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3 Merit Financial The Gold People GOVERNMENT DEBT SURVIVAL GUIDE Table of Contents Understanding the Problem Identify the Trends, Make a Plan, and Keep it Simple Unemployment: What s the real number, and why does it matter? Game Over: Housing, Debt, and Bankruptcy The Real Problem: Government Debt Who Foots the Bill? How to Survive the Growing Debt Crisis The Silver Lining (Pg.)1

4 (Pg.)2 Merit Financial The Gold People GOVERNMENT DEBT SURVIVAL GUIDE Understanding the Problem If you wake up every morning and turn on a financial news station, you might think the economy changes direction almost daily. The Dow is up, and then it s down. Consumer confidence is off, and then comes back. We are constantly bombarded with these numbers, statistics, indices, averages, etc. Then comes the analysis: The economy is showing signs of recovery, you hear. Then two days later its Concerns are mounting there will be a double dip recession. As an everyday American who s not constantly submersed in financial data, how can you make sense of it all? More importantly, how do you plan for the future without a clear understanding of the present? These are the problems we are all facing when trying to accumulate and build wealth in this new economy. If all you listen to are the reports coming from the government and the Federal Reserve, you might be fooled into thinking things are really looking up. They stick to their guns, telling us that we are in fact in a recovery, and that though it s fragile, the worst of this crisis may be behind us. For the millions of Americans who have yet to find a job, and for the millions more who ve lost their homes and their livelihoods, this couldn t be farther from the truth. Let s look at some of the facts: 1. Unemployment is staggeringly high, and is probably much worse than the official numbers. 2. Banks are going bankrupt at record rates, yet the FDIC has about $19 Billion in assets to cover $4.4 trillion in deposits. 3. Taxation and government reporting are on the rise. 4. Government spending is completely out of control by any reasonable measure, and there is no end in sight. Does this sound like a recovery to you? It probably doesn t. Do you think the worst is behind us? It s probably not. So the question is: What have you done to prepare yourself for life in this new economy? If you re like most of us, you probably haven t done enough. The good news is it s not too late. We haven t yet seen the kind of debt-driven meltdown that is occurring in Greece. We haven t seen the horrors of hyperinflation. The fact is that most people don t even see it coming. For those that do however, there is a window of opportunity to take some steps to protect wealth and weather the coming storm. Identify the Trends, Make a Plan, and Keep it Simple The first step to putting together a useful financial plan is identifying the things that really matter. You missed this morning s Regional Manufacturing Surveys numbers? Who cares! Didn t catch the latest Wholesale Inventories information? It doesn t really matter. You don t need to call down to the census bureau and update your stats sheets! Keep it simple, and focus on the measures that really matter: employment, housing, and debt.

5 PH (Pg.) 3 Using only these three basic indicators you can create a common sense understanding of the long term outlook for the economy and gain some insight into how the government is likely to respond. Knowing this will give you a platform on which you can build your strategies. If you see unemployment subside, taxes go down, and government spending reigned in, you may want to dive back into the stock market and hold your cash in US dollar denominated assets. If you don t expect those things to happen, you ll want to make a plan that prepares you for the worst. Unemployment: What s the real number, and why does it matter? When most people think about the Great Depression one of the first things that comes to mind is high unemployment that lasted the better part of the decade. The important thing to understand about unemployment is that it is a cause, not a symptom of recession and depression. Though a flailing economy can cause unemployment, there cannot be a sustained recovery without putting people back to work. Pumping money into government funded programs to boost employment is simply not a solution. Just ask Franklin Roosevelt, who was still fighting 19% unemployment in 1938, five whole years after the start of the New Deal. It wasn t until the outbreak of World War II that real demand for products and production lifted the US out of the great depression, doubling GDP. unemployment numbers according to Shadowstats. com, which include estimated long-term discouraged workers. When you then add underemployed and short-term discouraged workers, the picture becomes even bleaker. The true national unemployment rate is likely not 9.5% as advertised by the government, but somewhere above 20%. How severe is the situation? For comparison, unemployment during the Great Depression peaked at just over 22%. It didn t return to pre-crash levels until after the onset of World War II. Is there anything on the horizon that will create that kind of demand for industrial production? Not in the foreseeable future. What s worse is that the official unemployment numbers don t paint an accurate picture of how bad the situation really is. Since unemployment was redefined in 1994 to exclude long-term discouraged workers, the real unemployment numbers (those which matter for consumer spending and tax receipts purposes) are likely much higher than those reported by the Bureau of Labor Statistics. The chart at right shows the real 22 % 21 % 20 % 19 % 18 % 17 % 16 % 15 % 14 % 13 % 12 % 11 % 10 % 9 % 8 % 7 % 6 % 5 % 4 % 3 % 2 % 1 % 0 % UNEMPLOYMENT RATE - OFFICIAL (U-3 & U-6) vs. SGS ALTERNATE Official {U3} Broadcast {U6} SGS Alternate

