approached the Phoenix Trust

We took the total value of the US federal and state and local debt as shown in the Fed’s statistics as of the end of 2008 ($8.6 trillion). We then set out to pay it down out of current and future GDP, in a manner similar to a mortgage paydown schedule, but augmented by the growth in GDP. For our base case (chosen conservatively), we assumed that:

1. US GDP grows by 2.0% going forward.
2. The discount rate required over the life of the 30-year instrument would be 3.0%. This compares with the current taxable 30-year US government bond rate of 4.4%, a reasonable and fair discount.
3. Using the GDP growth rate, the 30-year tax exempt interest rate, and a mortgage amount of $8.6 trillion, the US would have to “sell” the equivalent of 2.37% of its GDP for the next 30 years to pay down the set principal amount.

Our spreadsheet table in Appendix A is based on the following assumptions (note that there are four variables in this table, although only two are apparent):

1. The first element in the table is the amount that the Phoenix Trust is required to raise, or convert from debt to equity. Throughout, we have used the amount of total federal, state, and local debt outstanding as reported by the Federal Reserve Board. There may be those who believe social security should be properly funded as well, but these are value judgments we would prefer not to delve into; also, this would involve raising new money rather than swapping debt for equity. We did not made any adjustments for the 2009 projected deficit.
2. The second element is the long-term expected growth rate of US GDP. Herein we have taken total GDP growth (both the actual and the inflation-adjusted) as being a nominal rate of 2.0% per annum, as we do not expect much inflation provided the federal government is proscribed from running chronic deficits. Note that if no growth were to occur, the present value of the trust units would be about 50% of the current debt outstanding., Clearly there is a strong equity element to the trust.
3. We have used the 30-year treasury interest rate (although the duration would be much shorter than 30 years). The long-term, non-inflationary interest rate is close to 3% (according to Sydney Homer), so we believe that that rate is fair and equitable, if even on the generous side due to its tax-exempt basis. But then, like any well-planned underwriting, we want to leave room for some capital gains!
4. Finally, there is the issue of how much of the future US GDP could and should be sold forward. We have set that percentage at 2.37% of GDP, which is sufficient to eradicate all US government debt at all levels (as of the end of 2008). It is small enough so as not make too large an impact on the country’s finances, and is a percentage that will likely be politically reasonable to all Americans. We also believe that investors, especially foreign investors, would prefer an amount that was not so onerous as to invite problems in the future. [Note that with the planned deficits in 2009, perhaps the size should be roughly $10 trillion, in which case it would require 2.75% of US GDP to be set aside annually to pay down the units.]

Risk/Reward Matrix

We can determine a potential payoff table for investors using various assumed rates of return and differing growth rates for the economy in the future. We have done so briefly in the following table.

If the required interest rates in the future are lower than those established at the outset 3.0%), even if nominal GDP growth is not robust there is still good capital gains potential. To the extent that, having cleared out the excess debt, the growth rate is faster and the required interest rate lower as risks in the economy decline, the gains can become very interesting, although we have not extended the payoff matrix to encompass these scenarios. There is also the possibility that US future long-term interest rates will be higher than we have assumed, particularly if inflationary pressures build up in future. However, this is unlikely so long as the government does not run chronic deficits and keeps the overall GDP/debt ratio close to .689. However, in the inflationary case, we would expect the nominal growth rate for the US economy to be a lot higher than the 3.5% maximum shown on the matrix.

Are We Just Rearranging Deckchairs?

In discussing this idea with others, we have run into the argument that we are simply rearranging the deck chairs on the USS Titanic – same debt, different package. Nothing could be further from the truth. First and foremost, the risks of GDP growth and interest rate changes have been transferred from the US government to the investor. Second, the assumption of a 2% US growth rate is necessary to double the actual present value of the Phoenix Trust units. Of course, the US government must set aside a fixed percentage of GDP every year for the next 30 years to pay into the trust, using fair measures of GDP performance, and should forgo all taxes on the trust returns, both income and capital gains. However, if this is accomplished, the buyer has excellent odds of coming out a solid winner, while the US economy gets the greatest win of all by achieving its full economic potential without that staggering load of debt.

