Tag Archives: Debt

Bogus Deficit Solutions

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As the federal debt climbs toward an ill-defined event horizon where the dollar crashes and basic services are shut down, voters face a cacophony of conflicting and scary predictions. Pres. Obama has threatened to withhold Social Security checks, as if Social Security is the lowest priority for the $4.1 trillion in revenues Washington hopes to receive this year. Washington is expected to burn through $1.4 trillion more than it collects this year, which is clearly a disaster. Still, should Obama take the entire blame?

To state the obvious, the deficit is the difference between federal revenues and outlays. Contrary to Pres. Obama’s carping about millionaire jet setters, the revenue side of this equation has resolved itself. Tax revenues peaked under Pres. Bush at $4.2 trillion ($450 bln deficit that year), but they have already recovered to $4.1 trillion. Falling revenues caused close to half of the deficit in 2009 and 2010, but they are no longer a problem.

What about Obama’s wasteful stimulus programs? Between the recovery stimulus, the housing stimuli, the auto bailouts, and the Fannie / Freddy bailouts, Obama has wasted well over $1 trillion. Still, that money is spread out over at least three years, and is mostly behind us. It cannot account for this year’s $1.4 trillion deficit.

Federal spending has been on autopilot for some time, and Obama’s spending increases are nothing extraordinary.

Federal Spending 2000 – 2011


source: Wolfram Alpha

The chart shows the impact of Obama’s stimulus, but spending has since returned to its historical growth rate. Likewise, the promised spending cuts negotiated the last time Obama and Congress butted heads are nowhere to be found.

The reality of the US’s budget problem is that the Federal Government is a beast with no master. Obama and Congress are only servants to an economic and political force that wants to grow. Most Congressmen owe their careers to some part of the federal beast, and no majority can form to pass even the smallest reforms. While Rep. Pelosi’s recent call for no cuts whatsoever sounds radical, that is basically the sentiment of every Congress for the past 90 years.

Obama’s calls for millionaires (read those who earn $150K) to pay their fair share are of course bogus, but so are Herman Cain’s calls to ‘cut the fat.’ Reforming obvious government waste cannot close a $1.4 trillion gap. Eliminating the Departments of Education, Commerce, Interior, Labor, NSF, Community Service, SBA, and Energy would only save $90 bln.

The debt limit impasse presents two stark and unpleasant choices: 1. The US can become a European socialist state with its current level of government services, but with high taxes, low growth, and a permanent underclass of the unemployed; or 2. The US must seriously rethink its big ticket programs: Welfare ($571 bln) , Social Security ($695 bln), Medicare ($453 bln), and Medicaid ($290 bln), and the military ($695 bln). To listen to Washington, simply freezing these budget items would bring about the apocalypse. Even if the budget were held to inflation it would take 21 years at the current GDP growth rate of 1.5% to balance the budget.

Is Obama to blame for this mess? No, but like all Washington insiders, he is opposed to any real solution. False compromises of tax increases and fantastical far off budget cuts cannot solve the US’s serious troubles. Real solutions like a balanced budget amendment, or simply letting the US hit its debt ceiling sound radical, but every moderate method has already failed. Beltway thinking is the road to disaster, which is something to remember when a GOP moderate asks for your vote.

The US As Greece

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Today, S&P placed US debt under a “negative” outlook, which means that US government bonds are at risk of a downgrade in the next few years. Basically, S&P does not think that the US Government will find a way to borrow less as a portion of its economy than it has during the past two years – borrowing as a portion of GDP has more than doubled since 2009. US Treasuries fell to a three year low on the news. Bad news indeed, but is this a Glenn Beck moment? Not really – the decline of the US’s borrowing power will be gradual and its victims surprising.

US government debt is sold at an open auction, making its effective rate variable depending on bidder interest. Because of the US’s ‘AAA’ rating, its debt had been considered free of default risk (i.e. the risk that principal and interest will not be paid on time), but today’s bond trading ended that assumption. Unless, after its review, S&P reaffirms the US’s AAA rating, US bonds will no longer be assumed to have no default risk.

If the US slides to a mid to low investment grade rating, what happens? Will the US economy shudder to a halt? Probably not, but things will be different.

First off, the US Dollar’s place as a world currency will be diminished. When people own US currency, they rarely own Dollars. Instead, they most often buy US treasuries because unlike raw Dollars, T-bills earn interest. T-bills are nearly as liquid as raw Dollars, so there is currently little risk for buying and selling them even if the holding period is as little as one day. Now that default risk is included in US treasury prices, that liquidity is reduced because holders are now concerned they can lose value at any time should their T-bills be devalued.

