16 January 2013

US Debt Update

So you may have been focusing on all this “fiscal cliff”, “debt ceiling” mumbo-jumbo.  It is all about something very huge and pressing.  It’s about how we pay for the ability of our everyday life to go forward.  Right now, every other social issue – gun laws, immigration, marital unions, et al – is subordinate to this, in my view.  Because if we don’t fix our financial issues, there won’t be any society left to speak of.

The situation, to date:  The Federal government has not passed a budget in over three years.  Spending remains out of control.  Our debts continue to dangerously accumulate.  The world markets haven't reacted yet, but nonetheless look on in disbelief at our irresponsibility.  Continued in this manner, one day not too long from now, markets may no longer be “OK” with all this.  And then it’s too late.

For our Federal government’s fiscal year 2012 (ended September 30), it collected $2.4 trillion in revenues.  That was mostly from individual income taxes (46%).  The rest came from payroll taxes, like Social Security and unemployment insurance (35%) that we and our employers pay, as well as corporate income taxes (10%).  All the rest (9%) comes from excise taxes (sales tax on stuff like alcohol, tobacco and gasoline), customs duties, estate and gift taxes, as well as income from our central bank.

In the same period, the Federal government spent $3.5 trillion, creating its $1.1 trillion deficit.  Since 2009, we have run deficits over $1 trillion each year.  These ~$1-1.5 trillion deficits have been 7% (like present) to 10% of GDP.  In the seven years of deficits before 2009 (as we were in surplus before that), our deficits averaged 2.5% of GDP.  Since 1980 (but excluding surplus years and prior to 2009), our deficits have averaged 3.2% of GDP.

There are only a handful of nations that are running budget deficits higher than us (by ~1-3%) right now – Greece (effectively bankrupt), Spain (being bailed out), Afghanistan (not even really a nation, just a series of neighbors’ borders delineating areas that they would like to stay away from), Egypt (in sociopolitical upheaval), Venezuela (economy in ruins after overspending on social programs despite having vast oil wealth), Ireland (yet another failed one of the PIIGS) and Japan (in a now two+ decade depression) to name the notable ones.

So how much is too much?  When are deficits too large?  To understand that, we need to understand why a deficit matters, or doesn’t matter.  A deficit is our government’s budget shortfall.  What funding it can’t source from revenue, it must borrow (or print, effectively the same thing).  So a deficit is basically a proxy for the growth of our debts – if we’re short $1 trillion on budget, we basically need to borrow $1 trillion.

If we want, we could run a deficit (aka grow our debts) forever.  We just need that growth to be less than the rate of growth of our economy (aka GDP).  Over time, despite our debt’s growth, it will still be an ever smaller percent of our economy thus.  So deficits in and of themselves are not problematic.  Run in the aforementioned manner, they actually can give us a little competitive boost in what we can achieve each year v. other nations.

But when our debts grow persistently faster than the growth of our economy, we can get into trouble eventually.  Again, deficits beget debt.  Debt bears interest.  Very large debts, funded at high interest rates, can consume budgets to the point of oblivion – like what happened to Greece and many irresponsible others of the past.  Right now, in a very low interest right environment, we paid $360 billion of interest on Federal debt.  That is presently about one-third of our deficit.  It is an effective interest rate of about 2.3%

If our debts grow where they are projected to, over just the next five years (source: White House), a one percentage point increase in interest rates will add approaching $200 billion of extra interest burden on the budget annually.  And again, rates are presently at generational lows.  Any real improvement in the economy, any hint of inflation, any slight slip in the market place in terms of fearing our creditworthiness; each has the potential to send interest rates materially higher than just one percentage point from where we are right now.

For perspective, a $200 billion increase in interest expense from just a one percentage point increase in interest rates, given our now rapidly expanded debt load, would immediately consume the entire budgets of the Departments of Homeland Security, Housing and Urban Development, Interior, Justice, State, as well as the EPA and NASA.  Combined.

With a two percentage point increase, the total interest burden would exceed all Medicare and Medicaid, or Social Security payments made by the Federal government (take your pick).  Not that long ago, interest rates naturally were about three or four percentage points higher than where they are now.  So this is not some unlikely, fictional landscape that I suggest.  We were there, pre-financial crisis, just a few years ago (just with far smaller debts).

Large debts ultimately become a trap for growth.  Japan for example is over 200% of GDP in debt.  It has for a very long time really low interest rates (and high savings rates, which also helps internally fund debt).  So they can survive the burden.  But with that debt burden, they cannot have normal, higher interest rates – associated with normal economic growth – as the interest burden would instantly destroy their budget.  So they are trapped into a very low growth, borderline deflationary environment just to keep their debt affordable.

And this is where we have been rapidly heading over the past several years.  Five years ago, our gross Federal debt outstanding was ~$8-9 trillion - ~65% of GDP.  Right now it is $16.4 trillion – 105% of GDP.  And again just to vividly underline,  until all those really great representatives we all elected get out of career self-preservation mode and start behaving in our interests, that debt is still bumping up an odd $trillion a year.  It is projected to top $20 trillion ~2016-17 (source: White House).  That’s a ~10-11% annualized growth rate.  Meanwhile, GDP (real) growth rates will have grown at ~2-4% annualized rates over the same period.