What about foreign buyers? Why would they exchange their US debt for the Phoenix units? Foreign buyers actually stand the best odds of enjoying a nice win from this arrangement. As price follows solvency (balance sheet strength), the change in the overall balance sheet strength of the American economy will be considerable. This will ensure that the US dollar will strengthen and future US growth rate will be faster, which means that the global value of the Phoenix units should outperform domestic returns. A final benefit is that the US would be providing global leadership in establishing a model to help other governments escape current and future insolvencies.

But Will Holders of US Government Debt Do the Swap?

Before we discuss whether the swap is acceptable, let’s dust off any reasons as to why such an exchange might be deemed unnecessary. To get to the heart of the possible opposition, what about these high level international meetings that have been convened to search for a way out? Won’t the G20 group of nations find a solution to the problem notably through some colossus global ‘stimulus’ package? Sadly, this is entirely unlikely, as these leaders have so far failed to acknowledge the critical role over-indebtedness has played in bringing on the crisis and no one has tried to deal with the issue.

And perhaps with good reason. First, the leaders don’t have a clear idea of what the real problem is. Second, few want to openly accuse the US of obfuscation or worse. Third, and perhaps central to the issue, as there has been no accepted measure of national insolvency, there is no effective fire to hold US (and Japanese) feet to. And finally, there is really only one country that can resolve the debt crisis: the US itself.

While we trust that we have offered some good reasons as to why this instrument is attractive, we invite naysayers to consider the case in which nothing occurs to ease the current debt burden. If, as we project, the current stasis continues, and the compounding of US government indebtedness, à la Japan, surges forward under all that “stimulus” (for which you can read “additional credit creation”), then we foresee the continued hinderance of the US (and possibly global) economies between a global slowdown and debt piled on debt. Together with the potential economic forces that are likely to be unleashed from exploding credit issuance, the trust exchange alternative will prove very attractive. Some have certainly visualized a worse outcome. In desperation, if the ability to tap global markets proves to be insufficient, will the US administration allow Bernanke to simply print money at a Zimbabwe-esque rate and push the US into some sort of hyper-inflationary spiral?

One very key issue for the new administration is how far it will allow Bernanke to take his current quantitative easing solutions before seeking alternatives; how much economic damage will it sustain before tackling the central problem that the US (and now the global economy) faces. Will the current, brutal credit (and equity) markets be allowed to forge on while the government fights fires by bailing out industry after industry, with no end in sight? Heaven knows that the past few months have been bleak – and are not likely to improve as time goes on. To put it mildly, we do not see any solutions being offered, even as the line up of corporate supplicants for additional government loans increases by the day. In short, there are strong incentives to issue the Phoenix Trust units and put the debt erasure process in motion.

But what about the huge extension of term involved? Today, you are holding T-bills, tomorrow a 30-year trust unit. Can investors adjust to that? First and foremost, the trust consists of series of reasonably fixed payments that can be broken up into longer and shorter instruments. While some US investment dealers have not exactly covered themselves with glory recently, they are infinitely adaptable to money-making opportunities, and breaking up and repackaging the units to suit different holders/buyers should certainly figure among them. The effective extension of term should not be a major barrier, and in any case, the $300 billion of the current value of the paydown of the units, which would come due every year, will create an endless supply of short-term government instruments. Parenthetically, if the demand for US Treasury-bill quality paper is all that high, there is nothing wrong with the Fed “selling” its imprimatur for a fee to the banks, who would do the actual issuance. Finally, for pension, IRA, and 401K plans, which hold a massive amount of US financial assets, a 30-year piece of paper with excellent capital gain potential would be a sound addition to the investment arsenal.

To that, we might add that if the US government offered, say, a 1% fee to the banks and investment dealers to aid in the transformation process, the lure of some $70 billion in fees (paid in Phoenix Trust units, of course) to a desperate industry would be welcome in the capital rebuilding of the nation’s banks and dealers.

Safeguards to the Phoenix Trust

Of course, simply issuing Phoenix Trust units will not cure the US solvency problem if the US Congress uses the new freedom from its current debt constraints to start in all over again to go back into deficit through the spend-and-borrow policies that got the US here in the first place. Clearly, there is going to have to be a prospectus in which there are sharp limits on what future US governments can do in this regard. We have noted that such limits may be promulgated in the past, but governments have found a way to short-circuit them in the name of “current necessity” (expediency). And so it will be necessary to have interest rate (discount rate) penalties built into the Trust units to prevent deficit financing as long as the units remain outstanding. We remain enough of the Keynesian persuasion that the odd deficit here and there is probably necessary to cope with future recessions. But something like a 4-year moving deficit-free target could be built in: a deficit in one year must be followed by enough non-deficit (surplus) years to completely repay that one year’s deficit. Otherwise, the interest rate on the Trust units would rise by, say, ½ of 1%. Do a little arithmetic with the Excel spreadsheet in the appendix and you will see that a small change like that is very costly – enough, hopefully – to prevent a lot of pork barrel politics once the US economy begins to settle into a growing mode again.