6 (Pg.)4 Game Over: Housing, Debt, and Bankruptcy So what could be worse than nation-wide unemployment with no end in sight? Combine that with weak housing, malfunctioning credit markets, and a skyrocketing personal bankruptcy rate and the true state of the economy starts to take shape. Let s look at some facts: 1. From 2007 to 2009, household net worth fell by $17.5 trillion, or just over 25%. This is roughly equivalent to a whole year of GDP. 2. Median home prices have fallen by more than 30% since 2007, and have made almost no progress in regaining that ground. 3. Personal bankruptcies are now occurring at a rate so high, that each year there are twice as many filings as there were in the entire decade of the 1930 s. Aside from wiping out net worth across America, the implosion of the housing bubble has created another side effect that is crippling economic growth in this country. During the pre-2007 housing boom, home equity was a driving engine behind the credit markets, making credit available to Americans with equity in their homes. Widely available credit increased buying power and demand for goods and services, helping create jobs and economic growth. With home prices adjusted and credit dried up, the lack of demand for goods and services resulting from high unemployment is magnified by the loss of yet another pillar of purchasing power. Without jobs and credit, people don t spend. Without spending there is no growth in demand. Without demand, production can t expand. Without production GDP falters. It s GDP growth that supports the dollar and gives the government the ability to continue borrowing. Now it should start to make sense why this recovery is really not a recovery at all. Though GDP is not growing at the same rate it was before the housing crash, something else is growing faster than ever before in the history of modern economies: Government debt. Understanding the effect of growing debt and its ratio to GDP is the key to putting together a common sense plan to survive this crisis. The Real Problem: Government Debt What do high unemployment, record bankruptcies, faltering spending and collapsed housing all have in common? They all decrease government tax receipts. From the local level, all the way to the halls of congress, government balance sheets are weakening by the day as tax receipts cannot keep pace with spending. In short, if jobs don t produce tax revenue for the government, the government must either reduce spending, print money (devaluing it as they do), or borrow more and go further into debt. For a look at the trouble excessive government debt can cause, look across the pond to Greece, where near anarchy in the streets was the result of a debt crisis which has been temporarily bandaged, but not cured. With lower tax receipts, and without sustained GDP growth, the ratio of national debt to GDP suffers, The chart on the following page from investingcaffeine.com shows current projections for debt to GDP growth.

7 PH (Pg.) 5 The resulting problem is simple: The government has now borrowed more than it can pay back, and one of two things must happen: Either Washington must drastically cut spending and drastically increase taxes, or they must systematically devalue our currency so they can pay it back with cheaper dollars. Preparing for the consequences and effects of these actions is crucial to preserving wealth in a nation entangled in a debt crisis. So now we re talking about government debt and GDP, but what do these numbers have to do with your personal finances? The answer is VERY LITTLE. That is, of course, if you ve taken steps to protect yourself from the results of a high debt to GDP ratio. THE U.S. FEDERAL DEBT (% of GDP) 27% Civil War 35% World War I 44% Great Depression 122% World War II Courtesy of Who Foots the Bill? If you have to sum up the purpose of generating income and investing and saving that income, it goes something like this: We produce income to trade it for the goods and services needed to provide a satisfactory lifestyle for ourselves and our families. We save and invest that income so that it can buy more goods and services tomorrow than it does today. Thus the purpose of money management is to grow and preserve purchasing power. Should the government continue creating money through liquidity enhancement and quantitative easing, it s common sense to assume (with more dollars chasing the same goods and services) that each dollar you save will lose value in terms of what it can buy. This is why currency devaluation is such a destructive force. A 20% annual return on your investments is worthless if the currency you hold is worth 20% less at the end of the year than it was at the beginning. What s the long term effect? The government avoids politically difficult decisions (like cutting spending) by printing its way out of a staggering deficit. Though money can be printed, value cannot. By printing its way out of a debt crisis, the government levies a hidden tax on those Americans who have saved and invested their wealth: The tax of decreased purchasing power.

