These points are widely misunderstood – even among people who purport to be value investors. Grahamites do not, as is often asserted, ignore market and economic conditions; nor do they exclude these considerations from their analyses. Instead, they ask questions such as: "how unusual are the results (profits, dividends, etc.) that X Ltd has generated over the past 5-10 years? Have monetary and overall economic conditions given these results an artificial or unusually favourable boost? Given general corporate "base rates" and those for similar companies, how likely is it that these results can continue? Are there grounds to believe that X's results in the future will regress towards some long-term mean? If so, does a purchase at today's price provide a margin of safety that sufficiently offsets the risk that X's future operations might not match those of the present and recent past?"

          Precisely because they draw conclusions about the prices of many securities, Grahamites also hold views, which are rough and prone to error, about market indices today and several years hence. And because they form judgements about the normality or otherwise of today's economic conditions, they also develop opinions about booms and busts down the road.

          Graham, for example, famously warned in the late 1950s about unduly and perhaps dangerously high asset prices (see, for example, his articles "The New Speculation in Common Stocks" and "Stock Market Warning: Danger Ahead!"). Conversely, he rejoiced when in the mid-1970s he detected attractively cheap prices (see "The Renaissance of Value" and "The Future of Common Stocks," all of which appear in Janet Lowe, ed., The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend, John Wiley & Sons, 1999). Similarly, citing implausibly high prices and correspondingly meagre prospects, in 1969 Warren Buffett closed his investment partnership. And at several points since the late 1990s he has warned investors to temper their expectations about the results they might reasonably expect during the years and decades to come (for examples, see the references on Leithner & Co.'s links page).

          Grahamites' views about markets, interest rates, overall profitability, etc., thus play a distinctly second fiddle to their analyses of individual companies and securities. They incorporate these views into their individual analyses; but within these analyses, company-specific factors and figures always predominate. Their approach resembles that of Lawrence Sloan, who in Every Man and His Common Stocks (McGraw-Hill, 1931) posed three questions about the funk then gripping the U.S. (and most other countries). First, was the country in the midst of a severe and possibly prolonged slump? The answer, he believed, was "yes." Second, could astute observers have discerned signs of trouble ahead of time? Sloan thought that they could have; and one economist, Ludwig von Mises, certainly did (see in particular Percy Greaves, ed., The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, 2006).

          Sloan's third question is perhaps the most important. Could investors have protected their portfolios from the Depression's worst effects? Maybe – but only if they were prepared to ignore the crowd and think for themselves. The problem was that during the boom, signs of bust were apparent only to those who sought them. As the Depression unfolded, mixed and positive signs remained numerous enough to persuade investors with optimistic and even neutral views of the world that all would soon be well. Then and now, the most sensible stance – particularly when one's analysis of the past yields the conclusion that today's prices and profits are improbably high, and that tomorrow's harvest might be rather thin – is to expect ructions, adopt a rather dour attitude and incorporate cautious macro possibilities into one's micro analyses. Mind the downside, in other words, and the upside will mind itself.

          How to apply this mindset to the conditions prevailing early in 2007? First, disregard high and possibly rising international tensions. They are real, but much less severe than those prevailing during most of the 20th century. Most notably, the risk of terrorism in Oz is trivial. Also, forget about the bird flu scare. As Jeffrey Tucker shows in "Bush's Fowl Play," it is largely the concoction of budget-maximising bureaucrats. Finally, ignore global warming. It's a possibility; but so too, as Lawrence Solomon shows ("Will the Sun Cool Us?"), is global cooling. And perhaps warming is a good thing. Whatever it is, it's not a hard fact. It is, rather, an accelerating barrow energetically pushed by (a) scientists whose status and income depend upon the state and (b) politicians and other zealots eagerly grasping the latest opportunity to aggrandise themselves and plunder everybody else (see, for example, "Climate Chaos? Don't Believe It" by Christopher Monckton). Even if global warming exists, says Bjorn Lomborg in The Sceptical Environmentalist, the interventions demanded to combat it will likely produce more harm than good.