The reader is advised not to get too wrapped up in the fine details of our proposal for such limitations. We would anticipate that once the investment dealer advisors take charge of such an issue, all of the warranties and covenants required by investors will be fully met.

A Running Start for Infrastructure Spending

One of the most important aspects of the Phoenix Trust is that it has been designed to remove the entire debt burden from state and local governments and provide them with fresh-start accounting. The US is in very serious need of massive infrastructure spending, which traditionally is largely handled and financed at the state and local level. The removal of debt from those governments means that they will be able to undertake projects that are currently beyond their means. Because capital (infrastructure) spending has the largest multiplier effect on the overall economy, the balance sheet cleanup at the state and local levels will enable them to immediately start a large number of such projects. This will provide steady, well-paid employment and all of the other benefits of capital spending.

And all this would come at a most convenient time—when the immediate negative effects on many marginal projects in the private sector are taking place. President Obama recognizes this and has pushed infrastructure spending to the top of his priority list—but financed by the issuance of further debt, not out of tax revenues that the implementation of the Phoenix Trust would allow.

A Model for Other Countries?

If the US were to lead the way in government debt reduction/elimination, other countries may well follow suit, which would benefit the global economy. Certainly, many countries could use such a boost. Japan, for example, is a perfect candidate for its own Phoenix Trust. (See Appendix B.)

The Largest Beneficiary: Global Growth

We intially invoked the Atrill Curve to show how the gross excess indebtedness of the US was causing US GDP to be under steady downwards pressure, to the point where the back of the recent economic expansion is now broken, perhaps irrevocably. We were also able to measure how much excess indebtedness the US was carrying as a result of the unfortunate policies of Alan Greenspan and a succession of Republican governments. It has been easy to see which economic sectors have contributed most to the excessive levels of US indebtedness, and therefore where clean-up efforts should be focused. As always, however, identifying the excesses is not the same as cleaning up balance sheets. However, the game is worth the candle, not only for “everyone else” but also for those whose debt must be erased. As the US banks (and many foreign banks as well) have already discovered, once the solvency problem really bites (as it is now), massive losses are the natural result.

Let’s revisit at the Atrill Solvency Curve and see the potential results of a massive debt cleanup. First, given its current condition, without a debt cleanup, the US will be generating lots of debt but almost no GDP growth to offset it if the Japanese model holds up, as our solvency dynamics suggest that it will. Given that the Atrill Curve tells us that the US could be generating its current GDP but with almost $30 trillion less debt, it is clear that a massive pile of financial resources has been misallocated. These resources have primarily been lent by the rest of the world, and worldwide benefits would result from redeploying them to more productive use. In other words, the Atrill Curve shows that not only would the US be better off, but the rest of the world would benefit from more resources that could be used to grow more quickly and productively. In short, eliminating excessive US debts will have a positive effect on both the US and the rest of the globe.

In summary, the Phoenix Trust solution, when backed with concerted action to reduce the indebtedness of the other over-leveraged sectors of the US economy, is a very attractive approach to resolving the current credit stasis and getting the US and global economies back onto a growth trajectory.

Concluding Observations

The founder of SAC, Dr. Verne Atrill, used to say that there were three, and only three, important inventions in all of the history of mankind. They are money, banking, and the auction market. Those three things alone have released the economic forces necessary to free mankind from the bondage of the daily grind of a hand-to-mouth survival, allowing man’s imagination to soar so that he can build and dream, and thereby realize the potential of our creative instincts, mostly for better although sometimes for worse. The one thing that Dr. Atrill should have placed in his list was a modifier, the word “honest”. Since the election of Ronald Reagan, the US monetary authorities in particular (followed, all too often by others) have increasingly permitted the banking discipline to be circumvented to forestall recessions, and the banks have fallen into line with this thinking as the risks of doing so steadily receded. In the end, we are arriving at the stage in which the issuance of money – debt – by the US government to bail out the problems that have arisen may have to reach the obscene levels not dissimilar from the Weimar Republic and Zimbabwe. Lenin once observed that to destroy a country, it was first necessary to debase its currency. Somehow, we do not think that this is what President Barak Obama has in mind, yet that is what his trusted advisors, almost all of which are cut out of the Republican cloth that brought us to this situation, are doing. When Alan Greenspan initially set out to mitigate the economic risks arising in the US (and for that matter, the world), he did so by continuously heaping credit on the US economy. On his way, he received a knighthood, but was really looking for sainthood. Unfortunately, the road to hell is paved not only with good intentions but also too much debt.

