I just read a Time Magazine article today about the U.S. debt and how it is no big deal the U.S. has so much debt. In fact, Zachary Karabell actually believes that our debt is a good thing. I have actually met Mr. Karabell last year at a conference we both spoke at, although he was paid and I was merely on a panel, but it is unlikely he would remember me. Regardless, I have to humbly disagree with the conclusions he came up with in his article.
Debt can be a good thing, but only in small amounts and for productive reasons. For example, a business that takes out a loan to hire a new employee to expand their business would be productive debt as it contributes to society, hopefully. However, taking out a loan to buy a 50” high definition TV is, in my opinion, a terrible reason to add debt to ones balance sheet. The U.S. government borrows money, recently, to hire people and encourage spending, but the government is not creating productive jobs because it creates nothing and it must tax the people in order to pay off the debt for the job it created. The government actually destroys wealth through taxation and wasteful spending. Basically, the government is borrowing money to buy big screen TV’s, bad debt.
The U.S. government does need to carry debt because we are the reserve currency and carry trade deficits. Debt for a government could be a good thing if that country is the reserve currency, but there is a point where too much debt is the ultimate problem. The impact of too much debt over time during strong economic times may not be a major problem because a growing GDP means more tax revenue is being collected and should increase over time as long as conditions are good. However, any economy has cycles where there are good and bad times, we are currently experiencing bad times, and when times get bad that large debt load becomes a problem and is no longer good, Greece is a good example of this, kind of.
Excess debt during poor economic times means tax revenues decline and the government will have to run deficits to pay for its spending, I am way over simplifying this. Generally, a government will spend much more during these bad times to spur the economy, known as the Keynesian Theory, but this spending, in my opinion, is not the way to spur the economy. As the debt builds and the central bank cuts interest rates the debt during these bad times might not seem so bad because the country has artificially lowered the cost of borrowing, again to spur growth. The key word is “artificially” lowered interest rates and the current interest rate may not actually reflect the current economic conditions or the risk of holding said countries government debt. The reason people ignore deficits more during lower interest rate periods is because the cost to carry the debt is so low, like now.
The U.S. currently has over $12T in debt, heading much higher rapidly, but the carrying costs of that debt is about $500B a year. Keep in mind this is because the Fed Funds Rate is at .25% which means yields on the U.S. government debt is very low, artificially low. The government can currently borrow money for 30 years, for those crazy enough to buy it, for less than 5%, not a bad deal, right? However, what happens if the bulls are right and the economy is recovering and rates have to increase? A 1% increase in Fed Funds would mean the aggregate increase on our debt would be roughly .70%, most of our debt matures in less than 10 years, not good I might add. That means our debt servicing costs, the interest we pay, would increase to about $600B a year, still not bad.
The problems start to get real bad when the Fed increases rates to say 3% or so. The cost to borrow on the 30 year treasury would go up dramatically to about 6%, on the conservative side, and even out short-term interest rates on our bills and notes would go substantially, everything is relative, higher. Before I go further you have to remember that debt is a deadly circular beast because the more you borrow the more you have to pay back and during rising interest rates in order to make all of your payments you either have to tax the people or have more deficit spending, guess which will win in the U.S.? If rates go to 3% because of a hot economy the interest on our debt servicing costs will quickly rise to about $800-$900B, depending. It will take no time at all for the interest payments to reach $1T and considering our debt mostly matures 10 years or less you cannot forget the refunding that must take place. The CBO just did an estimate on a lot of this in the past few days, I did not read the report, but I know the final numbers without a lot of obvious assumptions end up close to what I just said.
Karabell makes the argument that the U.S. would use the borrowed money to retrain our workforce and rebuild our infrastructure. That may be the case, but to fully upgrade our infrastructure, not including pie in the sky green energy items, would cost about $2T. I believe the last stimulus only applied a small portion of what is needed, so the infrastructure idea Karabell had does not pan out in my book. Plus, there is no return on infrastructure immediately, over time yes because it makes commerce easier, but that takes time. He also made the case that China and India are flush with cash and building their infrastructure now and, I think, was indicating that since the U.S. is so stable that excess cash will end up here, which is reasonable to assume, for now.
What he failed to address is the fact that the money they are flush with is ours from them exporting goods to us. Because they have such huge exports to the U.S. we have a trade deficit with them and they need to buy our debt to balance it out. It is a case of vendor financing and all vendor financing ends up with someone getting hurt, guess who in our case? The point I am making is that the Chinese and Indians will buy our debt now because treasuries are going up in value, thank you deflation, but how long will that continue for? Not only that, but if China un-pegs their currency from ours it will appreciate and their treasury holding, in RMB terms, will decline. Why would one invest in treasuries if your currency is rising and the country you are loaning money to as a declining currency, you wouldn’t do that.
Essentially, all gravy trains end and there is a limit to how much a country can borrow. Consider the U.S. has implicit guarantees on not only our debt, but also on banks, insurance companies and the mother of all bad investments the GSE’s. Oh, and if you ever expect to see GM pay back the money they got, well, I wouldn’t hold my breath on that one. All of those guarantees are about $23T, not including the national debt and the entitlement guarantees we have. Again, my point is the limit to what the market will allow a country to borrow cannot be far off. At the very least we will need to pay a greater risk premium on our debt which means the interest rates on our government bonds will detach from where the Fed sets them at and go through the roof.
