IMF comments on America's deficit...

IMF comments on America's deficit... S&P keeps its head in the sand... Greek investors are in denial... The only chart that matters... How to hedge yourself in a money crisis... Communism or capitalism, what's best for the poor?...

"I don't think the debate has yet even begun to understand how big a fiscal retrenchment is going to be needed," the IMF's chief economist Paul Mills told a Euromoney bond conference in London yesterday. He was speaking of the U.S. Treasury's huge annual deficits.

We stand agog. It's not every day someone from the IMF says anything sensible, important, and true. Bravo, Mr. Mills. We salute you.

In contrast to Mr. Mills was Moritz Kraemer, the head of sovereign credit ratings for Europe at Standard and Poor's (S&P). If anyone should have an expert view on the world's current monetary/debt crisis, it's Mr. Kraemer. And yet, answering a question about S&P's rating on U.S. sovereign debt, this is the best he could do…

Judging from past performance, you can count on Kraemer and the rest of the crack team at S&P to downgrade the U.S. approximately 30 days after the U.S. Treasury defaults on a debt payment. That people like Mr. Kraemer remain gainfully employed is evidence enough that the world's economy is in trouble.

Here's another shocker... The news service Reuters reports that among the 400 participants at the Euromoney conference – which included hedge-fund managers, market strategists from brokerages, and economists from major banks across Europe – only one person thinks Greece requires a debt restructuring. The bull market in wishful thinking seems to have legs. We wish it the best.

We don't invest in wishful thinking. And we are absolutely terrified of consensus opinions, especially among institutional economists. We remain skeptical of Greek bonds. We are likewise skeptical of the euro. We are even more skeptical of the U.S. Treasury market.

Why would Europe's troubles make us skeptical of the U.S. dollar? The dollar serves as the basis for the world's economy and monetary system. If Europe implodes, as it must, dollars will be used to bail it out. This process has already begun – the U.S. provides much of the funding for the IMF, whose funds are being funneled to Greece.

You might recall that for the last several years (since the end of 2008 at least), we've been warning investors to keep a steady eye on what we call "the most important chart" in the world – the price of gold compared to the price of U.S. bonds. Our forecast was that paper money (bonds) would suffer greatly versus "real money" (gold) as credits finally realized most of the West's sovereign borrowers were bankrupt.

We knew efforts to prop up sovereign borrowers with government money-printing schemes would prove to be highly inflationary and bullish for gold bullion. I'll let you judge for yourself if our view has been right. Here's gold versus the U.S. Treasury long bond over the last two years…

As you can see… over the last two years, the price of gold has gone up more than 60%. U.S. long-dated bonds have increased by less than 10%. Shorting bonds and buying gold would have produced a 50% gain in two years.

What I find most intriguing about this view of the world is it shows how improvements to the bond market are nothing more than inflation. For example… over the last three months, U.S. bonds have rallied sharply. They're up about 8% since April. Investors have reacted to problems in Europe by buying U.S. bonds and selling "risky" assets around the world. But the bond market rallies are never bigger than the rally in gold, which is up even more than bonds, as you can see in the shorter-term chart below.

This proves our thesis is intact. Sovereign borrowers are extremely powerful. Thanks to the backing of the Federal Reserve and the world's paper-dollar standard, they can manipulate the value of their currencies and bond markets almost at will. But they cannot control the price of gold, nor can they print more of it.

Here's gold versus the U.S. Treasury long bond over the last three months…

"It certainly appears that China's finally following through on its policy to diversify its foreign reserve holdings away from the U.S. dollar," says Stephen Green, the chief economist at Standard Chartered Bank, in today's Financial Times.

Standard Chartered has been watching China's actions in the U.S. bond market nervously. Green knows China's investment choices hold huge influence over currency valuations and commodity prices. Thanks in large measure to the massive increases in U.S. sovereign debt, China's foreign exchange reserves have doubled since December 2007 to $3 trillion. Does that sound safe or sustainable to you?

Green says a study of net purchases of U.S. government debt in China, Hong Kong, and London suggests China's purchases of U.S. Treasury obligations have fallen dramatically. China now seems to be spending most of its foreign exchange reserves on euro debt obligations, a move that would explain the euro exchange rate's strength in the face of its ongoing debt crisis.

We think that proves our point. U.S. inflation (quantitative easing and huge fiscal deficits) continues to support the Chinese bubble we've written about extensively over the last few days. It's also now supporting the European debt markets, via Chinese investments. This massive inflation is revealed in the price of gold, which continues to rally, as measured in all currencies and against most bond markets.

Our advice? Keep your eye on the charts above. We're living through a major collapse in the world's monetary system. Prices are unstable because the currencies are unreliable. The entire global structure of money and credit is a house of cards. There's no telling exactly how it's going to fall apart.