Other obligations of the US Government are now suspect. FDIC insurance on bank deposits is backed by the same ability to borrow that S&P downgraded. True, the FDIC sometimes holds a reserve, but that is also invested in US Treasuries. Everything the US Government does – Social Security, Medicare, defense – has become more expensive and more uncertain.

Even if the US someday becomes Greece and cannot borrow any more money, is that the end of prosperity? Not at all because money is only a prism through which real wealth is measured. Farmers will still grow their crops, and people will still heat their houses. The main effect will be a reduction in foreign trade, especially imports. As China is today, the US economy will shift to an export economy because foreign holders of US debt will spend their Dollars rather than using them to buy more US debt. US manufacturing employment will increase. The inflow of Dollars will drive down its value and drive up inflation. US imports will fall because foreign goods will become uncompetitive. Trading partners like China will suffer more than the US itself because they depended on exports to the US.

A US society that can no longer borrow will look different in many ways. Any activity that depends on borrowing will be curtailed because interest rates will climb relative to US Treasuries. The average house size will be smaller because real mortgage rates will be higher. Bloated universities will collapse as students will no longer borrow several times their salaries to finance questionable degrees. People will still work, but employment will shift toward manufacturing in response to foreign demand for US goods. Indeed, with foreign held Dollars chasing a finite number of skilled workers, the lives of tradespeople will likely improve. The US of the mid-21st Century might resemble the 1950′s in terms of living standards, income distribution, foreign trade, and government spending.

People will look back on the late 20th Century and early 21st Century as a time of wild excesses of debt, socialism, and unwarranted entitlement. While future people might wonder what it was like to live in a country where entry level office workers could qualify for six figure mortgages, they will likely not respect the lives or values of the ‘me’ generation that lead to the US Government maxing out its line of credit.

Sorry Beck & Ramsey, Now Is The Time For Debt

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Media personalities Glenn Beck and Dave Ramsey rail against debt because it is risky. Beck sees a storm on the horizon of government collapse and hyperinflation. Ramsey once fell to bankruptcy and now sleeps well knowing that no bank can take his home. Both men are correct that trouble is brewing and too much debt is bad, but now is not the time to de-lever for most people. Now may be the time to take on as much fixed rate long term debt as can be afforded.

Contrary to the absolutist Ramsey, debt can be either good or bad. Running up one’s credit cards to finance a vacation is irresponsible, but using debt to fund a reasonably sized home or a business expansion is generally good. With the signs of inflation on the horizon, holding large amounts of the right kind of debt may be the wisest strategy.

As Shout Bits has argued in the past, surprise increases in the rate of inflation act to transfer real wealth from savers to borrowers. Deflation does the opposite, which explains why the government – the world’s largest debtor – is still afraid of deflation even though all signs point toward inflation. Conspiracy theory alert: when the government keeps on talking about deflation while actively pursuing hyperinflation policies like QE2 and fiscal stimulus, it may be an ambush of the nation’s savings. All this would sound like truther babble except that the US government has done this intentionally in the past, including twice in the 20th Century. Devaluing currency to effectively default on sovereign debt is an age old trick, and it looks like the Obama administration is using the financial crisis as cover for this abuse of public trust.

If one owns assets that are largely protected from inflation (e.g real estate, commodities, TIPS, certain companies that can pass rising costs on to their customers), financing them with fixed rate debt doubles the inflation protection. As the value of the assets rises nearly as fast as inflation, the value of the debt will fall – making the debt easier to repay. Long term fixed rate debt is best because its value falls with inflation the most (i.e. its duration is long making it more sensitive to inflation changes). Should the inflation rate increase, this strategy will preserve the value of assets while reducing the real cost of the debt used to secure them – a win/win scenario.

To protect from increases in inflation, do not follow the Beck / Ramsey extreme austerity plans. Do not buy a house that is unaffordable, but do own a house. Do finance that house with long term fixed rate debt, and the inflation hedge is in place. Do not hold credit card debt, but do consolidate any debts into a fixed rate home loan if possible. Save, but do not hold pure cash in excess of a few month’s expenses, as cash is vulnerable to inflation and the Dollar’s value is uncertain. The Government’s policies of monetary and fiscal stimulus can work to the advantage of savvy investors.

IMPORTANT NOTICE: Nothing in this article is meant to be specific investment advice, and investors should not rely on this article as the basis for investment decisions. There is no such thing as a ‘typical’ investor. Never take investment advice from a source that has not evaluated your specific investment goals and risk constraints.