We now have at least two massive insolvencies comprising more than 30% of global GDP, and must consider whether the global financial system can accommodate both insolvent countries and remain operationally functional. The massive stimulus being proposed will only make the problem worse. The odds are horribly stacked against a successful debt-on-debt solution, and will place a severe strain on the rest of the globe in the future.

Dealing with a corporate insolvency is never pleasant, involving as it does considerable dislocation for employees, losses for shareholders, and cost to debt holders. However, companies that have chosen to deal with their own insolvencies with dispatch by selling assets and reducing debt tend to find that the day after, as it were, is much brighter; the company returns to productive endeavours and its stock price inevitably soars. Dealing with a national insolvency will be significantly more difficult and the short-term effects severe. However, not dealing with the two national insolvencies is likely to prove far worse in the coming years, even if the pain is more gradual. Even our assumption that the pain might be more gradual could potentially be an error in judgment as we have no evidence as of yet that the current stimulus will actually achieve anything useful at all. Judging from Japan, the US must take firm actions to resolve its financial problems or face future risk of an economy highly prone to stagnation and an ever-declining stock market. Further, US savers, the very middle class that the US is relying on to keep on borrowing and consuming, will be penalized by miserably low interest rates, thereby hampering both their efforts to provide for their own future as well as providing the necessary savings base to fund future capital investment. This in turn cannot help but steadily weaken the long-term economic outlook. As the private sector is pushed ever lower, the federal government will take over the financing of American activity in the hopes of a better outcome (as the Japanese government did before). It is not a pretty picture. That the US has such a clear “role model” would make such an outcome particularly egregious.

There are those who are assuming right now that after this recession, US household will be right back at the old hotdog stand borrowing and spending. But with US households carrying – as they are – nearly $7 trillion is excess indebtedness, we suspect that they will be far more likely to go back to more historically reasonable savings rates and saving levels, as well as paying down debt rather than resuming wanton spending for a long time to come, just as the Japanese have done before them. With interest rates as low as they are going, equity markets in a questionable state, and housing prices still falling (or at best leveling out longer term), the drivers of “risk-free” spending are all gone. Should the US consumer return to the more normal percentage of GDP levels of consumption of around the 60-62% mark, there is going to be a roughly 10% “hole” to fill before US GDP returns to the levels of even 2008. Already, the evidence is coming in that US households are saving and/or repaying debt, with approximately 80%+ of the tax rebates and other household government spending stimuli that are being received. With unemployment reaching well over 9% (and up to 16%+ if one takes into account those who are ‘discouraged’ from job-seeking), the incentives to save rather than spend are in front of everyone’s nose.

So what is it that will fill in that “hole”, or at least try to? As we noted at the outset, it is clear from the “stimulus plan” that is in process of being put in place, that it will involve a huge increase in government intrusion into the affairs of the US. If the record of Japan is any indication, this intrusion will widen and deepen over the years to come, not fade away “once the crisis is over”. We are sure that Japan thought the same thing that the US is thinking right now: apply some heavy stimulus and then pull back when a recovery sets in. That was more than 10 years ago and no recovery has set in, but the ongoing “stimulus” remains very much in place. Americans have always generally held a jaded view towards too much government in their lives. However, if the Japanese example holds as we suspect, government intrusion into the US economy is in its infancy and can be expected to grow strongly from here.

Using the Atrill Curve, one can determine that had Japan been solvent and used its financial resources efficiently, its GDP could have been somewhere in the order of at least 22% higher than it is. (That’s about a 2% compound rate of growth since 1998 just for restoring the Japanese national balance sheet to the efficient solvency range.) The mathematics of the Atrill Curve suggests that US GDP will also be substantially higher over time once it returns to a state of solvency. More to the point though, if that $31.8 trillion of excess US indebtedness had been better allocated around the globe, total global GDP would have been much higher than it is today. Looking forward, the strongest single reason for resolving the credit problems of the US (and Japan) is that the ongoing development of efficient global capital markets would point to excellent growth prospects for both the US and the rest of the world.

