Opportunities in Default, Deflation and Depression – Part II
Fact: The U.S. Debt and Stimulus Is Simply Not Sustainable:
Question: What Happens When Interest Payments Crowd Out Defense and Entitlements?
Niall Ferguson, author of The Ascent of Money: A Financial History of the World, has been commenting lately that the U.S. government should be hearing alarm bells, given the rising debt and stimulus programs. In contrast, mainstream economists like Paul Krugman have been saying that if the U.S. doesn’t stimulate more quickly and aggressively, it will fall into another depression or deeper downturn. Ferguson’s point of view from looking at history clearly is superior, from our perspective. He notes that most great empires and dominant economies fall rapidly in years or decades, rather than slowly, due to financial stresses from their increasingly over-extended empires.
James Dale Davidson and Lord William Rees-Mogg also made this argument in The Great Reckoning: How the World Will Change in the Depression of the 1990s (1991). Think about the Soviet Union, which suddenly lost its power after 1989, just after withdrawing from a failed war in Afghanistan. Likewise, Japan went from the strongest up-and-coming economy in the world to, suddenly, a “dead” economy from 1990 on. Japan is now surpassed by China as the number two economy in the world. Great Britain’s colonial empire unexpectedly collapsed after World War II, even though it was on the winning side. Germany’s economy abruptly collapsed as a result of hyperinflation in 1923 after Germany was defeated in World War I—and after it had paid massive, unrealistic reparations. Such conditions in Germany laid the ground for Hitler to take over and create World War II. The French monarchy was suddenly toppled in 1789 during the French Revolution in large part due to its insolvency after supporting the colonies during the Revolutionary War, never to dominate politics again. The South Seas and Mississippi bubbles crashed in 1720, ushering a 64-year bear market into Northern Europe. Last but not least, consider the classic example of the Roman Empire, which collapsed at first in mere years and then continued to fall over several decades after rising for over 600 years.
The cause of such declines usually revolves around a severe financial crisis and/or a major military defeat that typically springs from expanding an empire beyond a sustainable reach or maintenance level. In other words, it comes down to a financial crisis—an unsustainable financial trajectory or a bubble that bursts. Today, the U.S. has not only an aging population but a defense budget of $700 billion and mushrooming debt—an unsustainable trajectory.
Our role as global policeman is already over, although we have not recognized it yet.
After the fall of the Soviet Union, the U.S. was the sole superpower. But since the 1960s, when the Cold War fully began with the Cuban Missile Crisis, we have waged three wars that have been or are widely perceived to have been unsuccessful: the wars in Vietnam, Iraq, and Afghanistan. In 2009 the U.S. ran a deficit of $1.4 trillion after a heroic stimulus plan was initiated to mitigate what could have been a 1930- to 1932-like financial collapse. That large deficit arose, after many years of minor deficits in a boom that should have produced surpluses. Some of the boom-year deficit spending is attributable to rising war efforts that many see as having failed to achieve their objectives, even after eight years. Due to increases in Social Security and health care costs as the Baby Boomers age, the Congressional Budget Office (CBO) projects that deficits will continue at slightly lower levels even in a growing economy. The federal debt is projected to be $25 trillion or more by 2020, when you take into account the government’s holdings of Treasury debt for Social Security, and etc. Keep in mind, this is with projected growth and with Congress strictly adhering to its spending cuts in Medicare as spelled out in the new health care program!
But here’s the big catch! The $25 trillion debt scenario by 2020 assumes that government revenues will grow from 2.5 trillion in 2009 to 4.4 trillion in 2020—by 75%. Our demographic projections suggest that the U.S. will be doing well to get back to a $14 trillion GDP and government revenues of $2.5 trillion. Our projections for a deeper downturn in 2011 and 2012 make a U.S. debt level of $19 – $20 trillion by 2013 a likely scenario. At longer-term interest rates of near 5%, that would create almost $1 trillion in interest per year. If our debt goes to $30 trillion by 2020, such interest could reach $1.5 trillion long term, which is 60% of today’s total federal revenues! Does this sound workable to you?
