% of GDP, average debt maturity, baby boomers, budget deficit, Debt/GDP Ratio, European sovereign debt crisi, fiscal cliff, fiscal deficits, Intragovernmental Holdings, Reinhart & Rogoff, Sell in May, Social Security, US Congress, US government finances, US government revenues, US government spending, US Treasury
Continued from here.
Apologies, readers. Deficits left me feeling a little nauseated, I had to take a little breather on this series! In my last post, I highlighted the 2010 total US budget deficit (ignore the primary deficit, it’s irrelevant) was a whopping 8.9% of GDP. In the past half-century, this is the 2nd largest deficit on record (2009 being the winner), but it’s in good company. Nine of every 10 years politicians have outspent revenues, and in 2009-12 the deficit’s expected to consistently exceed $1 trillion (and 7.5% of GDP). It’s no longer surprising how quickly politicians can turn the truly exceptional into the simply mundane…
I think I also sidestepped the quicksand of Republican vs. Democrat debate?! This debate, and their respective philosophies, seem utterly pointless when there’s no credible attempt to eliminate deficits – it’s just moving the deck chairs ’round the Titanic. And deficit rhetoric’s always presented as ‘spending cuts, no tax hikes‘, or vice versa. Such one-sided (and unworkable) solutions are ludicrous – the only sensible solution is a deficit elimination plan based equally on tax hikes & spending cuts.
But as I’ve pointed out, even if we make heroic Defense & Other Discretionary spending cut assumptions, a solution will be unpalatable to politicians of all stripes. Realistically, it will include at least a 4.6% of GDP (almost $700 billion) hit to individuals (i.e. voters) in direct tax hikes or payment cuts. Find me the politician who delivers that message..?!
Let’s touch on the looming ‘fiscal cliff‘ for a minute. A $1.2 trillion sequestration (automatic spending cuts to commence in 2013) is a joke. How many people remain unaware this stretches over 9 years? Why do politicians indulge in this type of obfuscation? Behind in your own work? Try impress your boss with your own personal 9 year catch-up plan… And there’s more trickery – $0.2 billion‘s derived from interest savings on the savings. Got that?! Yes, pretty notional and certainly not a spending cut! So, sequestration’s really an annual $109 billion spending cut. About 0.7% of GDP, or just 8% of the budget deficit… The actual ‘fiscal cliff’ is much larger, however, due to the potential expiration of Bush tax cuts.
Against the backdrop of a European debt crisis, and shaky US growth, the impact of this ‘fiscal cliff’ would look like – well, yes, a cliff! Not to worry, dear reader, I’m sure Congress will come up with a ‘solution’… The real problem (apart from the obvious) is the tawdry & v public debate (plus a presidential election) that will accompany it. Promises to be a re-run of last year’s debt ceiling crisis, and I’m sure the markets will react just as badly. Really screws up my usual sell for summer/buy for winter bias… And I despair of the daily US media expression of schadenfreude at the European debt crisis. Screw the past: ‘Those who cannot see what’s in front of their very noses are condemned to repeat it…’ Right, let’s get to US debt:
– Total US government debt reached $13.6 trillion in 2010, a 93% Debt/GDP ratio. This debt continues to rise relentlessly and now stands at $15.7 trillion, having passed 100% Debt/GDP in late 2011
– The good news (if we ignore unfunded/off-balance sheet liabilities)? The real debt situation is actually significantly better. Total Debt (often, confusingly, called Total Public Debt) is actually composed of $10.9 trillion of debt Held by the Public and $4.8 trillion held by Intragovernmental Holdings
– These Intragovernmental Holdings are securities held by Social Security, Medicare, Disability etc. trust funds. But, as the category suggests, aren’t they just another part of government? Yes, of course. This non-Public debt engenders endless debate & confusion – is it truly outstanding debt? No!
– Think about it: Social Security, a part of government, holds (‘in trust’) an asset (US government debt). This is offset by Treasury, another part of government, which holds a liability (that same US government debt). Let’s look another way: If you wrote a check to yourself for a million dollars, are you a millionaire?! Now suppose you lodge it to a savings a/c, and amazingly your bank honors it. Congratulations, you’re now a ‘millionaire‘, but are you any wealthier?
– So, trust fund assets & non-Public debt are complete fiction. But why? Sure, the assets are just the kind of fiction politicians love… [Although it’s extraordinarily cruel to suggest to current/future retirees there’s a $4.9 trillion pot of cash set aside for them]. But why on earth would politicians sign up for a debt fiction that significantly worsens total US debt & ratios?
– Well, it arose from another political fiction, and is a stark reminder of the dangers of unintended consequences. Let’s not rehash history too much, but in the ’30s the President & Congress (mis)appropriated insurance/pension terminology (‘benefits’, ‘contributions’, ‘trust funds’ etc.) to sell Social Security as a form of ‘insurance‘. What insurance scheme have you ever seen where the insurer can simply spend all ‘contributions’ received, and then change/eliminate eventual ‘benefits’ at any time?
– In reality Social Security, and other benefit programs, heralded a massive new source of government revenues. And boy, I mean massive… Most people don’t realize Social Security began as a 1% contribution, or their employer pays a matching contribution. The total contribution has since grown almost eight-fold, from 2% to 15.3% (a 2% holiday was granted in 2011)
– Wishful thinking: Imagine contributions were used for productive investment (buying equities, starting in the Great Depression – wow!), rather than government spending/consumption… Imagine a government funding part of its spending (over almost 8 decades) with debt, not contributions (& a gigantic future liability). Would things have been different? One might even wonder whether this spending (and debt/liabilities) would ever have occurred if this revenue was never created?
