Sprott - 2013-01 - Ignoring The Obvious

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					                                                                            January 2013

Ignoring The Obvious
By: Eric Sprott & Etienne Bordeleau

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Not a day goes by without hearing about the fiscal cliff, the debt ceiling or another political deadlock. We would not
disagree that some of these are important issues that need resolving but, in the grand scheme of things, they are
relatively superficial.
As we all know, central banks around the world have been frantically expanding their balance sheets. While exceptional
times might warrant exceptional measures, Figure 1 below paints a rather troubling picture. The monetary base,
the amount of money in circulation in the economy, has expanded at an incredible pace. Since the mid-80s, the
U.S. monetary base had been very stable at around 5-6% of GDP. Through fractional reserve banking, this amount
was sufficient to maintain annual inflation around 2-3%. With the banking system collapsing in 2008-2009, it was
necessary for the Fed to increase the monetary base. However, banks are now in much better shape than they were
in that period and the benefits of monetary expansion seem to be waning.
The Fed is not the solution to every economic and social woe and trying to hide real problems (eg. structurally high
unemployment and rampant poverty, unsustainable income inequality and exploding government liabilities) with
money printing achieves nothing constructive.






           1984                     1988                    1993                    1998              2002   2007   2012

Source: Federal Reserve Bank of St. Louis, U.S. Department of Commerce: Bureau of Economic Analysis |         ignoring the obvious   |   january 2013                                                           1
First, while we are supposed to be in the midst of an economic recovery, about one in five Americans are on food
stamps (Figure 2). As the chart below shows, this measure of poverty has been fairly steady for the past year. We also
find it hard to reconcile this data point with the headline unemployment numbers, which seem to be improving. We
prefer a more comprehensive measure of unemployment, commonly referred to as U6, which includes discouraged
workers and those working part time against their will. By this measure, we see that “Total Unemployment”
has come down, but remains extremely elevated at around 14% of the labour force. Moreover, food stamps and
“Total Unemployment” tend to move together. If food stamps users stabilize at current highs, we believe that it is
a sign that the natural unemployment rate in the U.S. economy is now significantly higher than it was pre-crisis.


                             Total Unemployment rate (LHS)                                                                       25%
                             Percentage of Population Participating
     16%                     in Food Stamps Program (RHS)
                             Headline Unemployment Rate (LHS)                                                                    20%
      4%                                                                                                                         5%
      0%                                                                                                                         0%
       Oct 2004           Oct 2005          Oct 2006           Oct 2007   Oct 2008   Oct 2009   Oct 2010   Oct 2011   Oct 2012

Source: U.S. Department of Labor: Bureau of Labor Statistics

Income Inequality
Second, income inequality has been growing steadily since the mid-1980s. Figure 3 shows the share of total U.S.
income earned by the middle class and the top 5% of households. As of 2011, the top 5% of households brought
home over 22% of all income generated in the country, whereas the middle 20% of households (quite literally the
middle class) got less than 15%. Coupled with the unemployment picture, this shows that a majority of the U.S.
population has been losing ground to the most wealthy. In a society that relies on consumption for 70% of its
economic activity, this certainly does not bode well for the future, since the wealthiest traditionally do not consume
much of their income. To top it off, the recent “fiscal cliff deal” just reduced disposable income further by increasing
payroll taxes by 2% for all those working, putting additional strain on the working class and their discretionary
spending dollars. (See Figure 3). |          ignoring the obvious    |   january 2013                                                                     2


       22%                       Top 5 Percent
                                 Middle Class
       20%                       (3rd quintile of population)





            1967        1971         1975           1979           1983    1987         1991    1995      1999        2003        2007   2011

Source: U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplements

Government Obligations
Another obvious problem is the liabilities of the Federal Government. The current cash reporting basis that the
Department of the Treasury uses, vastly understates its deficit and future liabilities. Some estimates put the current
unfunded liabilities of the Federal Government at about $222 Trillion and show an increase in the deficit from 2010
to 2011 of around $11 Trillion, which represents about 70% of the U.S. total GDP.1
Simple back of the envelope calculations can be made using the Treasury’s “Financial Report of the United States
Government – 2012”, which comprises a detailed breakdown of its future financial obligations for health care, social
security and other government services.2 This reporting is similar to what every corporation is mandated to calculate
for the purposes of U.S. GAAP reporting.
Of course, accounting can always be “massaged” to improve one’s situation. This problem is most acute when there
are many assumptions, like for pension and benefits accounting (a.k.a. social security and Medicaid/Medicare).
ShadowStats makes the necessary adjustments and finds that for 2012 alone, the deficit amounts to $6.9 Trillion.3
This represents about 45% of annual GDP. While laudable, the current haggling by policy makers for a meager
$2 Trillion in deficit reduction over 10 years represents only the tip of the iceberg.
A significant part of these deficits is caused by current and future health care spending. The Deloitte Center for Health
Solutions recently published a report entitled “The hidden costs of U.S. health care: Consumer discretionary health
care spending”, in which they analyze the many components of health care spending and how those expenses are
underreported in official numbers. Figure 4 shows their estimates for total health care spending by age group for 2010.