8 (Pg.) 6 PH How to Survive the Growing Debt Crisis: What little economic growth there has been in the last two years has clung to the coattails of federal spending and bailouts. Securities markets have thrived since the crash on earnings posted by companies flush with federal money, or benefiting directly from programs such as the Cash for Clunkers and new home tax credits (all paid for by you know who). These programs, however, are not sustainable engines of growth, and can t be counted on to drive the economy indefinitely. During the tech boom, anybody could throw a dart at the board and pick stocks that would likely grow with time. This economy is much different. It s important to be diversified. It s important to be conservative. Many of the old rules of good wealth management still hold true. Here are some new ones that could help you avoid some of the pitfalls that could lie ahead. 1. Diversify Beyond Traditional Investments In an environment with low consumer spending, weak housing, high taxes, and soaring debt, it s hard to find an asset class that is not directly affected by these systemic problems. Investors who intend to come out of this ahead should look to assets outside of the traditional realms of stocks, bonds, and real estate. After the stock market collapse in 2008, many investors who thought they were diversified by owning mutual funds and bonds found out quickly that all sectors of their portfolio came down at the same time. A well balanced portfolio should contain at least some assets that gain ground in the event of a shock to the system. Those assets are out there, and if your investment advisor can t find them, you should probably diversify your advice as well. 2. Prepare for Currency Instability In a world where central banks create and destroy money at such a breakneck pace, it s important to prepare yourself for currency instability. This means dealing with the possibilities of both deflation and inflation. In a deflationary scenario, cash is king. In an inflationary environment, commodities (especially precious metals) play a crucial role. In an uncertain situation such as this, it may not be a bad idea to have both. Remember: Returns are not what they seem! You have to evaluate your wealth in terms of purchasing power. In a country with an unstable fiat currency, simply designing your portfolio to attain returns is not enough. You have to design it to weather the type of hyperinflation that has followed every major expansion of money supply throughout the history of fiat currencies. 3. Don t Bet on Things You Don t Understand In a growing economy, investments in most things tend to pan out at least relatively well. As we talked about before, there have been times when most anyone could pick a handful of stocks, invest for the long term, and expect decent returns. In this type of environment, successful stock picking has become increasingly difficult, if not impossible for the everyday investor. Without sustained growth, the effect of speculators and traders on asset prices could be magnified. For example, when the majority of shares in a stock are owned by long term value investors and mutual funds, instability is much lower than when such positions are held by hedge funds or traders. All you have to do is look at the