          Put out of your mind, in short, the exotic and hypothetical risks that are stirring ever more people into a collectivist frenzy. Instead, focus upon a danger that is much more pedestrian, whose evidence is much firmer, whose consequences politicians are doing their best to ignore, and that has thus come to few investors' attention. Why wait? Be the first on your block to recognise that the U.S. Government likely is – or before long will probably become – bankrupt.

          Also, prepare financially and psychologically for the fallout that might occur if and when people realise that Uncle Sam is broke. One unambiguously good result would be the abandonment of the idiotic (in its conception), inept (in its execution) and disastrous (in its results) "war on terror." Even better would be the consignment of America's interventionist foreign policy, which has wrought so much damage upon so many people, including Americans, to the same historical junkyard littered with the relics of Roman, British, French, Russian and other imperialisms. Only people with a material or reputational interest in warfare, such as the laptop bombardiers on the editorial page of The Australian and The Decider's lapdogs in Canberra, have anything to fear from the resurrection of George Washington's Farewell Address and America's return to its Jeffersonian roots. The power the anointed lose is the liberty the benighted recover.

          Another positive (younger people are more likely to enjoy its benefits) of America's bankruptcy would be the drastic pruning of and the weaning of people from Social Security, Medicare and other alleged government "benefits." The bad news for all Americans is that their taxes may well rise steeply; and for everybody, Americans and non-Americans, Uncle Sam's lurch towards insolvency implies significantly higher inflation and interest rates. That, in turn, augurs poorly for most financial assets.
 

Let's Define and Quantify Our Terms

          Laurence Kotlikoff, in a must-read paper entitled "Is the United States Bankrupt?" and published in 2006 by the St Louis branch of the U.S. Federal Reserve, concludes that "countries can go broke, that the United States is going broke, that remaining open to foreign investment can help stave off bankruptcy, but that radical reform of U.S. fiscal institutions is essential to secure the nation's economic future … Unless the United States moves quickly to fundamentally change and restrain its fiscal behaviour, its bankruptcy will become a foregone conclusion." Fed Chairman Benjamin Bernanke, in his testimony to the Committee on the Budget of the U.S. Senate (Long-term Fiscal Challenges Facing the United States, 18 January 2007), used much more diplomatic and less apoplectic language, but did not reject or even question Kotlikoff's conclusion.

          Is the American Leviathan destitute? Clearly not: it continues to possess an impressive ability to confiscate from Peter, lavish much booty among its legions of vassals and mascots, and distribute the rest among the Pauls whom it wishes to control. How, then, can one possibly contend that Uncle Sam is or is going bankrupt? Beginning in the 1930s, with another spurt in the 1960s and climaxing during George W. Bush's presidency, he has made promises to his growing hordes of dependents and foreign creditors that, as time passes, he will be less and less able to fulfil. The U.S. Government is insolvent in the sense that the net present value (NPV) of its liabilities greatly exceeds the NPV of its assets (or the assets it can be expected to raise in order to meet these liabilities). Leviathan is bust in the sense that, given its vast present and growing future shortfall of assets relative to liabilities ("fiscal gap"), at some stage it must acknowledge reality, liquidate and retrench. It is broke in the sense that, as occurs in many workouts, it will pay its dependents and creditors less than it originally promised them (see also "Broken Army, Broken Empire" by Pat Buchanan).

          Although it doesn't explicitly say so, the U.S. Government – or, rather, a recent (15 December 2006) Treasury/OMB report entitled Financial Report of the United States Government – concurs (see also "GAO Chief Warns Economic Disaster Looms" and "Demographic Reality and the Entitlement State" by Ron Paul). During 2006, the fiscal gap continued to swell rapidly and now stands at ca. $53 trillion. And that's just at the federal level. One could increase it by adding various local and state shortfalls. Further, this figure assumes the continuation of short- and medium-term economic sunshine, i.e., that nominal GDP will grow at a rate of at least 5% per annum during the next five years. In other words, because the Treasury's projections do not incorporate economic weakness, this estimate of $53 trillion could easily err on the low side.