Unlike the Roaring ‘20s bubble in the U.S., the 1980s bubble in Japan, or present economic conditions in China, the current economic situation in the U.S. is one of financial downturn and crisis, with rising budget deficits, a persistent trade deficit, and very low savings rates. We are a net debtor nation, and big time. Europe is similar. The richest nations in the world cannot afford an endless stimulus program, because we are already too much in debt—government, business, consumers, and financial institutions. Financial institutions in the U.S. already have more debt than either the government or all consumers. They used to lend against consumer and business deposits. Now, they borrow to lend at even higher leverage to the system, which brings an unprecedented level of debt.
We cover this topic in more depth in our free special report: The Debt Crisis of 2011-2012 (available for request at http://www.hsdent.com/escart-lp). We show that U.S. total debt is $42 trillion in the private sector, $14 trillion and rising in the government sector, and $46 trillion and rising in unfunded liabilities for Social Security and Medicare/Medicaid (80% of that in health care costs)—for a total of $102 trillion, or 7 times GDP. Given that GDP has fallen and is likely to fall a good bit more while social costs continue to grow, this ratio could rise to 9 to 10 times GDP by 2012–2013. This makes Greece look good!
How long before the bond markets have the same reaction that they did to Europe’s debt crisis and raise interest rates on government bonds until the U.S. finally agrees to cut budgets and raise taxes instead of endlessly stimulating an already dead economy?
People keep asking us why we don’t recommend long-term Treasuries, which appear safe and are declining modestly in yields. We say wait until U.S. Treasury yields spike to 4.5% or higher on default concerns, as just occurred in Southern Europe, and then consider buying. We will comment further should that scenario occur. If it doesn’t, investors have already piled into long-term Treasuries; Treasury yields are very low and further appreciation should be minor at best. Europe started stimulating its economies in 2008 and wanted to continue to do so, but the global bond markets pulled the plug in April and May of this year. The U.S. has become even more dependent on selling bonds outside of the country: Over half are currently being financed overseas, and the percentage is rising. China is already cutting its allocations to U.S. Treasuries. Fortunately, in the short term there is a final bubble in Treasury bonds, as U.S. investors see nowhere else to go. However, bubbles never last and yields are likely to spike to at least 4.5% on the 10-Year Treasury.
Great Britain has been the boldest in its response; its government plans to cut the budgets by 25% and raise taxes as well. Such austerity programs are obviously the opposite of stimulus. Hence, demographics and debt deleveraging will resume their natural course, which will lead to economic failure and falling tax revenues. Such austerity programs are happening more and more across Europe. How could this not happen in the U.S.?
We have said from the beginning that the U.S. government is checkmated. If it stimulates too hard, the markets will raise interest rates at great cost, due to rising deficits and debt. If the U.S. doesn’t stimulate aggressively, the economy will melt down in a deflationary spiral, due to massive demographic and debt deleveraging forces.
Let’s start by looking at the realities of the U.S. government’s budget and finances in Chart 1, which shows the CBO analysis of the president’s budget, with projections to 2020. This chart projects a public debt of $20.294 trillion by 2020, not counting debt held by the government for Social Security and Medicaid funding, which is about $4.5 trillion currently. That uncounted funding is real debt that requires servicing to pay its benefits; adding it to the CBO projected amount could bring the total public debt to near $25 trillion by 2020. Note also that this chart is a summary that doesn’t detail the key areas of expenditure that most of us relate to.
Chart 2 summarizes major expenditures by category for 2010, with $0.713 trillion for defense, $0.547 trillion for welfare, $0.702 trillion for Social Security, $0.847 trillion for health care/Medicaid, and $0.782 trillion for all other, for a total of $3.591 trillion. Since 2009 expenditures came in below forecast, this total number is likely to be too high as well.
Chart 3 shows revenues in 2008 at their best at $2.524 trillion; revenues are projected to be $4.416 trillion in 2020. Based on our extremely reliable long-term demographic forecasts and also given rapidly falling immigration levels in the U.S., we say that there is not a chance in hell revenues will be anywhere near that high!
Let’s be generous and project revenues to be 20% higher than today (0% to 10% higher would be a more likely estimate). That added 20% would put revenues at $3.029 trillion. Now look at expenditures. In 2008 total expenditures were $2.928 trillion, which created a budget deficit of $0.458 trillion in good times, with low social expenses like welfare and higher tax revenues. In 2020 the CBO projects $3.267 trillion in mandatory expenditures, including Social Security and health care; $1.487 trillion in discretionary funding, including defense and education; and $0.916 trillion in net interest (part of that coming from rising deficits in Social Security after 2014)…for a total of $5.670 trillion. Given the straight-line, rosy projections of revenues in 2020, the deficit still comes out to $1.254 trillion in Chart 3—which alone is unsustainable long term.
Assuming the more-realistic revenues of $3.029 trillion shown in Chart 3 in 2020, that would create a deficit of $2.641 trillion, which is atrocious. Note that $3.029 trillion doesn’t even cover the mandatory payments! Even if the U.S. cut all discretionary spending (which isn’t remotely possible), it would still have a deficit of over $1.154 trillion, mostly due to rising interest costs—and that is not sustainable long term. If revenues come back to only 2008 peak levels due to the long-term downturn (which is the most realistic scenario), then the deficit would be $3.146 trillion with no cuts and $1.659 trillion with no discretionary spending—and interest would be 36% of revenues. Why aren’t intelligent grown men and women shaking in their boots over this—even given the rosiest scenarios? The answer can only be gross and massive denial from politicians to Wall Street to investors to consumers.
Do you think that there is even a remote chance that you or people you know will collect the promised benefits for Social Security and Medicare/Medicaid any more than most pensioners from state and local governments or General Motors or most large corporations will collect their promised pensions and benefits? What are those odds if you are affluent, as most of our subscribers are? No great business, no great government, no great union can defy the law of financial gravity, as expressed in the first law of physics: “Every action has an equal and opposite reaction”—especially when a pervasive bubble in credit and asset values finally bursts, as in the 1930s in the U.S. or in the 1990s in Japan.
The truth is that the debt level is likely to be closer to $35 trillion if the U.S. government makes no changes to its budgets and stimulus programs, given much lower revenues and the higher welfare/social costs that we project will occur in a declining economy during its Winter Season, much as occurred in the 1930s. Conversely, interest costs are likely to be lower than projected due to deflation. It is during the next Spring Season (2020s to 2030s) that the government would start paying interest rates more like 4% to- 5%+ and that the U.S. would feel the real pain of such high levels of debt (as will Japan to an even greater degree, given their much higher debt ratios and lower interest rates today).
Assuming a slow economy for a decade, as demographics clearly dictate, the rising U.S. debt level clearly is not sustainable. Furthermore, there is no way that an aging population is going to vote to keep spending hundreds of billions to police the world when it comes straight out of their retirement benefits—which will have to be restructured downward even after massive cuts to discretionary expenditures like defense. Hence, within a decade the U.S. “Superpower Era” of military dominance will suddenly disappear, as Niall Ferguson correctly warns. All it takes is a longer, more objective view of history to see the obvious!
Add to that the financial pressures on retirement benefits and the cost of armed conflict that has not accomplished its goals for those countries and our own purposes. In executing the wars as we have so far, we have increased our government budget and trade deficits, with the result of weakening our response to the present major economic slowdown and to future military challenges. Our government needs to stop accelerating debt for short term stimulus programs like “cash for clunkers” and housing tax credits that only get younger consumers to buy now instead of a year or two from now, only robbing future demand and creating higher debt for our children. The government needs to orchestrate a massive private debt restructuring program to lower interest and principle payments for the private sector directly and to invest in clear infrastructures that cannot afford to be financed now, but will pay off in the future and help retire the government’s rising debt.
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