Gold, Goodwill, and Growth

by Michael Rozeff

A correspondent suggested to me an idea about government balance sheet goodwill that’s worth
sharing. That led me to a few further thoughts about gold and economic growth. The basic idea
behind all of this balance sheet analysis is simple. A stronger balance sheet of the government
means a stronger fiat currency and a lower price of gold in that currency, other things equal.

If we look at the balance sheet of the United States (meaning the national government), it appears
that the assets are worth less than the liabilities. I used as an example that the $2.2 trillion of
current tax revenues might grow for 2 percent forever and be discounted at a 4.5 percent rate.
This gives a present value of $90 trillion. But we read that government liabilities may exceed this
by $60 trillion or even more. (See, for example, Laurence J. Kotlikoff’s paper “Is the United
States Bankrupt?)

The suggestion made was that maybe there is an intangible asset being left out, which is
goodwill. That's a useful way to think about balancing the balance sheet. In this case, if the total
assets (tangibles and intangibles) and liabilities are 150 trillion, then 60/150 = 40 percent. This is
a large share of intangibles, which suggests its existence may be questionable.

What’s in this goodwill? More taxes. One such intangible asset is the government’s capacity to
raise taxes. When people worry about the government seizing assets in 401k accounts or forcing
such accounts to buy United States bonds, they are envisioning this missing government asset.
Kotlikoff mentions a national retail-sales tax. Others mention value-added taxes. These are all
examples of ideas to make the government balance sheet balance by increasing the assets, as
opposed to explicitly cutting down the government’s promised liabilities, or making the
government’s real payouts be less than the promised amounts by defaulting.

Higher taxation is a double-edged sword, for any significant tax increase will lower economic
growth and cut the growth rate of tax revenues. It may enourage more government spending. It
seems to me that such a step will weaken the balance sheet overall.

A government tax increase is a government asset, but it’s a taxpayer liability. The taxpayers
either will pay for the promised government benefits or else they won’t get them, which means
government defaults on its promises. There are no other ways left except to invade some other
nation and steal its wealth.

Balance sheets balance. The United States balance sheet will balance, one way or another.

We can invert the problem of the imbalance in another way. At what perpetual growth rate of
national income would the assets be worth $150 trillion? The answer is just a tad under 0.03. In
other words, if the U.S. economy grows at 3 percent forever and if the discount rate for taxes is
4.5 percent, then the United States’ balance sheet balances. The tax revenues then have a present
value of 150 and so do the liabilities. Apparently, Kotlikoff and others who look at the
demographics and the promises made by the government do not find that growth will be
sufficient to fund the promises and debts made. Notice that they exclude contingent liabilities,
and they made their estimates before the depression hit and before the United States jacked up its
spending.

Long-term growth is very important. That is why I focused on it in several earlier articles.
Investing is paradoxical. It depends on a continuing series of short-term decisions and
considerations, but insofar as these decisions look at fundamentals, the focus is on long-term
matters. Present values discount the entire future. One has to look at the long-term future in any
fundamental valuation approach, even if one is deciding whether to buy or sell every day of the
week.

Let us say that the government share of economic activity grows, as it is projected to do in the
United States. In my view, that lowers growth, because government spending is inefficient or
wasted. Capital cannot grow if savings are absorbed by government and dissipated on pyramids.
Lower growth undermines the currency.

In this balance sheet approach, a change in the politics that points to pro-private sector growth
policies will solidify government finances, and that will strengthen the dollar and weaken gold. I
am watching the Obama commission on fiscal reform due to report in December. So far there
have been no news reports that leak any trial balloons.

There is an argument to be made that the world economy is the appropriate way to analyze this.
All the major fiat currencies are to some extent related through central banking connections and
coordination of the major governments. The world price of gold matters, not just the price in
dollars. In this case, we should be thinking about a world balance sheet or a balance sheet that
consolidates the major countries. Global growth, global tax revenues, global government balance
sheets, and global inflation all matter.

In this approach to understanding gold, gold’s price depends on the strength and weakness of the
major fiat currencies, and they depend on government finances, especially tax revenues, which
depend on economic growth. And all of this is filtered through what market participants
EXPECT. Psychology is important.

The stronger that the politicians feel the pressures of having to maintain the welfare state in order
to satisfy voters who vote for it, or the more able they are to impose the welfare state – however
one looks at this – the less likely are they to stand by and let the deflationary forces work
themselves out. All the major countries (China, Japan, US, UK, France, Germany) have fought
the depression for several years with greater spending and more inflation. The European Central
Bank joining in of late is a MAJOR event.

The first reaction of the governments to the economic slowdown was to preserve the welfare
states and even to use the crisis as an excuse to enlarge them, as Rahm Emanuel made explicit.
Their first reaction was instinctive: save the banking system. That’s central to the structure of
existing governments. They could not even bother to count the costs. Furthermore, all the major
governments have a kind of cartel of governments, which is why there are so many supra-
national organizations like G7, G20, EU, and IMF. They cannot afford to have any important
dropouts or failures, such as Greece. This threatens the entire political structure. Again, their
instincts are to save that system.

Saving it now means that the G20 is starting to make noises about fiscal restraint. Their
borrowing costs are starting to rise. They will retrench if that’s what it takes so that they can fight
another day. They will not retrench with enthusiasm or will, however. That goes against their
general thrust, which is preservation and extension of their powers. Therefore, we have to wait
and see if they back up their talk with actions.

The governments have backed themselves into a corner by following Keynesian or neo-
Keynesian policies of fighting the depression with spending and money creation. Their best shot
was to have gone about a process of rapidly liquidating the insolvent banks and enterprises.
Instead, following their instincts and thinking this depression was just another mild recession,
they went for bailouts of banks, debtholders, and government-sponsored enterprises like Fannie
and Freddie.

The only hope for government balance sheets at present is a genuine economic recovery, but the
policies of the governments have prevented the adjustments needed to build a basis for such a
recovery that would build back their tax revenues. More and greater subsidies of failing and
uneconomic activities prevent growth of the economy and their revenues. They have weakened
their balance sheets and gotten only a temporary stimulus in return. If they continue along this
path, they will spiral down. The world will be looking at a cadre of Japan-styled economies. If
the governments do not allow renewed liquidation of unprofitable banks and enterprises and
promote pro-growth measures, growth like that of Japan in the 1990s and 2000s will occur. That
was 1.5 percent and lower.

The problem with renewed liquidation is that it means renewed depression for a time. It’s very
unpalatable politically. Tax revenues will fall off and political pressures for inflation escalate.
This path threatens insolvencies of governments and turnover in control in elections.
Consequently, the governments now have no easy way out. They didn’t have an easy way out
when the depression began, but they made it even worse for themselves. Euroland is an example
of the emerging outcome, namely, a resort to further debt buildup and further central bank
quantitative easing (inflation).