We like the advice offered by Rahm Emanuel, President Obama’s chief of staff, who said, “You never want a serious crisis to go to waste”. This is the most serious economic crisis the US has faced in the past century. Drastic action must be taken. But not the kind that the US (and other central banks) are undertaking. The markets are not responding well to proposals for more credit stimulus because the invisible hand of the market knows that the solution to a debt crisis is not more debt. It is too bad that Mr. Greenspan and the Republicans did not understand this in the past, and that many others of the Ben Bernanke School of Economic Recovery are falling into the same trap.

We will make one 100%-safe forecast, and that is that the US willreturn to its efficient solvency ratio no matter what, because that is where the economy in total tends to operate – the least cost of capital. The only unanswered questions on the table are first, how will the US get there, and second, how long will it take. In the shorter term, we remind the reader that the system is not self-correcting at current solvency levels, but rather self-reinforcing. As of the end of 2008, the debt to GDP ratio at the margin had risen to 10:1 in the US, a result of the rapid slowdown of US GDP; in early 2009, GDP growth has turned negative, and the ratio at the margin has become infinite. While this “always” happens in recessions when GDP goes negative, if Japan is any indication, then GDP is unlikely to recover with any degree of robustness – or perhaps we should just say that GDP is unlikely to recover.

President Obama may be forgiven for wanting to wait and see what happens if he permits current efforts to fix things through massive credit issuance to persist. Unfortunately, the regretful part of furthering the now failed and damaging policies is that when they finally prove to be wrong, fixing the damage will be increasingly more difficult. Based on the evidence, it would appear that the US is unlikely to recover from its current debt malaise and at best, will merely be able to limp along in the future. And what if they are “half right” – that is to say, the US limps along as Japan has done, with the government playing an increasingly large role in the economy as the private sector slowly recedes in importance and efficacy?

As for the rest of the world in 2009, our concern is that all or much of the stimulus undertaken by non-US central banks will wind up financing the US, leaving those countries that thought were trying to improve their domestic economies in a position of having inadvertently poured their resources into an American financial black hole. On what we would facetiously call a ‘positive note’, the curious thing about Japan is that as of 2009, the current state, local, and federal government debt aggregates to about two times GDP (up from about 40% at the outset of eruption of the solvency problem, or roughly where the US is at the time of writing). With a solvency ratio that shows that total Japanese debt relative to its GDP remains at just over 3.5 times, this means that Japan could use the Phoenix Trust debt solution and make it to a safely solvent condition in a single jump! However, it has taken Japan 10 years of zero GDP growth to get to this condition. We might surmise that the US could possibly do the same thing, perhaps also in a ‘mere’ 10 years. As long as the American electorate has plenty of patience and does not mind a zero growth policy with massively increasing government intervention in its economic life, the US may be able to avoid seriously addressing its debt situation now, and simply let the federal government do most of the GDP heavy lifting. At some time, perhaps a further 10 years out, the US may also be able to use a future Phoenix Trust solution to take the US to healthy solvency in a single jump. If the game is worth the blowtorch – and the political risks that come with it – then by all means, ignore the debt problem for now and hope for the best. However, history has not been kind to Japan during its own ongoing dark period.

An economy that economizes is one in a constant state of creative destruction (and balance-sheet healing). Those who cannot keep pace and innovate will fall by the wayside and die. If death is not allowed, then life can exist, but it cannot flourish. The only thing that can grow under current circumstances is the government debt load. Somehow, we doubt that President Obama wants this as his legacy.

If, as many fear, all or virtually all of the capital of US banks in total is essentially wiped out in writedowns of those loans that have no hope of repayment (and many real estate loans may fall into that category), then enlarging the Phoenix Trust offers a mechanism to provide more money to recapitalize American banks as well. We would hope, however, that the penalty which the government exacts for that provision will stop banks from ever again being so profligate with their depositors’ and shareholders’ money. Our concept of the Phoenix Trust itself may be replaced by another even more imaginative approach, but the concept paying down (eliminating) debt is not one that can be circumvented — at least not without violating at least one of our three criteria for a successful outcome, whether by selling assets or something closely akin to it. Indeed, one criterion, honouring all contracts, applies as well to the ideal of maintaining the purchasing value of US currency, apparently long forgotten by the Fed.