1 See website of Professor Lawrence Kotlikoff of Boston Universityfor details:
2 Updates to his calculations for FY2012 should be made available in the near future.
3 |         ignoring the obvious   |   january 2013                                                                                3
FIGURE 4: TOTAL HEALTH CARE COSTS BY AGE – 2010, $ BN                             FIGURE 5: U.S. POPULATION 65+ YEARS

                    Under 25        25-44            45-64       65+
                     years          years            years      years                                2010        2020        2030         2040        2050    2060

Source: The hidden costs of U.S. health care:                                                 Source: US Census Bureau 2012 National Population Projections
Consumer discretionary health care spending, Deloitte

What is striking - but not that surprising - is the very large increase in health care costs faced by seniors. The report
cites that “Seniors and Baby Boomers account for 64 percent of health care costs, but comprise only 40 percent of
the U.S. population.” For seniors, total health care costs represent, on average, approximately $30,000 per person per
year. Other estimates by Carnegie Mellon University professor Paul Fischbeck (although a bit dated) show that these
annual costs increase dramatically as people age, reaching as much as $45,000 for 80+ year olds.4 Considering that
GDP per capita was about $46,800 in 2010 and the income inequality mentioned earlier, these are figures that would
put most households in dire straits.
Also, structural trends will lead to an ever greater share of the nation’s income being dedicated to health care.
Figure 5 above shows the evolution of the U.S. population for the 65+ age group, as forecasted by the U.S. Census
Bureau. The U.S. will end up with a steadily increasing segment of its population (from 13% in 2010 to 20% in 2030)
composed of persons aged 65 and over. This matters for two important reasons. First, this means a smaller workforce
contributing to GDP growth and paying taxes to support government programs. Second, and this is related to the first
point, this trend will put tremendous pressure on social security and health care spending in the country, thus leading
to structurally higher deficits.
These facts are by themselves troubling, but coupled with the population trends described in Figure 5, they become
alarming. To illustrate the impact of overall population aging on total health care costs, we use the per capita numbers
implied by the Deloitte study and apply them to the U.S. Census Bureau projections for all age groups. While we
believe that those numbers fundamentally underrepresent health care inflation, we inflate per capita costs for each
age group using the average “medical care” component of the U.S. Department of Labor Consumer Price Index.
Finally we assume a 4% nominal GDP growth, which some might argue is overly optimistic when taking into account
the smaller workforce we discussed earlier. In any case, Figure 6 shows the results of our simulation.
Only with the change in the composition of the U.S. population, total health care costs are forecasted to go from 22%
of GDP in 2010 to over 30% in 2040. These are huge numbers! To put them in perspective, in 2011 total U.S. GDP
was $14,500 Billion, so an increase from 22% to 30% of GDP would represent a $1.2 Trillion increase in health care
spending in that year. If we increase the health care inflation rate by only 100bps, we calculate that by 2040, the share
of GDP attributed to health care will jump to 40%.

4 Our calculations are similar to those carried by ShadowStats. |          ignoring the obvious   |   january 2013                                                                                                    4




             2010                       2020                       2030                        2040                       2050                       2060

Source: US Census Bureau 2012 National Population Projections,U.S. Department of Commerce: Bureau of Economic Analysis, U.S. Department of Labor: Bureau of Labor
Statistics & The hidden costs of U.S. health care: Consumer discretionary health care spending, Deloitte

According to the Deloitte study, about 60% of those costs are borne directly by households and the remaining 40%
by the public sector (30% to Medicare and Medicaid). This means that households, of which the majority is either
poor or in the declining middle class, will face an even larger squeeze in their discretionary spending.

To conclude, 20% of the population is on food stamps, an ever increasing gap between the wealthy and the rest and
ever-increasing health care spending are all deep rooted and immensely important problems that get a ridiculous
fraction of the attention that they deserve. The impact of these issues on both government finances and future
economic growth are enormous.
As we discussed, the purpose of asset purchases by the Fed might no longer be improvements in the real economy,
but rather a more subtle financing of U.S. government deficits. However, in the long run, expanding the money supply
inevitably leads to inflationary pressures. Luckily for the Fed and the U.S. government, there is so much slack in the
labour market that inflation might be years away. And, if we are right about the long run unemployment rate being
structurally higher, then the Fed has all the room it needs to continue Quantitative Easing (QE) to infinity. This might
allow them to continue to hide the true financial position of the government for many years to come.
Nonetheless, the rising GAAP deficit and the sheer size of the U.S. Federal Government’s liabilities to its citizens
makes it clear that one day or another, services (health care, social security) will have to be cut. Financial alchemy can
hide reality, but it does not provide any tangible services.
Europe’s (unresolved) experience with its debt crisis provides an insightful window into the future. Austerity measures
in Ireland, Portugal, Spain and Greece have caused tremendous pain to their citizens (25% unemployment rates) and
wreaked havoc in their economies (double digit retail sales declines).
Are we going to ignore the obvious?

To learn more about Sprott Asset Management’s investment insights and award-winning
investment capabilities, please visit |         ignoring the obvious   |   january 2013                                                                                                    5
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