          As a related matter, it's important to emphasise that there's – literally! – no accounting for the U.S. Government. Its internal auditor, Government Accountability Office, found for the tenth year in succession that Uncle Sam's financial statements are unreliable and that his financial controls are inadequate (see the Comptroller General's comment on this year's Financial Report). The U.S. Government is bankrupt in the sense that, by private sector standards, its financial condition is not just unaudited: it is simply unauditable.

          The Pentagon's balance sheet, for example, is laughably crude. It does not emerge from standard methods: instead, an estimated list of liabilities is simply subtracted from a vague list of assets. A report compiled in 2003 by its own Inspector General stated "we identified $1.1 trillion [yes, that's a "t" and not a "b"] in department-level accounting entries to financial data used to prepare DoD component financial statements that were not supported by adequate audit trails or by sufficient evidence to determine their validity. In addition, we also identified $107 billion in department-level accounting entries to financial data used to prepare DoD component financial statements that were improper because the entries were illogical or did not follow accounting principles. . . . [In conclusion], DoD did not fully comply with the laws and regulations that had a direct and material effect on its ability to determine financial statement amounts."

          More generally, the financial management of most (up to 20) of the federal government's 24 largest agencies fails to meet requirements enacted by Congress in 1996. Uncle Sam resembles nothing so much as an inept, hopelessly spendthrift and disorganised man who hurriedly stuffs a shoebox full of whatever documents and receipts he can find – and then throws the mess into a bewildered accountant's lap. In the private sector, people who generate waste and loss face the ire of shareholders, are usually denied access to capital, often receive pink slips and running shoes and sometimes find themselves in gaol. In the coercive sector, however, mismanagement is virtually never punished: indeed, it is typically lauded and rewarded.

          Also note that this fiscal gap does not incorporate the costs associated with the invasions and occupations of Iraq and Afghanistan. In "The Economic Costs of the Iraq War," Joseph Stiglitz and Linda Bilmes estimate that its NPV is $1 trillion or more, and growing (see also "Inflation: The Hidden Cost of War" by Ron Paul). This, to put it mildly, is somewhat higher than the initial and breezily confident estimates of Administration and neocon insiders. Defence Secretary Ronald Dumsfeld, for example, opined (19 January 2003) "well, the Office of Management and Budget has come up with a number that's something under $50 billion … How much of that would be the U.S.'s burden, and how much would be other countries', is an open question."

          A study by Jagadeesh Gokhale and Kent Smetters ("Measuring Social Security’s Financial Problems," NBER Working Paper No. 11060, January 2005) concluded that the U.S. Government's "fiscal gap" is closer to $65.9 trillion. That's more than 500% of America's annual GDP and 200% of its accumulated wealth. The $53 trillion estimate equates to ca. 400% of America's GDP in 2006, and has increased from about $20 trillion – an amount equivalent to 200% of GDP in 2000. (As a comparison, the net debt of Her Majesty's Government is £490 billion. That's equivalent to $US950 billion and to 38% of Britain's GDP. Adding the NPV of "off balance sheet" liabilities produces an amount that approximates 100% of its GDP.)