In a note by Nouriel Roubini, he observes that a sharp rise in the public debt burden (public debt/GDP ratio), which the U.S. Congressional Budget Office estimates will rise from 40% to 80% in the next decade, an increase of about $9 trillion, will put a dent in US growth. He calculates that if long-term interest rates were to increase to 5%, the resulting increase in the interest rate bill alone would be about $450 billion, or 3% of GDP. The implication is that the fiscal primary surplus will have to be permanently increased by 3% of GDP [presumably through tax increases], which could constitute further pressure on the disposable income of the U.S. consumer. Against this background, the total “burden” of the Phoenix Trust payments on the US economy which would amount to 2.37% of US GDP (see Appendix A) pales into insignificance by comparison. Worse, if the US emulates Japan as we fully expect, these numbers are grossly optimistic.

Finally, when all else fails, try the obvious. It strikes us that the only issue really open to discussion is how long the new US administration will be willing to wait to find out that their current solution is no solution at all. President Obama has the acuity and the charisma to take on this issue, but the question in our minds is, does he have the courage? For all of our sakes, we hope that he does.

Finally, for those who choose to dismiss our analysis and the solution that we have proposed, we would request that they offer a workable alternative that meets the three criteria for a successful resolution of the debt problem. The US government needs to find a definitive and decisive solution to the debt problem. In the end, ours is the only one offered so far which can end the current malaise, and not simply prolong the agony.

When the Problem is Debt, the Answer is Not More Debt – SAC, 2009

And Afterwards

We have not dealt with the massive excess indebtedness which is being carried on the books of the banks, both in the US and abroad, including Canada. Nor have we dealt with the huge excess indebtedness (all by historical and efficient standards) of American households. While dealing with households and eliminating much of the excessive debt there will correspondingly lift a massive amount of the debt from US (and global) banks, this will require political value judgments because in many instances, we think that the US government might well consider taking on some of the debts of its citizens into the Phoenix Trust structure. The stunningly massive amount of derivative securities which makes much of the current bank debt more or less feasible (less, as it turns out) and the associated sterile leverage associated with those derivatives can be dealt with by the simple expedient of having them treated like insurance contracts and properly reserved against. Those which are not used for purely speculative purposes will survive: those which are simply used by banks and hedge funds to game the system will disappear. Off balance sheet leverage currently being employed by the banks will be brought back onto balance sheets. Should investors be willing to purchase securitized instruments with full and plain disclosure, then caveat emptor but the risks will be set out clearly and the bank sponsor non-involvement in them will be known in advance. Following the recent catastrophe in these instruments, however, we suspect that there will be little appetite for them anyway for a long time.

We have read many analyses for dealing with the bank loan problems and how to deal with them, a goodly number of which make eminent sense to us. In terms of getting the banks back onside, their massively excessive leverage reduced (rapidly), and the whole issue of dealing with and eliminating problem loans, we are happy to leave to others. Job One – to us – is to get the government balance sheet into sound working order and then allow the free market to do the rest, all within the confines of a return to sensible and sound banking regulation. It is not that we do not have a lot to say here, but it is not necessary to repeat or reiterate what many thoughtful observers have already said.

Currently, the experts say that cities and states across the U.S. face years of crippling budget shortfalls before any economic recovery will bring them relief. That means unpleasant political conflicts, layoffs and scaled-back services, possibly accompanied by increases in fees and taxes. State revenue lags economic activity. However, the Phoenix Trust has been designed to lift the debt burdens from state and local governments and thereby allow them to get back to business without the crippling load of servicing debts undertaken when the great housing bubble (and bust) was on. The ability to hire and put economic events into motion is premised on reducing debt burdens as far and as fast as possible.