All else equal, when nations start to materially exceed 100% gross debt to GDP, markets get nervous.  They express their nervousness by demanding that that nation borrow from the market at a higher interest rate.  If the market loses all confidence in that nation’s ability to repay its debts, there effectively is no interest rate that will clear the transaction, and the nation no longer has any source to borrow from.

Along that path, real-world effects of being fiscally irresponsible begin to materialize.  Interest rates on everything skyrocket.  The nation will then desperately print money out of thin air in order to satisfy its debts.  As that process abets weakening its currency’s value.  Whether it prints or not, the markets lose faith in the value of its currency, and its value collapses.  Suddenly everything costs many times more to purchase.  Almost overnight, the entire economy grinds to a halt.  Social unrest explodes, and some medieval form of totalitarian rule must be installed until (if ever) the nation recovers from the catastrophe.

It sounds so draconian – so otherworldly from a modern-day American’s point of view.  But it happens to nations all the time when they collapse under their own ineptitude.  Just not to the US.  Yet.

Our interest rates are at generational lows.  Our dollar has not collapsed.  Yet we run Greece-like deficits and our central bank has been printing $trillions out of thin air for a few years now via their “quantitative easing” efforts.

So why have we been spared this fate thus far?  For a handful of reasons.

The first is, we simply aren’t really there yet.  Our debts are only now touching what has been generally regarded the “danger zone”.  But that’s not a very good reason.  That’s like saying everything’s OK because we haven’t hit that brick wall yet, one hundred feet in front of us, that we are driving 100mph toward.

The second reason is, our central bank the Federal Reserve has been in the market place now for some time buying that very debt it issues on behalf of the Treasury.  Just in case any other would-be buyers (China) start to lose interest.  Thus, it is artificially keeping interest rates lower than otherwise through this action.

The third reason is, the world led in so many ways by the US, is suffering still the deflationary effects of a mild depressive state after the acute phase of the ~2007-09 global financial crisis.  This has the effect of keeping global interest rates subdued (see Japan for the past two decades).

The fourth – and most important – reason is, the world simply has no place else to go with its money.  Unrisked wealth needs to be stored somewhere.  And it needs to be in some currency.  And that currency needs to be perceived as safe.  Safe from manipulation or restriction on convertibility.  Its proprietor nation must be perceived safe as well.  Safe from invasion or coup or social unrest or excessive corruption.

And the currency must be liquid and abundant.  Only the dollar and our treasury notes we issue to borrow are perceived safe enough, are large and liquid enough markets for the world to store so much value there.

Over 60% of the world’s surplus wealth (aka allocated reserves) is sitting in dollars, down from 70% over a decade ago, as the world explores places other than the “only” alternative of the post-World War II era.  What are the alternatives?  At most, the euro was almost 30% of allocated world reserves, but has since reversed (presently 24%), demonstrating to me that the world does not presently see the Euro Zone as a credible alternative to the US as a long term store of value.

The Japanese yen at their economic peak over two decades ago was almost 10% of world reserves (presently 4%).  That leaves places like the UK’s sterling or Switzerland’s franc.  Their economies just aren’t big enough to support the world’s nest egg.

What’s left?  Currency’s antimatter – gold.  Just not enough of that either.  China?  Forget about it.  Why don’t they tackle property ownership rights and freedom of assembly and speech issues first, before we actually start regarding their renmimbi as a safe store of value.  Until then, they are just a really big and only-recently-to-date financially successful grand experiment right now.

No other nation satisfies all the necessary criteria like the US does.  Even despite our present fiscal inanity.  The world is very much nervous about us, but they simply have no other place to go.  So for these very bad reasons, we can continue our very bad behavior far longer than any other nation on Earth would otherwise be allowed.  This is the bad lesson our elected representatives are learning.  The markets haven’t punished us yet for our do-nothing position, so therefore we can continue to do nothing.  Until, of course, we can’t.  But you don't want to wait until then.

In my view, the last time the world was in this position, was perhaps the 3rd or 4th Centuries AD.  When the known Western world had become defined by Rome.  Rome dominated, wavered, faltered.  Rome may have been hated, loved.  It didn’t matter.  It was the thing that defined the rest of the known world, for the rest of the known world.  After Western Rome ultimately disappeared, it ushered several centuries of dark times.  So the nation pretenders to our station should be careful what you wish for.

The point is, the modern world hasn’t been here before.  The US literally built this post-World War II modern economic world.  It remains its foundation.  And it is now becoming unbalanced as a result of excess ineptitude and corruption of its rulers.  The world does not know what to do with that.  So it just looks on, in a sort of hypnotic state of disbelief or denial.

Unlike Rome, I believe we’ll get this wet blanket lifted off us.  And underneath it as we speak is a finally recovering housing market, a secular domestic shale oil industry about to usher in a new economic boom and much more.  It is so obviously easy to be gloomy about everything over the past few years.  I turned optimistic a few weeks before the election.  And I stay that way.  Holding my breath.

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