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You will be happy to discover that this month’s letter has finally reached

the length I promised, or almost. I must admit it has not been an easytask by any measure but I have humbly abided to the democraticreaders

hip of “The Staines Letter” who has been pleading since inception

that I manage to shorten the length of my letters

. Next month’s letter

will confirm this trend and be less than 10 pages long. So before I lose any

further precious typing space let’s jump to this month’s essay.

My previous letter was all about crunching the numbers on USgovernment debt and seeking to achieve a better understanding of allthose complex and sometimes misleading extrapolations that accompanyit. My conclusion was that this hysteria surrounding the rise of USgovernment debt levels appeared to be considerably disconnected withreality and I suggested instead that you consider long duration UStreasury securities as an investment.This month I was hoping to explain why this conclusion did not apply toall countries and explain why. Talk about timing. Since then, hell hasbroken loose for the Club Med countries and the short Euro suggestion Iwas about to share is like offering you flood insurance after a tsunami hastransformed your home into some underwater attraction for scuba divingtourists. Too late to offer the flood insurance trade, the European Unionship is sinking with the Euro sinking even faster, the question now iswhether there are any life boats.Comparing debt levels across countries based on debt/GDP anddeficit/GDP ratios is a useless exercise if you have not initially recognizedwhich countries enjoy

double sovereignty

and which only

simplesovereignty

. There are major differences between these two groups andany comparison that does not consider their level of sovereignty is boundto produce useless conclusions. The rules that apply to sovereign nationsissuing debt in their own sovereign currency (double sovereignty) andoperating under flexible exchange rates do not abide to the same rules

and constraints than those who don’t (simple sovereignty).

INSIDE THIS ISSUE:

“

Sorry, son, all my

money’s tied up incurrency.”

—

W.C. Fields

The website!

http://www.thestainesletter.com

The End Of An Era 1Bretton Woods Inertia 8Summary 9Make a buck

…?

11Inside the press & other 14

“

Gold gets dug out of the ground in Africa, or someplace. Then we meltit down, dig another hole, bury it again andpay people to standaround guarding it. It hasno utility. Anyonewatching from Marswould be scratching their head.

”

—

Warren Buffett

If we put aside the inflation and currency risk for the time being, themost evident risk for an investor in government debt is basically one ofsolvency. What creates a government solvency risk? At the end of theday a government faces a solvency risk if unable to redeem its existingdebt or if it is unable to finance itself through the issuance of new debt.The debt levels, the deficit levels or even the amount of unfundedpromises are all subjective issues that will vary with perception andsentiment. The first group who enjoys double sovereignty, in the likes ofthe US, Japan, Switzerland, UK and Sweden

always

have the ability torepay their debt. They can

never be forced

into default. Should theyrequire new money either to repay maturing debt or for the issuance ofnew debt in their own currency they may

always

“print”

the neededcurrency whether in the form of new debt issuance or by simplycrediting bank reserves accounts held at the central bank. The first andtraditional option in times of deficit is to issue more government bonds.In the US, the Treasury will issue bonds that the banking sector or non-bank sector will purchase. If the bank purchases the bonds its asset mix

will have simply changed (less reserves more Treasuries) and if it’s the

Non-Bank Private sector who purchases the bond then, same as for thebanking sector, its asset mix changes (less deposits more Treasuries)which will then also reduce the deposits at the bank of the purchaser and reduce the need for reserves by that same bank. Now suppose thatfor whatever reason the yield demanded by market participants rises tolevels where the interest cost would weigh heavily on the budget, thinkof Greece as a recent example.

Unlike Greece, when you enjoy double sovereignty you won’t even be

forced into paying this higher level of interest. The monetary body willsimply credit bank reserves accounts held with the central bank. In theUS, if the Treasury chooses to simply credit the bank reserves accountsheld at the Fed it will simultaneously instruct the bank to credit thedeposit accounts of the recipients of the spending (military, education,you name it). By doing so the fed is monetizing the deficit, or put simply,it is issuing non-redeemable money instead of debt and in the processsignificantly reducing the interest cost of its deficit. For the governmentthere is no difference between issuing treasuries, bank notes or electronic credits.External financing issues are renderedinconsequential.So as we see there is no instance where a country withdouble sovereignty can be forced to default, none.

