Archive | November, 2012

Why we are in Deep Trouble

16 Nov

Welcome to The Debate Over Angels.  If you haven’t read the about section, the name comes from the debates that are said to have been conducted by the Byzantine Senate in the time just before the fall of Constantinople to the Ottoman Turks.  The Byzantine Empire was originally the eastern half of the Roman Empire.   Gradually the eastern section became the more affluent section and even as Rome fell, the eastern half survived for 1000 more years.  In 1453 though, the Empire was about to fall forever. In the last days, it is said the Senate had lengthy discussions over whether angels where male or female.  Our political discussions today are little more relevant to our fate than those debates.

I decided to have this first post talk debt in our country in general and why it’s going to throw us over a cliff.  It’s not the limit of our issues and in talking about solutions, we have to talk about energy and medical care, but for this first post, let’s just keep it to debt in general.

The following graph is from Karl Denninger at the Market Ticker blog.

Looking closely at this graph reveals a lot about the “growth” we’ve had for the past 3 decades.  The red represents total debt in the country (both private and public).  The green represents GDP.  With the lone exception of a correction we started to get in 2008 (and was stopped by rapidly rising federal spending), you can see that dept is increasing faster than GDP growth every single year since 1980.  That’s almost 30 straight years where our country has added more debt than GDP (similar graphs could be shown around the world).

Let’s think about what debt is. It is using money now with the promise to pay it back and more later.  Since debt growth has surpassed GDP growth every year, if we fulfill that promise the growth of the last 30 years has been an illusion as it all must be paid back far more than full.  In 2008, it was clear that the private sector had reached its limit on its ability to continue debt growth and we started with a correction (and with it, a very nasty economic downturn).  This did not last long though as federal spending rapidly started rising and took the place of declining private spending.

For all the talks about what to do or not to do with the federal deficit here in the United States, we unfortunately are getting very little in actual solutions even talked about from either major political party.  Unfortunately the math, both here and abroad is looking increasingly grim and if we don’t embark on solutions of our own in the near future, we are going to be forced by the market into a situation far worse than most can imagine regarding our national (and world) economic choices.

In 2012, the federal government will likely collect $2.469 trillion in taxes, while it spends  $3.796 trillion.  That’s a deficit of $1.327 trillion dollars.  Put another way, the federal government is spending 53% more than it is bringing in via tax revenue.  Since GDP includes government spending more than 9% of GDP is from borrowed government money.

Let’s take a step back now and think about how this actually works.  If the federal government wants to spend more than it brings in, it has to raise that money somehow.  The way this works is the Treasury Department issues bonds, both short and long term.  The idea is that you or a company or another country can buy them now and the government will pay you back later with a little more than you paid initially.  Since this has traditionally been a safe investment, the interest levels on them have been low.  You were never going to make a fortune on them, just a small increase.

Let’s imagine you are thinking about buying now though.  With $16 trillion in total federal debt and with the government adding a trillion every year, would you hesitate a little longer before buying any longer term bonds?  Would you worry just a little that maybe, just maybe, the government might decide it’s not going to pay you off, at least not in full?

If you were worried about that, you’d probably need a little bit more incentive to buy, so maybe those bonds have to pay you just a little more (higher yield).  If that happens on a large scale with a lot of people/companies/countries, then the government is going to have to have higher interest rates on the bonds to still attract people.  Since people can now make more on the bonds, of course they are easier to sell.

Raising the interest rates on the bonds though causes a few issues though.  The biggest being that the government has to pay for that extra interest on all that money it’s borrowing.  Paying for that interest, means that it has to issue even more bonds.  Well borrowing even more than it already is, isn’t going help people feel more confident the government is going to repay them.  If they see the deficit rise even higher to pay for that added interest people/companies/countries are going to get more nervous.  That in turn means the government has to offer even higher interest rates to keep them, which again increases the deficit, which again means people fear being paid back.

This isn’t just some theoretical eventual possibility.  It happened in Iceland in 2008.  It has started in Greece with interest rates quickly going from middle single digits to over 100%.  Only European bailouts have kept them from defaulting and that is likely still coming (similar problems exist in Spain, Italy, Ireland, and Portugal with the rest of the EU only good by comparison).  It’s also happened historically.

A fair question at this point, is why do we still see low rates on government debt today then?  If this is all true, shouldn’t $16 trillion have been enough to start the chain reaction?   There are a few answers for this.

1.  Treasuries have traditionally been considered safe investments.  With stocks and other investments seeming risky of late, people have put a lot of their money into treasuries, indirectly helping to keep the system afloat.

2.  The set-up for selling bonds in the US is unique.  We have a group of banks called primary dealers who, in return for other privileges, are required to bid on bonds.  The biggest reason though is…

3.  The Federal Reserve has bought a tremendous number of treasuries itself.  For all the talk we hear about China owning all our debt, the Chinese have quietly sold off parts of it and aren’t increasing anymore.  The Federal Reserve is now the single biggest holder of Treasury bonds.  This added buying does allow for Congress to continue to spend well outside our nation’s means for now.

This will not keep though.  The Federal Reserve buying large amount of debt that it does not intent to sell is extremely inflationary.  Since we are in a major recession/depression, we see many things selling pretty cheap, but look closer at the things you need, especially if they are coming from overseas.  Food is one example.  Gas is probably the best example.  In spite of demand being less in a weakened economy the prices have risen a lot in the past few years.  Fed Reserve Chairman Ben Bernanke is a lot of things (and I would argue should be in jail), but he isn’t stupid and knows there is a definite limit to how far he can take things without completely destroying our currency.

That’s the ultimate choice we face though if we continue down this path (and it’s frankly shocking to me we haven’t hit the wall yet).  The government either loses the ability to borrow money thanks to run away interest rates and thus is forced to instantly balance the budget (which thanks to large amounts of wealth disappearing with government default on bonds and all that money disappearing from government recipients/employers/contractors/etc will be a lot larger than even the $1.3 trillion listed above) or the Fed absorbs the loses and we get hyper-inflation.  Either way, we choose to deal with the issues right now, or we accept those outcomes.

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