I get what Karabell is saying, but he is speaking in the here and now which is suicide when talking about so much money. You must look forward in order to see the real problems and it is kind of crazy to think that all this borrowing will go towards retraining the people and vastly improving our infrastructure. The government is the worst at spending money efficiently and much of that money goes to wasteful projects like DNA research on bears in Montana, no offense to bears, but I just do not care about their DNA. On top of all that, who knows if we will actually emerge from this downturn, sorry I do not buy an inventory rebuild as a real economic recovery. If we do not exit this thing in the next10 months our problems will be bigger than we think.
On top of all of this there is the whole impact to our currency, which is not good. The more debt we issue the more we dilute our currency and at some point the world will demand some type of other reserve currency, it is being talked about now. If we lose our reserve currency status we are in a heap of trouble, I know that could ‘never happen.’ All of these problems or these potential problems leave me a couple of conclusions, besides the fact that bulls will spin even really dangerous debt problems positively, that; 1) Precious metals are cheap and 2) The Fed will never raise the Funds rate to a reasonable level again.
To kick off the New Year you should go read this guy’s silliness. It is no wonder why he has been largely discredited and why he completely missed the housing bubble in 2005-06, he was the guy laughing at Peter Schiff when Schiff told him lending standards were nonexistent, guess who was right?
What I found amazing is that Mike Norman actually thinks that issuing treasuries is not borrowing money. Furthermore, he actually states the following, this blew my mind because it is utter nonsense:
Some would argue that the vote simply gave the government the right to “borrow” $290 billion more, so it did not really increase its spending power at all, only the amount it could take from others. This argument would be wrong.
Government spending, by definition, increases the amount of reserves in the banking system and those reserves are the funds used to buy Treasury securities. Therefore, it is correct to say that government spending itself provides the money to buy the debt.
How else can you explain how the national debt went from $900 billion to $12.4 trillion over the past 30 years with interest rates falling to historic lows or even zero? If the issuance of government debt were truly “borrowing” then rates would have climbed to astronomical levels.
If this made you say, what!? You are not alone. I know what he is saying and on the surface he is kind of right, but it is also the words of a true idiot. I will explain this in a very simple way for Mike to understand, if you issued your own debt and could control your interest rates, would you keep interest rates, the amount you pay, high or low? Clearly you would keep the amount you pay low, unless you like paying a lot more for what you borrow. Now, that is a very simplistic way of approaching the total issue and it is much more involved than that, but I fear if he reads this getting into details would probably confuse him.
Apparently Mr. Norman is one of these people who thinks you can issue unlimited debt or “increase the amount of bank reserves to buy treasury securities” and we never have to pay the piper. I find this fascinating that one can think that investors will never, ever, want their money back or that even though we have to pay interest on the amount of money we spend it is still not considered borrowing. I am not sure how that is not debt or borrowing nor am I sure how one can borrow their way to prosperity, but I find this disturbing among many economists in the US, including one Nobel Prize winning economist who writes for the NY Times a lot.
The last time I checked those who tried to borrow their way to prosperity, Dubai, Argentina, home owners, Eastern Europe and so on all ended up not doing so hot or defaulting. I am not suggesting the US will default on its debt, that would be crazy, we will simply inflate our way out as that is the game plan. Well, I guess I am early in giving out my 2010 Contrarian Award to Mr. Norman for going against all conventional wisdom and basic economic teachings when we examine debt and prosperity. Debt, for a lack of a better term, is good. I gotta stop, my head hurts.
Regular readers know that I am or have become a bigger proponent of income investing lately and if you don’t know what I am talking about you should be reading my material more. However, there seems to be preconceived disconnect with my philosophy and what you believe to be true about interest rates moving forward. Some people see my bullishness on bonds in the face of rising interest rates as purely insane, especially given what treasuries are doing, but I can assure you it is not.
Keep in mind I am talking about investment grade corporate bonds and high yield bonds, my favorites are ‘BB’ and ‘BBB’ rate paper in an ETF format, I do not like mutual funds because of the once a day pricing. As an aside I do like selective sovereign debt as well, but don’t go out and buy Eastern European government debt or anything, be selective as the risk return is there, but supply is going to be an issue moving forward so it will pay to be extremely selective in 2010. Anyhow, back to corporate debt and why I like it.
Treasuries are entering a bear market for the first time in my memory and I expect there to be a bear market until the next crisis hits, so for only a few months. The reason there is a bear market is simple, supply, end of story. You cannot issue an endless amount of paper and expect the market to eagerly accept it without paying more for it because people, foreign central banks in this case, know they will never fully be repaid for the US debt they buy now, it is mathematically impossible for the US to repay its debt so don’t shoot the messenger hate the calculator. Because of that mathematical probability interest rates on treasuries are going higher and, according to those wonderfully bullish, and misguided, government data figures investors are pricing in interest rate hikes which kill treasuries and other high grade corporate debt, high grade being the operative word, so remember that please.