– So, the actual US Debt/GDP ratio is about 70%. Not so bad in absolute terms & far better than many European countries (or Japan!). Wow, some GOOD NEWS!
– But… Yes, there’s a v big but – let’s return to our line of reasoning above. With the Baby Boomers now retiring, the US faces decades of ever-increasing Mandatory Spending on Social Security, Medicare & Medicaid. Non-Public debt might be a fiction right now, but inevitably represents future deficits & debt…
– Depending on the benefit, and/or your assumptions, trust funds will tap & exhaust their assets within the next couple of decades. How that occurs is open to debate, but the end result’s always the same. One alternative is to dispense with the fiction of trust fund assets: Instead, Congress directly faces the massive deficits (and rising debt) these ‘benefit’ payments entail…
– OK, so that won’t happen! The trust fund fiction will obviously be maintained – with a little Congressional wangling, these payments might not even show up as deficits. Fools paradise, of course, but a great way to blame previous generations and wash their hands of the problem. Regardless, debt will rise…
– Remember, non-Public debt’s now automatically rolled over, no cash flows in/out of Treasury. If Social Security goes along with the fiction their trust fund can be eventually tapped to make benefit payments, it’s got two choices: i) Redeem or mature debt securities for cash, which Treasury must finance with new Public debt, or ii) it’s permitted to sell securities for cash in the open market, and the debt must immediately be re-classified as Public also
– So, even if the current deficit was eliminated (really? – ever see the hysteria surrounding a potential military base closure?), the government’s got $4.9 trillion of (pretty much) guaranteed additional Mandatory Spending (and debt) stored up. And that will push the US to a real 100% Debt/GDP ratio at some point. In fact, if Congress carries on like it has in 2009-12, the true Debt/GDP ratio could exceed 100% in less than 4 years time!
– As I’ve said, the only viable solution is significant hikes in direct taxes & cuts in direct payments. I stress ‘direct‘ – politicians might squeeze out some Discretionary Spending cuts (which are for the ‘general good’, and may go unnoticed), but what politician (Democrat or Republican) is ready to hit the average voter directly in their pay packet/pocket? Actually, a federal VAT is an additional and relatively painless measure, but not in a society where politicians portray consumption, rather than saving, as a patriotic duty. But that will change
– Meanwhile, the potential US debt trajectory is truly alarming. If only we had some real examples politicians could take as fair warning… Oh er, right… Or they could consult the bible – Reinhart & Rogoff highlight 90%+ Debt/GDP ratios retard growth rates by 1% or more annually – the last thing a high debt economy needs. Critics of R&R (and there are many – often politically motivated) point out Italy & Japan have survived higher debt levels for years. And these are good examples?!
– For some real alarm, take Spain: Its 10 year yield is 6.41%, vs. a 1.52% US yield, and its Debt/GDP ratio’s actually lower! Sure, but Spain’s got all kinds of regional debts/deficits, you should count those too! Fair enough, let’s do the same for the US. Um, who’d come off worse in that exercise?! But Spain’s facing bank bail-outs. True, but the average bank bail-out’s usually amounts to (only!?) 10% of GDP – Spain’s might cost more, but 10% still provides a hefty $150 billion. However you slice it, the US & Spain still appear to be on fairly similar debt trajectories, but are treated v differently by the markets. For the moment…
– I’m confident Congress won’t make the really tough decisions – until the bond market ultimately forces it. Politicians have forgotten that famous Clinton White House quote: ‘I’d like to come back as the bond market. You can intimidate everybody‘! Very true – the bond market’s usually content to allow countries to think they’re masters of their own financial destiny, until suddenly they’re not…
– In fact, the bond market’s permitting a particularly lethal set-up for the US right now (the prior convergence of European rates was similarly lulling & lethal). Look at this table, average yield on marketable US debt’s now 2.17%! And with 2-10 year yields now ranging from 0.25% to 1.52%, it’s sure to fall lower. A blessing right now, but when interest rates finally normalize (or adjust up sharply due to inflation and/or credit pressures), this will be a curse. With total debt still climbing, it’s easy to see a tripling in interest costs for the US not so far down the line
– And there’s another lethal aspect to US government debt. I’m amazed how little it’s currently commented upon, particularly as it’s self-inflicted. The US has one of the lowest average debt maturities in the developed world. Overlooked in the current European hysteria is that the average sovereign debt maturity there is over 7 years – countries have a significant window before headline rates really start to hurt. The US, at 4.8 years, has a much lower threshold of pain if things start going horribly wrong…
– And this shorter debt maturity is no historical accident. Look here – before 2008, there was a decade long effort which almost halved duration to 4 years! And this was (even then) in the face of dire long-term debt projections (they’re just more dire now). God, I’ve seen some stupid CFO decisions in my career, and this is really no different. But I guess we can’t point the finger at the politicians, for once – Treasury takes the blame for this!
Finally, to finish up, I do see one other possible way out for Congress… But that will have to wait for another day and a v different post! What? Oh, sorry, I’m not trying to be optimistic here, just open-minded… I never said it’s a sensible way out of this mess! Simply the most likely (and craven) path that Congress (plus the White House/Treasury & the Fed) will inevitably take.
ps My sincere thanks to the following books & sites – all well worth reading: