11

Does “Backed By Government”

March 2009 Really Mean Anything Anymore?

MARKETS Is everyone feeling a little richer these days? Chances are, most people would answer
AT A GLANCE this question with an unequivocal “Yes!” After all, the stock markets are up
resoundingly over the past three weeks. So much so that proclamations of a “new bull
market” are starting to be heard. We’ve turned the corner, or so it is being claimed. All
Eric Sprott is well with the world once again… or is it? If you were to receive a cheque in the mail
Sasha Solunac for $1 million, you would probably be pretty happy, right? But what if you found out that
everybody received the exact same cheque. Chances are, you would be far less
happy, perhaps even discouraged, and for good reason. Your savings have just been
plundered.

One has to be very careful with how one interprets asset price signals these days. It
could be inflation/currency debasement masquerading as a recovery/bull market. After
all, this is the era of quantitative easing, a policy measure that has the potential to be
highly inflationary. As is well known, the Federal Reserve has been adopting ultra-easy,
unconventional monetary policy measures for the past year. Quantitative easing is the
next iteration of these unconventional monetary policy measures – one that takes the
concept of money printing to the next level. Quantitative easing, in a nutshell, is the
policy of taking freshly printed money, created out of thin air, to purchase risky assets,
thereby influencing their price. It is targeted money printing whose goal is to take the
free market out of the equation. If the free market is deemed not to be valuing risky
assets highly enough, then the government will usurp the market’s pricing power by
creating more demand than really exists (in economic terms, shifting the demand curve
to the right). Note that we include the Federal Reserve as part and parcel of
“government”. To believe they have even a modicum of independence is naïveté to the
extreme.

During this initial stage of quantitative easing, the Federal Reserve is buying $1 trillion
of US government treasuries and agency debt, up to ten years in maturity. Are these
“risky assets”, even though they are “backed by government” and, technically, AAA?
The answer is absolutely yes, which is why it is considered unconventional for the Fed
to be buying them. The value of government debt over time, in both nominal and real
terms, will very much depend on future levels of interest rates and inflation, respectively.
Sprott Asset Management
This makes treasury bonds far riskier financial assets than, say, 90 day T-bills. True,
Royal Bank Plaza government bonds aren’t likely to have default risk. After all, any quantity of money
South Tower could be printed to pay off debts in the domestic currency. Be that as it may,
200 Bay Street government bonds are far from being risk-free. To wit, baby boomers who are relying
Suite 2700, P.O Box 27 on government bonds to sustain their standards of living through retirement could be in
Toronto, Ontario for tremendous disappointment.
M5J 2J1
Another way to look at quantitative easing is as a government-induced pyramid scheme.
T: 416 943 6707 By all accounts, US government bonds are already very expensive. The unwinding of
F: 416 362 4928 leverage that has been occurring over the past year created enormous demand for the
Toll Free: 888 362 7172 US dollar and US treasuries – demand that was more technical than fundamental in
nature. Through quantitative easing, the government is ensuring that an already
www.sprott.com expensive asset becomes even more expensive. Does this sound familiar, when an

Sprott Asset Management 1

 over-priced asset becomes even more over-priced? That’s right, it’s called a bubble. In
order to save the economy and the financial system the government once again, as is
its wont to do, is replacing one bubble with another. It’s the same old shtick. One that
will end as badly, and likely far worse, than the previous bubbles. We would advise
investors not to be the last suckers out of this pyramid scheme. When the government
comes knocking, wanting to buy your treasuries at highly favourable prices, then by all
means sell it to them post-haste! When the government is buying, you should be
selling. Need proof? Just look at what banking shares have done over the past year.

It’s also worth noting that, like all bubbles and pyramid schemes, the government-
backed bond bubble will require continual and growing inflows in order to be sustained.
Can anyone honestly envision a way out of quantitative easing, once started? To quote
Winston Churchill, it’s a puzzle inside a riddle wrapped in an enigma. Here’s the puzzle:
the US government will be issuing boatloads of debt over the next few years, stuffing
the bond markets with an ever-increasing supply, which somebody will have to buy lest
interest rates go higher and derail the stimulus. Enter quantitative easing, but this
creates the riddle: will people still want to own US bonds given the deteriorating fiscal
situation and the fact that the government is the only willing buyer of them? Which
causes the enigma: the Federal Reserve eventually becomes the largest, and perhaps
even only, buyer of US government debt, realizing that it can’t stop doing so because
the termination of the policy would send interest rates to the moon. We would then
have the perverse situation where the government would run burgeoning deficits and
incur massive debts, financed with ever-increasing debt issuances, which would in turn
be bought by the Federal Reserve with neverending quantities of freshly printed money.
In effect, government deficits will be financed with printed money. Quite the
conundrum, isn’t it?