High grade corporate debt is technically, and in my opinion, anything rated higher than ‘A’ and issues interest rates slightly above treasury yields. We are talking about your really safe corporate paper issued by IBM and similar firms. Essentially, those are a riskless investment which is why your yield is so close to treasuries and why those bonds will get crushed when/if interest rates go higher. For those who do not understand how bonds work think of bonds and interest rates like a teeter-totter with interest rates on one side and bond prices on the other side, when one goes up the other side goes down. Therefore rising interest rates are bad for bonds because new bond issues will have higher yields so your existing bond will have less appeal in the marketplace and if rates go down new issue bonds will have lower rates which means your existing bond will be more attractive because it has a higher interest rate. Make sense, good.
All of that is important because we are at zero interest, technically we are in the negative interest rate area because of quantitative easing and deflation which is bond friendly. However, this red hot economy we are in, sarcasm is my trademark, many people are expecting an interest rate hike to happen at some time this year and they are right. The Fed will raise interest rates in 2010 from 0-.25% to .25-.50%, wow. There is an outside chance that rates may go to 1% by the end of the year, but that is pure speculation right now because the economic data or ‘recovery’ is spotty at best. Even if rates go up it is relatively meaningless to lower grade corporate bonds because it does not hurt the spread as badly as it does for higher grade corporate bonds.
What I mean is newer higher grade corporate debt and treasury debt will have higher yields than current issues so existing paper will get slammed. However, existing lower quality corporate paper will do OK as we would need rates to go up substantially in order to really hurt the spread. I am not saying that there is no risk in lower quality corporate debt, defaults will be a huge issue moving forward, but I am also betting that the Fed’s liquidity programs end up not going away either. In fact, I would speculate that the Fed’s balance sheet will continue to expand over the next 12 months, perhaps double again if the FASB gets its way and the SIV’s have to be added to banks balance sheets right away, but again that is speculation right now.
If the Fed does actually raise interest rates this would be a bullish signal to the markets because it means we have real growth in the economy as well. This means lower grade paper would perform better, even if that growth is only at lower levels. However, higher interest rates will not be good for stocks, in my opinion, which is why I shifted focus to lower quality corporate bonds and to companies like Alteria. I would not expect, even if the economy is cruising, to see rates go much higher than 1-1.5% though because the Fed is stuck and it cannot move rates higher or to a meaningful level ever again. Regardless, corporate bonds of ‘BBB’ or ‘BB’ and selective ‘junk’ should do OK moving forward in the face of higher interest rates because of what I said previously. We will not see huge returns like that of 2009, but I think they will do better than stocks moving forward, plus you are first in line when the company folds, something to think about.
Why the Fed is stuck
What do I mean by that, a meaningful level? You see, the US is in a debt trap that we cannot escape from, it is simple mathematics. The Fed will not be raising rates to protect the dollar, they want a weak dollar that is for another post, they do not really care about inflation as they really want massive inflation but we cannot create it. The Fed will raise interest rates to keep politicians off of its back and that is about it, but raising rates higher than 1.5% presents problems that the US cannot handle.
Congress just had to raise the debt ceiling by a few hundred billion to fund the government for the next 6-8 weeks, unbelievable, and a more ‘permanent’ fix of raising the debt ceiling to about $14T will be coming soon.
I know this is no big deal to liberal democrats because, after all, under Bush we had to raise the debt ceiling 7 times and to them 8 or 9 wrongs make a right, but this is a major, major problem. Considering that raising the debt ceiling to $14T moves the total US debt to just about 100% of GDP marks a new low for the US and is the greatest amount of debt any country has ever attempted. What I am saying is that our current debt servicing costs with the Fed holding rates at 0% and using QE is about $500B+ a year and our average maturity of our debt is less than 10 years, again this is a first in all of the world’s history.
If the Fed moves rates up past 1.5% then that debt servicing cost will go up, dramatically, and there will be major consequences that the American people are not ready to face. Forget the debt ceiling, we will repeal that silly little rule, especially since we have to raise it almost every year anyhow. Within 7 years out debt servicing costs will begin to take its toll on the national budget squeezing out typically paid for items, like earmarks. Defense spending will have to decline immensely which is why the US remains a superpower even though we have a relatively small manned military compared to say a China, India or North Korea. The dollar will decline much further, it will anyhow as the latest rally, which I anticipated, is a head fake and was driven by Dubai, Greece, Fear, short covering and the selling will comeback harder and faster than you could ever imagine.
All of the senseless spending is coming home to roost, now. China is telling us where to stick it as there is not enough dollars to buy our debt, which is kind of funny in a sick way, and they said no to strengthening their Yuan which makes sense for them and smells of protectionism to me. When we demand a foreign country make their products more expensive in the US just so we can shrink out trade deficit thereby boosting our GDP and sell more products to them that is protectionism, straight up. I do not like to be so grime, but many of the things I foresaw and have been keeping to myself are coming out in the open. Things are not good, but hey as long as the market keeps going up, who cares right? Well, you will when it comes crashing down around you. Fixed income never looked so attractive right now.
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