9 (Pg.) trading records of the major investment banks over the last two years: They have been raking in the money. For every trade they make, someone is on the other end. With the resources available to Wall Street traders compared to those used by everyday investors on Main Street, it s no wonder picking winners is so much harder these days. The bottom line is this: If you don t understand where the asset s value comes from, DON T BUY IT! Having a portfolio comprised of 80% mutual funds which own stock in companies you don t even know is a dangerous position to be in Don t Count on the Status Quo One of the worst mistakes so many Americans made in the last decade was betting on their income, their homes, and their net worth to increase indefinitely over time. Even in an economy free of government debt concerns, with functional credit markets and strong job growth, assuming things won t get worse is a dangerous game. In this scenario, it could be financial suicide. Keep in mind the fact that the government must take steps to address the debt. This means you shouldn t bet that taxes will not increase. Don t plan your retirement savings based on your current income tax levels. We re a few months away from the largest tax increase in US history. It probably won t be the last. Don t assume your income level will stay the same or increase. Though it may (if you re one of the lucky few), you shouldn t assume you ll continue generating income at the same level you currently do. With an economy that could be on the brink of even more systemic failures, there is no telling which segment could be hit next. Hopefully it won t be yours, but you should prepare as though it will. 5. Create Your Own Gold Standard Perhaps the most difficult part of money management in a debt ridden society is finding a measuring stick with which to assure the purchasing power of your wealth is preserved. For the majority of recorded time, purchasing power was measured in gold. The advantage of gold is that unlike paper money, it cannot be created out of thin air. Thus, it has held its value relative to what it can purchase over time. That s why each dollar used to be backed by gold. It meant that the government couldn t just manipulate the currency up and down at will, and that the dollar was more than just a promise to pay from the boys in Washington. Imagine if Mr. Bernanke and friends at Federal Reserve had to come up with the gold to back all the money they ve printed! Grab the shovels and picks; it s going to be a long night. Let s check the facts: 1. With a current government debt above $13 trillion, it would take about 34,200 metric tons of gold at today s price to cover that liability. That s about 13 times all the gold mined in the world each year. 2. Throw in the unfunded liabilities of Social Security, Medicare, and Medicaid, and it takes about 171,000 metric tons to cover it. That s much more than the total amount of gold ever mined in human history. Clearly getting back to the gold standard would be completely impossible for the US government. They would have to hold themselves accountable for national finances in a way that simply isn t likely to happen. That being said, you can hold yourself accountable for your finances, which will help you stabilize your wealth as the government fails to stabilize the economy. Though gold has gone up in US Dollar terms every year since 2001, there is another interpretation of the same fact: The value of the US Dollar has gone down in every year since Though the government can instantly manipulate cash, it s much harder for them to do so with gold. Let s take a look at GDP measured in US dollars, and then measured with relationship to gold. This tells the story of how the economy is really doing: No spin, no manipulation, just purchasing power.

10 (Pg.) 8 GDP in Billions of US Dollars (Chained 2010 Dollars) GDP in Terms of Gold Purchasing Power (Billions of Ounces) Billions of Ounces Billions of US Dollars $ 1800 $ 1600 $ 1400 $ 1200 $ 1000 $ $ Estimated drop by % Drop from 2000 to $ $ In short, the purchasing power of our GDP in terms of how many ounces of gold it will buy has steadily decreased over time, with a massive fall of over 60% since Yet is it any wonder that the ratio of gold to oil has stayed relatively constant? If you look at the ratio of gold to housing costs, food, and most other essential goods and services you will see the same. The picture is becoming clear. Are dollars a better measure of purchasing power than gold? They probably are not. So does it make sense to keep track of gains and losses in your net worth in terms of dollars as opposed to gold? Can you purchase the same house for the same number of dollars you could in 1990? How about gas for your car? If you had maintained your net worth in terms of gold purchasing power, you would probably be miles ahead of where you are. Here is a simple experiment. Look back over your finances and estimate your net worth in years gone by. Then take the average gold price for that year (available from various sources, including kitco.com), and divide your net worth by the price of gold. How many ounces of gold could you have bought with your net worth in 2000? How about now? Have you kept pace? If you re like most of us, the answer is no. That s because you would have had to pick investments with outstanding performance over the last ten years to keep pace with gold. Another way to look at it: You d have to have picked investments that outpaced the deterioration of the dollar s purchasing power. Very few people did, and even fewer will be able to in an increasingly difficult economy. If our goal is to protect wealth in terms of gold purchasing power, there are really only two ways this can be accomplished: 1. Pick investments that consistently beat gold over the long run OR 2. Own gold in case your other investments don t beat it In truth, the best strategy is probably a combination of the two. There have been times when the purchasing power of gold has steadily declined over time. This happened between 1990 and 2000 as seen in the GDP comparison charts above. That economic environment however was quite different from the one we face today. Confidence in the markets was much stronger, debt much lower, and gold was not performing as it is now. In these times, outpacing the purchasing power of gold with conventional investments was relatively easy. Today however, that s simply not the case. The Silver Lining There is one good thing about all this mess: The fundamentals are easy to understand. With minimal time and effort, you can watch unemployment, housing, and debt numbers and have a relatively strong grasp on the major trends in the economy. There will come a time when these steps will be less necessary for financial survival. When that time comes, you will know! You ll see the employment rate rising, the debt levels subsiding, and life returning to the credit markets. Until then however, be conservative, keep it simple, and stick to these common sense steps to surviving the debt crisis.

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