“…

the US, Japan,Switzerland, UK andSweden

always

have theability to repay their debt. They can

never be forced

into default.Should they require newmoney either to repaymaturing debt or for theissuance of new debt intheir own currency theymay

always

“print” the

needed currencywhether in the form of new debt issuance or bysimply crediting bankreserves accounts heldat the central bank

.”

“For the government

there is no differencebetween issuing treasuries, bank notes or electronic credits.External financing issuesare renderedinconsequential.

”

It’s a very different story for the second group, the countries that don’t

have control on the currency in which they are issuing government debt.Many Asian and Latin American countries have issued debt in foreigncurrencies or in the case of Europe in a common currency. When acountry other than the US issues debt in dollars, it will have to find thedollars needed to redeem the debt. These governments do not enjoy

sovereignty in the currency of issuance. They have no ability to “print”

the currency needed to honor their debt. European countries have no

individual control on their currency. Although the power to “print” may

appear surprising to many, in fact, it is the ease with which countries areready to abandon currency sovereignty that has always astonished me.External financing issues become center stage in times of stress.When one is comparing or investing in sovereign debt across differentcountries it is essential to understand that not all government debt ismade equal. Some enjoy the immense privilege of double sovereignty and

some don’t. The risks and benefits of investing across these groups areextremely different. Now that we have indentified this key difference let’s

have a look at the debt levels of these two groups. In the latest FinancialStability Report published by the IMF in April 2010 we find:

Country Gross 5y CDS Structural CurrentDebt/GDP spread Deficit AccountBalance

Double Sovereignty countryJapan 227.3 66 7.5 2.8United States 92.6 42 9.2 -3.3United Kingdom 78.2 77 7.6 -1.7Australia 19.8 38 4.9 -3.5Canada 82.3 n.a 3.0 -2.6Switzerland 39.8 45 0.3 9.5Simple Sovereignty countryGreece 124.1 427 8.9 -9.7France 84.2 50 4.6 -1.9Germany 76.7 33 3.8 5.5Portugal 85.9 160 7.1 -9.0Spain 66.9 130 7.3 -5.3Ireland 78.8 155 7.9 0.4Italy 118.6 125 3.5 -2.8http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/chap1.pdf (page 5)

“These governments do

not enjoy sovereignty inthe currency of issuance.They have no ability to

“print” the currency

needed to honor their debt. Europeancountries have noindividual control on

their currency.”

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TSL 03 -The End of an Era - 30.06.10

"Comparing debt levels across countries based on debt/GDP and deficit/GDP ratios is a useless exercise if you have not initially recognized which countries enjoy double sovereignty and which only simple sovereignty. There are major differences between… (More) "Comparing debt levels across countries based on debt/GDP and deficit/GDP ratios is a useless exercise if you have not initially recognized which countries enjoy double sovereignty and which only simple sovereignty. There are major differences between these two groups and any comparison that does not consider their level of sovereignty is bound to produce useless conclusions. The rules that apply to sovereign nations issuing debt in their own sovereign currency (double sovereignty) and operating under flexible exchange rates do not abide to the same rules and constraints than those who don’t (simple sovereignty)..."

"The first group who enjoys double sovereignty, in the likes of the US, Japan, Switzerland, UK and Sweden always have the ability to repay their debt. They can never be forced into default. Should they require new money either to repay maturing debt or for the issuance of new debt in their own currency they may always “print” the needed currency whether in the form of new debt issuance or by simply crediting bank reserves accounts held at the central bank....."

"Since then, less has changed than is generally perceived and the pursuit of globalization and free trade is very much alive; in stark contrast to geopolitics which have very little resemblance to those days. Communism is no longer a threat. The policy of spreading capitalism ideology and military deference has been largely achieved and the threats to US hegemony have significantly evolved. Why would the US continue to accept the mercantilist policies of Germany and most of South-East Asia now that the dollar has now long reached a reserve currency status? The only dysfunctional contender, the EURO, has already proven to be an unreliable alternative. The large increases in public debt coupled with the return of politics at the center stage of economic policy are likely to prove the tipping point for many trade policies that have shaped our world for over 65 years...." (Less)

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