Our best advice? Make sure you have plenty of real money – gold. And if you're not willing to short stocks, keep half your savings in gold and the other half in short-term U.S. Treasurys (one-year paper). That's the only way to have a hedged position in a world that's gone crazy.

We've gotten lots of requests from subscribers to other Stansberry & Associates publications for access to the now-famous June 2011 issue of my newsletter, Stansberry's Investment Advisory. You can read a free copy here.

New 52-week highs (as of 6/20/11): Forest Laboratories (FRX) and Annaly Capital Management (NLY).

In the mailbag... a subscriber who doesn't know much about economics but loves to argue politics. Oy vey. What's your complaint? Let me know here: feedback@stansberryresearch.com.

"I have a great deal of respect for the information coming out of the newsletter, but when I read Porter's comment that 50% of the people in the U.S. don't pay income taxes, I wondered if that was really true. So I looked it up and found that it isn't true – but what is true is that 50% of the taxpayers in the U.S. don't pay very much in taxes (on average about $400) because they don't make much money at all (average gross income of about $15,400)...

"When we look at the looming deficits in the trillions through the next 10 years, almost 60% of the projected deficit is just the Bush Era tax cuts for the richest 5% of the people in the U.S. So 5% of the U.S. population will be causing 60% of the deficit, and yet you're trying to find a way to cover the deficit by digging into the pockets of people making an average of $15,000 a year. Good luck with that idea. I can't imagine how the U.S. is ever going to reach any realistic solution to our overwhelming financial problems when people of obvious high intelligence focus is on pushing the solution on the backs of people who don't have any money to speak of at all. Talk about closing your eyes to the problem – this is an issue of responsibility that has to be addressed realistically (where can we get the money), not with hype that won't accomplish the objective. Please think of a better answer than what you are now pushing on your readers." – Paid-up subscriber Bill Burdette

Porter comment: One of the things I dislike the most is trying to engage in any debate about these kinds of fiscal questions with people who look at the data with a political perspective in mind. At the risk of encouraging more of these kinds of e-mails, let me simply give you the facts.

At present, roughly 50% of the population doesn't pay any net federal taxes. Despite your claim, the point isn't in dispute. Here's a detailed piece from the USA Today that reviews the numbers and offers plenty of sources. Since this article was published, Obama's policies have made the problem worse by allowing people to claim tax refunds even when they haven't paid any taxes.

In my opinion, allowing around 50% of the people in the country to pay zero federal income tax is a huge mistake. When no economic feedback influences people's voting decisions, voters are much more likely to make bad choices. That's dangerous for our country and not in the spirit of America. Similar tax structures have led to massive economic problems in many large countries – like Argentina.

In regards to being "realistic" about these problems, I've studied these numbers as much as any analyst in the world. And here's the most important "realistic" fact that you won't see discussed anywhere else. No matter how you structure taxes, tax revenues never surpass 20% of GDP.

You can look throughout American history, and you won't find a period of time where tax revenue exceeds 20% of GDP – except for rare, single-year periods where there were windfall capital gains revenues… all of which were caused by huge decreases to the capital gains rate.

On an ongoing, sustainable basis, it is impossible to collect more than about 20% of GDP in tax revenue. Given this fact, how realistic is it for the federal government to ever spend 25% of GDP, as it has been doing for years? Likewise… given this fact, how realistic is it to pretend that high marginal rates of progressive tax are likely to lead to increases in revenues? We already know they can't.

I would suggest that instead of trying to engineer social outcomes using tax policy, we instead focus on how to collect as much revenue as possible. We already know that low marginal rates of tax encourage compliance and lead to increases in tax revenue when measured as a percentage of GDP. Said another way, low flat taxes produce the greatest amount of revenue. They do so because they're fair and easy to collect.

I've suggested a simple, 20% flat tax, for everyone – expressed as a constitutional amendment that guarantees everyone the right to 80% of his or her income. If God can survive on 10% of your income (the amount of traditional tithes), certainly the government should be able to make do with twice that amount.

The allegation that I'm trying to balance the budget on the backs of the poor is absurd. People with low incomes would pay equally low taxes. People with high incomes would pay equally high taxes. This idea of fairness is in the American tradition, while the idea of progressive income taxes was one of the primary planks of the Communist Manifesto.

Finally, if you're truly interested in helping the poor, the best thing you can do for them is allow America's economy to grow and allow our currency to stabilize. To accomplish these tasks, you must lower the marginal rate of tax. Otherwise all of our capital and most of our capitalists will eventually leave America to pursue better opportunities in places like Russia, which after experimenting with communism for years now offers its citizens a low 12% flat tax.

Regards,

Porter Stansberry

Baltimore, Maryland

June 21, 2011