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.
I have talked about this before, but figured I would bring it up again as it is making headlines that the US may lose its coveted AAA rating. Does it really matter if the US loses this rating or not? It does from an ego point of view, but that is about it since it is highly unlikely that the US will default on its debt. Instead the US will more than likely simply inflate our way out of the mess we are in rather than actually default, but that would still count as a “default” to a certain degree.
What you need to know about rating’s agencies and how they rate sovereign debt is that the game is rigged. We know these agencies did a bad job with the mortgage debt and other private debt in the recent past, but Green Light Capital wrote a great piece on how Moody’s in particular rates sovereign national debt. Basically, the firm only looks about a year out to see how these countries can finance themselves and they do not tax demographics or tax policy into account yet they are predicting some 5 to 7 years out. It was a very interesting read and I will post the article below. Essentially, Moody’s is telling everyone that there is nothing wrong until there is something wrong and then they downgrade the paper, sound familiar?
I could also point to Executive Life which carried AAA ratings right up until the day it filed for bankruptcy, but I would be dating myself. This is what ratings agencies do, they have a CYA policy and then try to argue that their service is covered under the 1st Amendment, when clients pay for it which is not how the real world works. Anyhow, getting back on point, would the US lose its AAA rating? More than likely we will, but not because of default, but because of devaluation of the currency.
Investors will always get back the face value of the debt they buy from the treasury, I would guarantee that, but the US never guarantees the value of said dollars. Hell, Zimbabwe guarantees you will get back the face value of their debt, but, well you get the point. In a nut shell, even if get taken down to a AA rating it will not even impact our interest rates since we set them. Until we actually have a real crisis, meaning a currency crisis or consistent failed treasury auctions which would force higher interest rates – see Argentina – then the borrowing costs will remain wherever we set them.
Essentially, until the market says otherwise we still call the shots, but I will be the first to tell you that we cannot and will not be able to call the shots forever. With the total public debt, including intra-government debt, at $11.9T, according to treasurydirect.gov, which is 83% of 2008 GDP, we are getting up to a level when people are going to question are ability to pay them back. I mean, it’s not like we were really going to pay them back to begin with, but at least we gave them the illusion of repayment with debt-to-GDP well below 100%.
With the administration and CBO, I never give estimates much weight because they are always wrong as in way too low, calling for trillion dollar deficits for the next 10 years and that is if we have an actual recovery I think we need to think worst case scenario. If we do not recover in the next year or two then double those numbers and then we are talking reality or close to it. That is when the market will tell us that we know you are full of it and will demand higher returns on their loans to us. Basically, a credit rating means nothing on sovereign debt as it is still market driven and a great example is Japan who lost most of its AAA ratings already.
My big fear is and I think we are far away from this unless something funky happens in the currency market is a failure in the USD. However, in my opinion I think we would need to see treasury auction failures happen well before we see a currency failure occur and based on demand right now that simply is not going to happen. China, Russia and India can talk all they want, we are listening, but they are still buying and that is all that matters right now. Yes, we need to get our act together, I am not denying that, but it is not as severe as many are saying, unless the DXY slips below the 71 level then I will be a bit worried and you should be too.
This is a major problem since consumer spending is 70% of GDP and the longer consumers saves, which is good, versus spend the longer the economy may remain in a slump. This combined with reduced credit available is not helping the bulls case. in fact, the spin is that consumer confidence is not indicative of how consumers behave, which is a 180 degree turn from the last positive reading which was proclaimed as “the return of the consumer.”
The index came in at 46.6 versus 49 reported last month and, more important in my opinion, consumer expectations decreased as well. Consumer expectations was reported at 62 versus the last reading of 65.5 which is a pretty substantial drop. What is the reason for this drop in confidence and expectations? Jobs.
The hope of a jobless recovery is an oxymoron at best and a foolish belief unless you do fancy footwork with the economic numbers, which is the norm nowadays. Unemployment is going to rise, we know this, and confidence will remain low as long as those 500K a week numbers continue to pour in. The good news is that the weekly unemployment numbers cannot continually come in at 500k a week, eventually there will be no one left to fire, sorry, layoff or right size.