          Finally, note that Treasury has expressed this $53 trillion fiscal gap as a net present value. To make it disappear in the future Uncle Sam must confiscate that amount now from his subjects and deposit it in bank accounts earning hefty rates of interest (the GAO uses 5.7% as the assumed long-term rate of return). But in Main Street U.S.A., these deposit rates do not exist. Because they didn't collect interest on the money that they didn't deposit into these hypothetical accounts this year, Americans will have to "deposit" even more next year. As a matter of elementary maths, 5.7% of $53 trillion is a bit more than $3 trillion – an amount ca. 15 times greater than Uncle Sam's present annual budget deficit. Even if the deficit suddenly became a very large surplus of, say, $500 billion and remained at this level (a very unlikely proposition), the fiscal gap would still continue to rise relentlessly. Accordingly, during the next year it will likely swell by at least another $3 trillion – plus whatever additional outrages the Racketeers in the White House and on Capitol Hill can devise. So for the sake of argument let's add another $4 trillion, making a total of $57 trillion, as an early guess of the fiscal gap in 2008. In last year's Financial Report, the Treasury downplayed the gap. But this year their talk is tougher. They state "the net social insurance responsibilities (scheduled benefits in excess of estimated revenues) indicate that those programs are on an unsustainable fiscal path and difficult choices will be necessary in order to address their large and growing long-term fiscal imbalance." Further, "delay is costly and choices will be more difficult as the retirement of the 'baby boom' gets closer to becoming a reality with the first wave of boomers eligible for retirement under Social Security in 2008."

          What do the present magnitude, the growth in the recent past and the plausible rate of growth in the near future of the U.S. Government's fiscal gap mean? As Chris Martenson notes in the "United States Is Insolvent," they imply three things.
 

• First, it's unlikely that America can "grow out of the problem." Uncle Sam's financial position has deteriorated by over $22 trillion in 4 years and by $4.5 trillion during the last 12 months (see the table below, extracted from this year's Report). The economic sunshine of the past three years has not reduced the gap. Quite the contrary: it has widened and is deteriorating ever more rapidly. If the fiscal gap can balloon so quickly during allegedly good times, what might happen if and when the economic horizon darkens? It is unlikely, to put it mildly, that any economic weakness will alleviate it. • Second, for many Americans, particularly younger ones and those completely dependent upon Leviathan, the future portends stagnant and perhaps much lower standards of living. How to close the fiscal gap? According to Laurence Kotlikoff, "the answers are terrifying. One solution is an immediate and permanent doubling of personal and corporate income taxes. Another is an immediate and permanent two-thirds cut in Social Security and Medicare benefits. A third alternative, were it feasible [as if the first two were politically palatable!] would be to immediately and permanently cut all federal discretionary spending by 143% [i.e., to eliminate all such spending and run a mammoth and unprecedented budget surplus]." When pigs fly … • Third, history shows us that every government that has so incompetently managed its finances has tried to "print its way out of trouble." Do American politicians possess generous amounts of the courage required to fix this mess? Given their country's fiscal problems, the prancing and babble of its presidential hopefuls, and the posturing and preening of politicians more generally, is at best a self-deception and at worst a cruel hoax upon the public. If they truly sought, in Ms Pelosi's words, "to build a better future for all of America's children," then they would drastically prune – if not completely abolish – the welfare-warfare state.

          The truth, of course, is that the Fed cannot painlessly inflate, nor the pollies prattle, America's way out of this predicament. But no matter: because draconian cuts of expenditure are not realistic solutions to its impending bankruptcy, inflation is a much more likely possibility. Inflation today – that is, the central bank's expansion of the money supply – reduces the purchasing power of money tomorrow. Thanks to the central bank's inflation, the extent of debts (measured in nominal dollar amounts) may remain unchanged or even rise; but as purchasing power falls, so too do real values. Inflation thus imposes a hidden tax upon its victims. What's the material difference between (a) 0% inflation and the confiscation of x% of your money and (b) x% inflation and no overt confiscation? Nothing: in each case, your purchasing power falls by x%.

          The rhetorical difference, of course, is that (a) is political suicide and (b) is ignored or misrepresented in the mainstream media. (Its demand that the central bank deliver "low interest rates" is, in effect, a demand that the bank generate high inflation; and the phrases "steady inflation" and "the gradual destruction of the purchasing power of money" are virtual synonyms.) Do not, therefore, expect that you will rise one morning to headlines proclaiming that Uncle Sam is broke. Instead, anticipate that it will be an extended and covert affair. The central bank's inflation can promote only two things: the size and waste of the welfare-warfare state and the penury of the middle and battler classes. Indeed, to the extent that the U.S. Government's bankruptcy takes the form of an enrichment of privileged "insiders" and the gradual impoverishment of benighted "outsiders," it commenced years ago and is proceeding silently apace.