Above all, it should be understood that the operation of the Atrill Curve provides government with the most important and completely a-political advance in controlling the economy ever. It is not control over the day to day decisions made by households and corporations everywhere that is important. It enables government to place a “governor” on the economy which will keep it operating at or close to its efficient maximum which is the key. Left to its own devices with reasonable oversight, the economy will economize naturally. With no controls on the banking (credit generation) system, as we have discovered, things can go very seriously amok. The twin goals of keeping the cost of capital low and maximizing the overall activity of the economy are very worthwhile, even if the odd recession occurs. Recessions are the periodic cleansing actions required to get rid of failures and recycle capital to more productive uses. Even Alan Greenspan acknowledged this important function in his book – while at the same time doing everything he could to prevent one from happening. Too many American industries lost sight of the business cycle and have paid the price. When the “big one” was finally unavoidable in 2008, for some, like the auto industry, the outcome was catastrophic. The application of the mathematics of Accounting Dynamics will not usher in a new era of endless growth and prosperity, at least not in the way that Alan Greenspan imagined it when he systematically set out to interfere in the economy at critical junctures and thereby set off the train of events that finally broke in 2007-8: it will, however, usher in a new era whereby absurd excesses are headed off and thereby not permitted to [nearly] fatally disrupt the economic life of the nation and potentially the entire globe. From a global perspective, it will also unleash the financial resources which are desperately needed elsewhere on the planet. All members of the family of nations will benefit from this, not merely the US and those others which choose to directly use Dr. Atrill’s approach to solvency economics.

Appendix A- Phoenix Trust Paydown Table

Assumptions herein are as follows:

1. GDP growth – 2% nominal
2. Required interest rate – 3.0%
3. Percentage of GDP required – 2.37%

Note that we have used the year end 2008 numbers for total debt and GDP. These numbers are changing fairly rapidly, with GDP declining in early 2009 and government debt escalating at a rate that we had never thought likely. Resolving any differences is therefore a matter of degree, and 5 minutes with Excel can easily offer up correct, up-to-the-minute adjustments and new numbers. (For instance, an increase to $10 trillion in public debt by the time of execution would require 2.75% of GDP.)

Appendix B - Phoenix Trust Paydown Table for Japan

Assumptions herein are as follows:

1. GDP growth – 2% nominal
2. Required interest rate – 2.272% (e)
3. Percentage of GDP required – 7.25%

Here, as of the last data which we have for Japan, we find that it will take about 7.25% of the Japanese GDP to pay off the entire Japanese government debt load. In the case of Japan, since total government indebtedness is so large at almost twice Japanese GDP, the exercise of the Phoenix Trust solution to eliminating the Japanese government debt will actually bring the Japanese economy back to more or less ideal efficiency. Since their current solvency ratio is a little over 3.5, eliminating 2 leaves 1.5 or just about the peak of the Atrill Solvency Curve. However, the percentage of GDP required to service the Japanese Phoenix Trust is almost triple that currently required by the US.

It is not that the US could not wait while its own private sector is crushed into submission and total government debt as a percentage of GDP also reaches 2 times, to do their own version, but why on earth would they wait that long?

Appendix C -Zimbabwe Congratulates the US

We would be remiss if we failed to draw attention to another current monetary authority who has also been dealing a similar problem. In Marc Faber’s December 2008 letter he quotes someone worth listening to, just because the results have been so horrific. Dr. Faber introduces the quotation by observing that when Mr. Bernanke became Fed chairman, and when he talked about dropping dollar bills from helicopters onto the US, and taking “extraordinary” monetary measures in order to support asset markets, people did not take him too seriously. But as it turns out, he has done exactly what he wrote about and what he repeatedly stated in speeches. He is sort of the John Law of the 21st century - a money printer and market manipulator. A friend of Faber recently sent him the following comment from Dr. G. Gono, chairman of the Reserve Bank of Zimbabwe [Faber notes “no hoax” in his own brackets]:”

“As Monetary Authorities [of Zimbabwe], we have been humbled and have taken heart in the realization that some leading Central Banks, including those in the USA and the UK, are now not just talking of, but also actually implementing flexible and pragmatic central bank support programmes where these are deemed necessary in their National interests. That is precisely the path that we began over 4 years ago in pursuit of our national interest and we have not wavered on that critical path despite the untold vilification, misunderstanding, and demonization we have endured from across the political divide. Here in Zimbabwe we had our near-bank failures a few years ago and we responded by providing the affected Banks with the Troubled Bank Fund (TBF) for which we were heavily criticized even by some multilateral institutions who today are silent when the Central Banks of UK and USA are going the same way and doing the same thing under very similar circumstances thereby continuing the unfortunate hypocrisy that what's good for goose is not good for the gander.

