Monday, March 09, 2009

The Road to National Insolvency
March 9, 2009

Insolvency does not just mean liabilities exceed assets--it also refers to being unable to pay the interest and principal on one's debts and cover one's other expenses. The U.S.A. is headed for this insolvency.

How could the U.S. government become insolvent? Easy: when the costs of servicing its rapidly increasing debt rise to the point that it is no longer able to pay its mandatory bills.

The Mainstream business media is offering some faint recognition that borrowing several trillion dollars a year might have some consequences such as higher interest rates and less money available for private-sector-borrowing: Will the Obama Budget Hurt Private Borrowers? The humongous sums the U.S. Treasury must raise in coming years may eventually make credit unduly expensive for businesses.

But let's start at the beginning and build a more comprehensive context.

1. The U.S. government does not "print money" to fund its deficit: it borrows the money on the open market by selling Treasuries (T-bills) of varying maturities.
2. If the Treasury sells a 90-day T-Bill, then in 90 days the coupon (face value) of that bond is paid and the Treasury has to sell another T-bill to replace the one it paid off. If the government pays off $1 billion in short-term T-bills in any particular week, it must auction $1 billion of new T-bills to replace those paid off, i.e. roll over the debt.
3. To cover this year's deficit, the Treasury must sell more T-bills. Thus the Treasury won't just auction $2 trillion of T-bills to fund the 2009-10 Federal deficit--it must also sell untold billions more to replace all the Treasury debt which is coming due and must be rolled over into new Treasury bills.
4. The current era of low interest rates a.k.a. "cheap money" has allowed the Treasury to borrow stupendous sums of money at low rates of interest.
5. Even as these historically low rates, the interest on the public national debt (that is, not including the interest paid on the Social Security Trust Fund, which is considered "intergovernmental holdings") reached $260 billion in fiscal year 2009. The Treasury includes all interest, including that "paid" to the Social Security Trust Fund for the Social Security taxes collected but promptly "loaned" to the the general fund to spend, so you find news articles like this: Uncle Sam Will Pay $450 Billion This Year Just to Cover Interest on National Debt

According to the Treasury Department report, released on Dec. 10, the federal government expects to pay $449,070,000.00 in interest on Treasury debt securities for FY 2009.
The Health and Human Services budget, which includes Medicare and Medicaid, will cost $739,241,000.00 for the fiscal year; Social Security Administration, $699,976,000.00; and the Defense Department-Military budget, $656,722,000.00.

Here is a link to the Treasury's accounting of the debt: The Debt to the Penny and Who Holds It. It states that the debt held by the Social Security Trust Fund and other governmental agencies is $4.4 trillion, and the remainder of the debt (owed to citizens or "external" owners) is $6.6 trillion.

According to the Treasury, the average interest paid on this $10.95 trillion in debt is 3.7%. In January 2001, not very long ago, the average interest paid was 6.5%--almost double the current rate. Historically, a rate of 6-7% is not uncommon.

6. Thus a return to 7% interest rates would in effect double the interest paid annually to nearly $1 trillion per year. As noted above, this debt is spread out over varying maturities, so a rapid rise in interest rates would only effect a small portion of old debt at first.

Nonetheless, all new debt would be paying the new higher rates, and every month more of the existing $11 trillion in debt would roll over at the higher rates.

Think of that $11 trillion in debt as a mortgage which resets to higher interest rates as the "owner" keeps adding debt. Just like the homeowner who manages to make mortgage payments when the low "teaser" rates are in effect but who is unable to pay the mortgage when rates revert to actual market rates, the U.S. government will become insolvent as rates rise.

But why would rates rise? Why can't they stay low forever? I believe certain "one-shot" circumstances are masking longer-term trends:

1. Central banks (i.e. other governments) are buying huge amounts of Treasuries. (Central banks are still buying large quantities of Treasuries (Brad Setser, March 7, 2009). Theories abound, including the perceived need of central banks to build reserves to protect their currencies, etc.
The reason I don't see this is as sustainable is governments everywhere are busy announcing massive fiscal-stimulus spending bills, and whatever funds they can collect from taxes, borrow or print will soon be diverted to essentially "anti-rebellion" domestic spending.
2. Global savings are not infinite. The U.S. comprises about a quarter of the global economy as measured by GDP; by at least some measures, for the U.S. Treasury to borrow $2 trillion a year then a significant percentage of total global savings must be diverted to Treasuries.