          The reality, then, is that Americans and non-Americans are likely to face a future of uncomfortably high inflation – and possibly worse if somewhere down the track the $US loses its privileged status as the world's reserve currency.
 

In the Beginning, There Was Debt

          Laurence Kotlikoff notes correctly that solvency need have nothing to do with indebtedness. A particular government, for example, might year after year maintain its budget in surplus and never borrow a penny. It might laud itself as a model of fiscal prudence. But if its liabilities outstrip its assets, and if it cannot raise the assets required to meet its liabilities at 100 cents on the dollar when they fall due, then this alleged model of rectitude is actually insolvent. "To summarise," says Kotlikoff, "countries can go bankrupt but whether or not they are bankrupt or are going bankrupt can't be discerned from their 'debt' policies. 'Debt' in economics, like distance and time in physics, is in the eyes (or mouth) of the beholder."

          Well said. Yet Kotlikoff overreaches when he says "the focus on government debt has no more scientific basis than reading tea leaves or examining entrails." Quite the contrary: although one must infer cautiously, the source, timing and growth profile of the U.S. Government's "on-balance sheet" debt can teach us much about America's rise and fall, the causes of its present pickle and the possible source of its redemption (see also William Bonner and Addison Wiggins, Empire of Debt: The Rise of an Epic Financial Crisis, John Wiley & Sons, 2006). America's founder knew the lesson, but their descendents have ignored it. In James Madison's words, war is the most serious threat to liberty and solvency "because it comprises and develops the germ of every other. War is the parent of armies; from these proceed debts and taxes; and armies and debts and taxes are the known instruments for bringing the many under the domination of the few."

          Wars and economic "emergencies" are catnip to politicians because it is during these times that the government's powers and patronage can be extended most rapidly – and thus the individual harnessed most securely to the yoke of the state. According to H.L. Mencken (Notes on Democracy, Knopf, 1926), "the whole history of the [U.S.] has been a history of melodramatic pursuits of horrendous monsters, most of them imaginary: the red-coats, the Hessians, the monocrats, again the red-coats, the Bank, the Catholic, the slave power, Jeff Davis, Mormonism, Wall Street, the rum demon, John Bull, the hell hounds of plutocracy, the trusts, ... Pancho Villa, German spies, the Kaiser, Bolshevism. The list might be lengthened indefinitely: a complete chronicle of the Republic could be written in terms of it, without omitting a single important episode." In this respect, the "war on terror" is simply the most recent display in a long catalogue of deceptions. Monroe concludes that during wars and emergencies, an "inequality of fortunes, and the opportunities of fraud, growing out of a state of war, and ... degeneracy of manners and of morals [develops] ... No nation could preserve its freedom in the midst of continual warfare." Certainly the U.S. hasn't (see in particular Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government, Oxford UP, 1987).

          The trouble is that, since time immemorial, rulers have sought to wage war. And to do so, they must confiscate their subjects' property. Since the 1720s, when Sir Robert Walpole revolutionised the financial basis of the British Government, a government able to command the confidence of lenders has also been able to issue debt that need never be repaid. It needs only to create a regular and dependable source of revenue – a "tax base" – and then use a part of it to pay the annual interest and the principal of maturing bonds. For every bond it retires, it also issues a new one. In this way, a "national debt" becomes a perpetual debt. It thereby becomes an instrument of unending war. The Royal Navy extended British sovereignty and influence around much of the world during the 18th and 19th centuries, and Walpole's innovation underwrote its activities. The establishment of a national debt not only overturned the fear of Stuart tyranny: ironically, it entrenched Jacobite objectives into the heart of British government. HMG, in other words, could now maintain a permanent military establishment and finance its wars without the regular and bothersome application to Parliament. The British Empire, then, was built upon more than the blood of soldiers, sailors and civilians: it was a superstructure, and a permanent national debt was its foundation. This debt had the added benefit (to politicians) of harnessing creditors to the government.