As Monetary Authorities, we commend those of our peers, the world over, who have now seen the light on the need for the adoption of flexible and practical interventions and support to key sectors of the economy when faced with unusual circumstances.” SAC Note: Zimbabwe has a “closed economy”, which means that the inflation of the Zimbabwe dollar has not been spread around the world or even other countries in Africa. Nonetheless, inflation has been staggering, its economy reduced to rubble. While we do not forecast the same outcome for the US following almost the exact policies of Dr. Gono, we would not say that these policies are likely to be successful either. (As a coda to the above, Zimbabwe has abandoned its efforts to have its central bank in charge of currency issuance, and is now using an international basket of currencies.)

About Accounting Dynamics and Dr. Verne H. Atrill

In 1951, Dr. Verne Atrill, a physicist by training before the WWII, graduated from the London School of Economics (PhD thesis under the Lord Lionel Robbins) with the solid conviction that economics as practiced and studied, was neither a science nor a discipline. From that moment of epiphany, he set out to see if there was something – anything – in economics on which a systematic science of economics could be built. To do that, he knew that he needed sets of numbers that hung together (interacted) and the only set of numbers that was immediately obvious to him was the balance sheet.

Looking at the balance sheet, there are two main characteristics that were of significant interest. First, the balance sheet balances. Second, a balance sheet is not a stand-alone set of numbers but rather it is one which interacts with all other balance sheets which deal with that specific balance sheet (are the ‘trading connections of’). In fact, using one balance sheet, one can actually infer two balance sheets, that of the entity itself and that of all the trading connections lumped together as an “imaginary counter-entity”. The question was whether there were any mathematical relationships between the two which might be the subject of an actual science.

First and foremost, the fact that a balance sheet balances means that it obeys Newton’s Third Law, namely that for every action, there is an equal and opposite reaction. Rather than passing over this obvious, even trite observation, Dr. Atrill asked a second question, if the balance sheet obeys Newton’s Third Law, are there any other physical ‘laws’ that it also might obey. In his book, How ALL Economies Work (ALL being capitalized), he set out the work that he had accomplished in this regard by 1978. On Page 125, he lists 7 constants from the world of physics which can be deduced from first principles from the interaction of balance sheets (and had deduced further constants which he believed must also be found in the realm of physics as well). The seven known constants that he deduced are the digital sequences which correspond to:

• Planck’s Constant
• Einstein’s small k
• Newton’s Universal Constant of Gravitation
• The Elementary charge
• Avogadro’s Number
• The SI Speed of Light
• The Nautical Mile Speed of Light

At the heart of this work, the mathematics of thermodynamics looms large and elements of nuclear physics also play their part. The mathematics of Einstein and Minkowski also have a significant role in what he terms are the E and M conditions to which we have referred indirectly herein.

Dr. Atrill’s body of work has been developed and used by Dr. Atrill’s company, Strategic Analysis Corporation, to analyze and forecast credit strength, stock pricing, and currency pricing, all of which elements ‘fall out of’ the analytical base that Dr. Atrill provided. Indeed, the discovery of “structural solvency” and “structural pricing” as having universal application in all markets has provided SAC’s clients with unique insights into balance sheets and markets around the world.

Among other things, the discovery that price follows solvency has allowed SAC to forecast currency prices with long lead times. It was with great interest (for instance) that we watched and followed the deterioration of the US balance sheet and hence the US dollar, notably since 2002-3 when we first were able to forecast that if the then current trends continued, that the US would reach what we term a ‘second-order insolvent’ condition by 2007-8 with unknown but probably very unpleasant consequences.

In The Freedom Manifesto also self-published (in 1980), it is clear that Dr. Atrill did not trust governments (any more than corporations) if they were left unchecked. The solvency parameters of Accounting Dynamics, his name for the mathematical principles that he developed, have proven their worth in forecasting, even though their application in the real world has never been tested save by SAC. This is a truly an objective economics: unlike conventional subjective economics in which it is almost impossible to get agreement between two or more “economists”, the principle, res loquitur, applies universally to the numbers which every entity leaves behind.

This is not a “model” of the economy: it is an integrated mathematical theory. We hope that we have given the reader a taste of what those solvency parameters would entail, with the assurance that whether applied to companies and countries, their forecasting efficacy is powerful and consistent.

C. Ross Healy, MBA, CFA - August 2009 Chairman, Strategic Analysis Corporation