The spin is unreal and I cannot help to think that perhaps things are better than I think, then I look at the numbers again and statements like this; “Consumers continued to rate current conditions unfavorably in July. Those saying business conditions are “bad” increased to 46.3 percent from 45.3 percent, however, those saying conditions are “good” increased to 9.1 percent from 8.1 percent. (emphasis mine on this ultra low “positive number) Consumers’ assessment of the labor market deteriorated further. Those claiming jobs are “hard to get” increased to 48.1 percent from 44.8 percent (emphasis mine), while those claiming jobs are “plentiful” decreased to 3.6 percent from 4.5 percent. (emphasis mine, who could be saying jobs are plentiful?)
Commercial mortgage backed securities are also off the charts for defaults, up 585% from one year ago to $28.65 billion and the 10th straight month of increases for defaults. Why this is not talked about is beyond me, but I guess it doesn’t fit into the view of the media as part of the recovery we are in. What effect will these defaults have is what many are wondering and my answer is none.
With government backstops on everything there will be no repercussions of defaults, which is crazy. This ultimately means 2 things:
1. We really do not know how bad things are; and
2. How much is this really going to cost th taxpayers? This is why we need to audit the Federal Reserve.
The free markets are anything but free with guarantees on everything and the ban on short selling, through SEC rules and the fact that banks are not lending out securities to short. This is the greatest orchestrated recovery I think the world has ever seen, but the repercussions will be emense.
While equities will do OK, I guess until the top line numbers actually mean something, but the dollar will suffer. like it or not the Fed is printing money and monetizing the debt. All of the money we are borrowing will devalue the dollar and countries will stop buying our debt. I know, every expert says where can they go, the dollar is the most liquid and, laughably, “stable” asset they can buy.
The fact is they can buy the Euro, it is getting deep enough to be realistic in the near future, they can buy commodities, other hard assets and in China’s case more companies. The fact is the dollar is getting risky, in my opinion, simply because of our debt load. I know everyone says inflation is not the problem, and it isn’t know, but what is a problem is devaluation which has the same effect as inflation.
In short, consumers saving their money is good and the pundits should realize this. A society built on debt is dumb and should not ben encouraged, but that is what out government is doing.
To meet the massive needs of the US the treasury is offering 4 debt auctions next week. Although next weeks auctions are for less than last weeks record of $104 billion it is still sizable at $73 billion. The need for the massive debt offerings is to finance the governments big spending spree which has yet to offer real relief to its citizens.
While the debt is largely for Obama’s spending initiatives, it is also for debt servicing which has grown dramatically. It will be interesting to see the bid-to-cover ration, which we expect to be high as usual, with these auctions. The short-term and TIP’s, treasury inflation protected bonds, will be extremely high I am not so sure about the 30 year. Whoever would buy a 30 year treasury at 4.30-4.50% is crazy, period. I don’t know about anyone else, but I am concerned that we might find out that the Fed is doing more buying than we think.
Regardless, under the new administration the debt market has increased to $6.45 trillion and is poised to go higher. Just think if rates go up to historical levels just the servicing of this debt will cost hundreds of billions a year, perhaps trillions at this rate. The US has never actually ever paid off a bond it has always rolled the money or issued a new bond to pay back maturing treasuries. Eventually that will stop as foreign governments realize we will never pay back what we owe and there is no reward in the risk to carry US debt, especially at 4% or so.
People really see what is going on and that our debt has been, for a very longtime, been out of control. My fear is that by the time everyone figures out what has happen it will be too late. This is a national problem and it shows the fundamental flaw in the “new” US economy, we cannot be the worlds leading economy without producing things within our own borders. A service based economy with GDP largely grown through consumption is a recipe for disaster.
See the chart below of the Fed’s balance sheet, scary isn’t it? I know, people are going to say it is coming down a bit, sure, but not even close to what it needs to do. After all this was a credit problem, never a liquidity problem.
[caption id="" align="alignnone" width="970" caption="Very scary."][/caption]
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