Agcapita UpdateAugust 2011

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Since the downgrade of the US does not come as a surprise to adherents of the Austrian School of Economics and the unraveling of government finances has been a cornerstone in my investment philosophy for many years now, I don’t want to bore you with an extended bout of hand wringing and soul searching about Standard & Poor’s sudden revelation that the US actually might be a deteriorating credit risk. Lets step back and focus instead on the process in totality. Sovereign borrowers have gone through a two-decade period of having almost no restraint on their ability to run deficits and borrow to fill the gap. That is now ending and so going on the safe assumption that the political class will not change it spots and that deficits will continue - how can we expect the gap to be filled in the future? I’d like exercise an author’s holiday prerogative and plagiarize briefly from my April 2010 letter. According to Kenneth Rogoff’s research in the three years following a financial crisis, on average, cumulative fiscal deficits almost double. We seem to be well along this path in the current crisis. Rogoff also shows that how these deficits are financed is critical to the question of whether inflation ensues, whether you have a Japanese or an Argentinean style post-crisis experience. If the deficits are funded from existing private sector savings (“belt-tightening” as Rogoff describes it) they are typically not inflationary - e.g. Japan. If they are monetized by the central bank (the money is created) they are inflationary - e.g. Argentina. Today, in one corner, we have the wholesale liquidation of mal-investments that have accumulated in virtually every segment of the western economies from residential and commercial real estate down to the municipal bond markets. In the other corner, we have

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governments that continue to resist this cleansing process as it threatens the politically influential financial sector. The result is that via bailouts and unprecedented fiscal deficits private sector credit problems are being moved onto public sector balance sheets - balance sheets that are already in precarious condition from past over-spending and unfunded future liabilities. By nationalizing private sector losses governments around the globe have seriously compounded their existing budget problems. According to research by Société Générale EU and US net liabilities add up to around $135 trillion. That’s roughly four times the capitalization of the world’s equity markets and forty times the cost of the 2008 financial crisis. Even after the farcical debt-ceiling crisis and “resolution”, the US plans to accumulate an additional $10 trillion in deficits over the next decade. These enormous numbers beg the question of how our governments plan to fill their funding gaps. To quote Jens Parsson from his excellent book “Dying of Money”: “The government is free to incur any deficit and issue any amount of debt it may wish, so long as it is willing to draw purchasing power away from other borrowers and to tolerate the rise in interest rates which will result. The debt will create no inflation. Government deficits and government debt thus are not inflationary if they stand alone, but they never stand alone. The creation of government debt is practically always accompanied by an increase of money. Competing against private borrowers for a static supply of credit capital, a large government debt issue would drive interest rates upward, and high interest rates are anathema to a government.

A large government debt issue simply could not be marketed without a large increase in the money supply. Therefore the government creates not only the debt but also the money with which to buy it. In addition, large government deficit expenditure tends to accelerate the velocity of money because the government spends its money more rapidly than cautious private spenders do. This combination of increased quantity and velocity of money, not the deficits, does the job, both for economic stimulation and for monetary inflation.” Will we see inflation or deflation over the next decade? I believe you can answer this question by considering the effect of the following factors: – Government spending & deficits - increasing – Regulation - increasing – Taxes - increasing – Money supply - increasing Unfortunately, all state activities however financed require that capital be taken out of the hands of the private sector, then deployed in typically loss-making (capital destroying) activities. The net result is that growing government spending, deficits and printing are setting the stage for much greater problems in the future. Rather than allowing private sector savings to replenish the pool of capital our governments are going further into debt. What western economies desperately need is more capital. There is no way to create capital other than through savings and hard work - a message to which our governments are perennially reluctant to listen. Printing money seems alluringly easy at first, but it does not create capital, and worse, the inflation it creates ultimately causes long lasting harm to the

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production structure of the economy. It follows that until the developed nations stop engaging in capital destroying activities and our capital base recovers, sustained real growth is unlikely to take place. What we are now experiencing is the effects of a depleted and declining capital pool, combined with enormous expansion of the monetary base and negative real interest rates. I believe that rather than pure inflation we will face stagflation in the developed world as further state expansion into the economy will reduce real growth while accelerating fiscal deficits combined with money supply expansions will lead to inflation. Low growth + high inflation = stagflation. “Compromise - to make a dishonorable or shameful concession.” Before I conclude this month I want to engage in a small tangential observation about

the politicians we find in government these days. When did the current group come to believe that compromise was a virtue? Almost everyone outside of the cocooned political capitals of the world believes that if you are right then you should attempt to prevail. Compare and contrast the political class that elevates compromise to a virtue. Ultimately, the growing crisis of sovereign insolvency isn’t even an ideological issue it is simply a mathematical issue. No government can indefinitely provide $1 of services with less than $1 of revenues - a fact that no amount of compromise will change. Ignore this at your peril as eventually all spendthrifts run out of palatable options. Kind Regards Stephen Johnston

#205, 120 Country Hills Landing NWCalgary, AB T3K 5P3 Canada

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