A Melman Minute — February 9, 2011

During the past few days, I have been catching up on the flow of data which accumulated during my recent visit to South America. One of those sets of data reveals a pattern which is startling at best and immensely troubling at worst. The size of the American National Debt is what is at issue.

One year ago, the US National Debt stood at $12.354 trillion and was rapidly approaching the "Authorized National Debt Limit" which at that time stood at $12.394 trillion. Congress immediately acted to raise the debt limit by $1.9 trillion to $14.294 trillion and many believed that an increase of that magnitude had probably resolved the problem for some time. They were wrong.

In just one year, the National Debt has risen by $1.7625 trillion and now has reached $14.116 trillion - or just $177.5 billion less than the amount Congress authorized just one year ago and America's debt is currently increasing at the rate of almost $150 billion per month!

As I recall, we were told that the reason for authorizing such a monumental increase in the authorized debt limitation one year ago was the government needed that room to stimulate the economy and restore prosperity. It hasn't worked. America remains plagued by high unemployment, falling real estate prices while finances at the state and municipal levels can only be described as "increasingly chaotic in nature."

Undoubtedly, despite all the political posing and posturing, Congress will likely soon pass a new increase in the debt limit and our guess would probably be to a level above sixteen trillion dollars, an increase which will be serviceable for perhaps one year and a few months at best. Then what? Does that country then go to eighteen trillion?, twenty trillion?, or maybe they 'bite the bullet' and authorize $25 trillion in one shot.

It must take some sort of blind faith in the miraculous power of government to micro-manage the economy to believe that prosperity combined with price stability and a strong currency will come out of such numbers. We do not have such faith at TMR and that is why we continue to maintain our opinion that holding precious metals and their related investments for both insurance purposes and as a means of achieving capital gains is a worthwhile strategy.

We mentioned state and municipal government difficulties in the above analysis and news is now emerging that the municipal bond market is now entering a period of crisis.

For the uninitiated, "munis" are bonds issued by states and municipalities and their attractiveness rests on two pillars. First, the interest earned from holding such bonds is always federal income tax-free and is frequently immune from state and municipal taxes as well and, therefore, such debt instruments have been attractive holdings for those with high income levels which would otherwise be subject to high levels of personal income taxation. Second, since states and municipalities have the legal right to tax, it has always been assumed that they would be able to increase such taxation revenues at will in order to make certain principal and interest was always paid promptly on those bonds.

In the former case, given the recent passage of income tax reductions just passed by Congress, the comparative attractiveness for munis has been diminished. In the latter case, many are now fearing that tax rates in the states and municipalities have already been stretched close to their limits with little room for increases should they be required to service debt.

For these and other reasons - such as the monumental levels of such debt already in existence - companies that insure municipal debt are pulling in their horns. According to financial writer Michael Corkery who published an analysis in today's Wall Street Journal, "...fewer newly-issued muni-bonds are insured now - 6.2% versus 57% in 2005...Many insurers have stopped issuing guarantees because they themselves are still struggling with losses in the financial crisis."

Because of these and other factors, hordes of muni-bond holders have been exiting the market in recent months. As they sell their holdings, prices are driven lower, which drives up the rate that states and municipalities must pay for new issues, thereby exacerbating the whole situation.

Noted economist Meredith Whitney, famous for her accurate predictions of 2007's bank share demise, roiled the waters a few weeks ago by predicting, "There's not a doubt in my mind that you will see a spate of municipal bond defaults. You could see 50 to 100 sizeable defaults. This will amount to hundreds of billions of dollars..."

Corkery's article quoted a former Federal official who neatly summed up the implications of a major muni market default which he said, "...could have major macro-economic dislocations - teachers not getting paid, roads going unplowed; once that tree comes down look out - it's falling on everyone, both the innocent and the guilty."

We believe that the muni bond market shakiness is yet another problem which threatens America and, by implication, other major financial markets.

If that weren't enough, the specter of food inflation is raising its ugly head with increasing frequency these days. Perhaps even more importantly, fear of inflation is causing nations to begin the long road toward higher interest rates and THAT could easily abort whatever economic recovery is now taking place.

Two charts will easily verify that food price inflation is no imaginary matter. It is real and it is growing more severe over time. The two charts are those of two of the world's most widely used food commodities, wheat and coffee.

As can be seen, the rally in wheat is continuing and prices have now risen by about eighty percent during the past year, from near $5.00 per bushel to just under $9.00 per bushel presently.

We know of many people who cannot conceive of waking up in the morning without their pot of coffee, but that habit is getting increasingly expensive as commodity prices for the brown bean have risen by more than one hundred percent - from near $1.25 to over $2.50 per pound - during the same period of time.

Historically, rising inflation has been perhaps the greatest single positive influence during past golden bull markets and the fires of inflation do appear to be glowing ever-brighter.

As of 8:00 AM PST, precious metals are moving higher with gold now close to $1,367 and silver once again above the $30.00 per ounce level. Base metals are retreating slightly following their recent strong rallies and mining share indexes are down about 1% on average. In other markets, crude oil is up slightly, the US Dollar is once again declining and interest rate futures are trading close to unchanged on the session.

In financial markets, both the Dow Industrials and Canada's TSX Index are making only minor moves so far.

All quotes US$ unless otherwise indicated.

Next "Melman Minute" scheduled for Friday, February 11 when we plan to discuss the growing unrest in nations such as Tunisia and Egypt at some length. Frankly, we are growing suspicious about the supposedly "democratic" nature of these "spontaneous" demonstrations.

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