In the real world, there is only one good way that government spending can be
financed, and that is through taxes. If spending exceeds tax revenue, then the
difference will need to be borrowed. But borrowed money is simply future taxes. Either
way, government spending and taxes go hand in hand. Pay for it now, or pay for it later,
the piper will someday have to be paid. If the pipers are foreigners, then they will
demand returns that will take an increasing proportion of future tax revenues. In our
opinion, with the recent colossal deterioration in fiscal prudence, we are moving
dangerously away from any semblance of this undeniable reality. With baby boomers
now starting to retire, we are beyond any reasonable expectation that today’s deficits (at
least $2 trillion this year, plus another $10 trillion, using optimistic assumptions, over the
next decade) and unfunded social security and medicare liabilities (somewhere between
$45 trillion and $90 trillion in present value, depending on assumptions) could ever be
passed on to future generations. The buck stops here… literally and figuratively. We
are quickly approaching a scenario, if we haven’t passed it already, where the US
government has no hope of honouring its obligations… at least, not with anything that is
Sprott Asset Management worth a pittance.
Royal Bank Plaza
South Tower
200 Bay Street
Suite 2700, P.O Box 27 For the above reasons, and many others, people shouldn’t be taking much comfort in
Toronto, Ontario the phrase “backed by government”. For what does this phrase really mean, other than
M5J 2J1 a transfer of wealth within the context of an ever shrinking pie, thanks to the
government’s increased role in finance and economics. Unfortunately, we are moving
T: 416 943 6707 ever further away from Adam Smith’s invisible, yet virtuous, hand. The list of things
F: 416 362 4928 backed by government grows by the day. Bank deposits. Money market funds.
Toll Free: 888 362 7172
Commercial paper. AIG. Fannie and Freddie. GM and Chrysler. Even corporate
bonds. Nonbank institutions, like GE Capital, can now issue debt backed by FDIC, i.e.
www.sprott.com

Sprott Asset Management 2

 the government. With quantitative easing, the government is even trying to guarantee
the yield curve. In the near future, quantitative easing may even be used to buy
mortgages and stocks.

Unfortunately, the emperor has no clothes. Government guarantees are worthless.

They are merely guarantees to print more money. Ironically, the more the government
guarantees, the more worthless that guarantee becomes. To purport that “backed by
government” has any value is one of the biggest con jobs of all time.

Let’s take the Federal Deposit Insurance Corporation, or FDIC, as an example. Do you
believe there is a fund supporting your bank deposit? There is no fund. Only printed
money supports it. It’s just another government-backed institution. FDIC, as an
independent corporation, is completely and utterly bankrupt. In fact, they haven’t even
been collecting premiums from the banks for the past 10 years. There is nothing
backing FDIC except yet another government guarantee to print money.

From the point of view of the investor who believes his money in the bank is safe
because it is “backed by government”, we would posit that this trust is misplaced. It is
our opinion that, during this era of quantitative easing and other wanton money printing
measures, never have bank deposits been less safe. The perception of safety is just
an illusion. Bank deposits, and government bonds even more so, are almost certain to
lose purchasing power with each passing year, especially with interest rates where they
are now. There is a way that governments can guarantee that nothing will lose money.
It’s called inflation. But this is true only in nominal terms. In real terms, nothing
destroys wealth, specifically paper wealth, like inflation. This is the Achilles Heel of the
phrase “backed by government”. For the one thing they cannot guarantee is what you
will be able to buy with your backed-by-government paper. Sure, they can legislate
price controls. But history shows that this would only lead to chronic shortages and
black markets.

In our opinion, the only way that people can protect themselves against the money
printing binges the world is currently experimenting with, is by investing in tangible
assets. In this regard, the only truly AAA asset is gold. As the saying goes, all roads
lead to Rome. Week after week, no matter what we look at, all the evidence and all the
signposts point to the same conclusion: own gold. Government guarantees can only
redistribute wealth at best, destroy it at worst, but never can they create it or guarantee
the real value of paper financial assets. When the government wants to buy your
financial assets we would suggest that you sell to them, with a thank you, and use the
proceeds to buy real tangible assets. In our opinion, this is the only way to guarantee
the preservation of your wealth.

Sprott Asset Management

Royal Bank Plaza
South Tower
200 Bay Street
Suite 2700, P.O Box 27
Toronto, Ontario
M5J 2J1

T: 416 943 6707

F: 416 362 4928
Toll Free: 888 362 7172

www.sprott.com

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Sprott Asset Management
Royal Bank Plaza
The information contained herein may not be reproduced, quoted, published, displayed or transmitted without the prior
written consent of Sprott Asset Management Inc. (‘SAM’). The opinions expressed are solely those of the author. They
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are based on information obtained from sources believed to be reliable, but it is not guaranteed as being accurate. The
200 Bay Street
report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions
Suite 2700, P.O Box 27 expressed in this report are subject to change without any notice and SAM is not under any obligation to update or
Toronto, Ontario keep current the information contained herein. SAM accepts no liability whatsoever for any loss or damage of any kind
M5J 2J1 arising out of the use of all or any part of this report. SAM is the investment manager of the Sprott Funds. Important
information about these funds, including management fees, other charges and expenses is contained in its simplified
T: 416 943 6707 prospectus and/or offering memorandum. Please read them carefully before investing. Mutual funds are not
F: 416 362 4928 guaranteed; their unit values and investment returns will fluctuate. Performance data represents past performance and
Toll Free: 888 362 7172 is not indicative of future performance. Performance comparisons are drawn from sources believed to be accurate. This
is not a solicitation.v
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Sprott Asset Management 4