          These developments did not escape the attention of the America's founders. In January 1789, when General Washington mounted the steps of Federal Hall (close to the top of Wall Street and opposite today's New York Stock Exchange), took the oath of office and became the first President, his newborn country's Treasury was virtually empty. It was also burdened by debts of $77 million – an amount equivalent to ca. 30% of the new country's rudimentary GDP (this and subsequent historical debt-to-GDP ratios have been derived from Donald Stabile and Jeffrey Cantor, The Public Debt of the United States: An Historical Perspective, 1775-1990, Praeger, 1991). The rebellion against Britain had cost treasure as well as blood, and the colonists were only slightly more willing to submit to local than to Imperial taxes. Under the Articles of Confederation, the admirably loose-fitting constitutional garment that had joined the rebellious colonies, the nascent federal government possessed no power to tax. The states could levy taxes and forward them to the Continental Congress; but they too were hobbled by debt, and popular hostility towards taxes was pervasive. Hence little more than a trickle of funds flowed into the Congress's coffers (see also Stabile's The Origins of American Public Finance: Debates over Money, Debt, and Taxes in the Constitutional Era, 1776-1836, Greenwood, 1998).

          Alternative means were therefore sought to finance the war. As it is doing today, Congress resorted to external creditors and the domestic printing press (see in particular Murray Rothbard, A History of Money and Banking in the United States: the Colonial Era to World War II, Ludwig von Mises Institute, 2002). As a result, by the time Washington vanquished Cornwallis in 1783, American governments owed large sums to King Louis of France, to Dutch bankers – and the thousands of American soldiers, farmers and merchants who had lent their labour, goods and capital to the cause. Virtually all agreed that it had been right and proper to borrow in order to secure their political independence.

          But what about the new country's financial sovereignty? Over the next two decades, how – indeed, whether – the debt would be repaid and the budget balanced became the subject of a ferocious debate between two leading lights: Thomas Jefferson and Alexander Hamilton. "Hamilton was indeed a singular character," Jefferson wrote of his rival. "Of acute understanding, disinterested, honest, and honourable in all private transactions, amiable in society, and duly valuing virtue in private life, yet so bewitched and perverted by the British example, as to be under thorough conviction that corruption was essential to the government of a nation." It is only a slight exaggeration to say that their fiscal contest was the seed that germinated "factions" and party politics in the U.S. Washington sat uncomfortably between them at the cabinet table and lamented the "internal dissensions" that were "tearing our vitals."

          To most early Americans, the very existence of public debt and deficit was inexcusable. Many likened it to the seizure of property without the owner's consent. Amassing debt to finance grandiose national projects, and then extending this debt into perpetuity, was widely regarded as monarchical, English and corrupting. But to a few élites, most notably Hamilton and his mentor, Robert Morris, debt was just another word for money; money was a potent form of power; and power, they believed, was their birthright. "The [national] debt was a tremendous source of power," wrote William Anderson in The Price of Liberty: The Public Debt of the American Revolution (University of Virginia Press, 1983), "for whoever controlled it would in all likelihood possess not only the chief taxing power but the prime allegiance of a large segment of the American population" (see also "Perpetual Debt: From the British Empire to the American Hegemon" by Scott Trask, which inspired the structure of the next couple of pages).

          Jefferson, whom Washingon appointed as America's first Secretary of State, agreed – and hastened to add that the very existence of a national debt, to say nothing of its growth, would centralise political and economic influence into a small number of privileged hands. It would thereby foment some of the very injustices that had prompted people to migrate to America – and had prompted Americans to rebel against George III. Legally and ethically, said Jefferson, "we should consider ourselves unauthorised to saddle posterity with our debts, and morally bound to pay them ourselves."
 

"The reality, then, is that Americans and non-Americans are likely to face a future of uncomfortably high inflation – and possibly worse if somewhere down the track the $US loses its privileged status as the world's reserve currency."

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