Recall that virtually every other government on the planet is also busy selling trillions of dollars of their own debt to fund their own deficit spending, and that private debt for new mortgages, corporate debt, etc. sucks up additional funds. It's not hard to foresee a point at which newly issued debt exceeds the available savings/surplus capital.

At that point, a competition for available funds begins, with the "winner" being the borrower who pays the highest interest rate and offers the most safety/security.

With the global economy in a complete freefall, global savings are also in a steep decline. Just as the demand for capital leaps, the supply of surplus capital plummets. That's the long-term trend.
3. The U.S. savings rate has jumped up recently, reflecting a new prudence/fear in U.S. households. But as unemployment rises, we have to wonder how many households will be able to save, say, $2 trillion a year to fund their own government's debt.

Yes, I know insurance companies and bond funds will also be buyers, but as people cash out their insurance and retirement funds to survive then this "national savings" might still decline.

4. Treasuries rocketed in value as the stock market's decline caused institutions and individuals alike to sell REITs (real estate funds), stocks and other securities and put their cash in safe Treasuries.

But with the returns on T-bills being so pathetic, at some point institutions' models for 7% annual average returns will require that they seek higher yields. At that point, money will actually flow out of Treasuries.

5. Major institutions like life insurance companies and pension funds cannot survive drawing 1% or 2% interest on their capital. They simply cannot put all their money in "safe" short-term Treasuries and continue to pay out redemptions and pensions. That reality suggests the rush to Treasuries will be short-lived, unless T-bills start paying 7%.

At some point fear will recede and the priority of professional money managers will shift from "safety" to "higher return." As noted above, they simply have no choice. Investors can earn 2% on their money themselves; why hire money managers? Because they're supposed to earn higher returns than T-bills.

There is a definite possibility of positive feedback loops triggering a mass exodus from Treasuries and a resultant jump in interest rates that surprises (almost) everyone. Let's say global savings dries up (already a reality) along with global profits and global tax revenues and indeed, every possible source of governmental revenues other than borrowing.

At some point, the desire for "safe" low-paying Treasuries will dry up, from a shortage of capital and/or a reversion to a less risk-averse model of portfolio management.

Once interest rates pop up, the face value of existing bonds plummet, causing a mass exodus which feeds on itself. The face value of bonds is exquisitely sensitive to the rates paid for new debt. A $1,000 bond earning 2% falls to $500 if rates pop to 4%. That is why any rise in rates would cause havoc in the bond market and cause selling as those holding bonds begin fearing the destruction of their wealth via plummeting bond values.

Once the psychological certainty of "low rates will last forever" is broken, then rates can rise quite quickly, and the value of bonds can fall equally quickly. A trickle then turns into a torrent, which causes rates to rise even faster.

One last trend few seem to fathom: tax revenues are about to plummet. As profits vanish and head counts drop, then so do taxes collected. As assets crash, then the fat capital gains taxes collected by states and the IRS alike are drying up like summer rain in Death Valley.
So all those rosy predictions that the deficit will shrink as the economy recovers--don't count on it. Capital gains will never return to 2005 levels, nor will financial-sector and real estate profits. Structural unemployment will remain far higher than most believe possible.

Four short years of $2 trillion deficits will effectively double the U.S. national debt and the interest it pays. The Social Security surpluses are "borrowed" every year without any notice, so the U.S. debt rose by $300 billion a year even when it supposedly ran a slight surplus; that $300 billion+ a year in new debt goes on top of the stated $2 trillion/year in deficit spending.

So the nightmare scenario is this: the debt doubles over the next 4-5 years, causing interest payments to double from $450B to $900B a year. But interest rates also double due to the global shrinkage of surplus capital and the monumental rise in demand for capital (borrowing). The $900B in interest then doubles to $1.8 trillion--roughly equal to Medicare, Social Security and the Pentagon combined.

Can't happen? Really? With tax revenues dropping along with profits, employment and assets, then where will the political will arise to cap entitlements and other spending? I predict the U.S. will continue borrowing trillions of dollars until it is no longer able to do so.

By then, the interest owed each and every year will crowd out all other spending. With the debt machine broken, the government will simply be unable to service its debt and fund all its mandated entitlements and other programs. It will be insolvent.

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