The Pain Has To Go Somewhere, But Where?

Roughly three months later than originally scheduled, the fiscal year 2009 Financial Report of the United States Government came out.? I had predicted a few times (latest here) that the final total of debts and unfunded liabilities would be about 4x GDP.? Well, I was close:

Category Amount
OASDI (Social Security)

(7,677)

Medicare Part A

(13,770)

Medicare Part B

(17,165)

Medicare Part D

(7,172)

Unfunded Liabilities

(45,784)

Net Explicit Debt

(11,456)

Total Debt and Unfunded Liabilities

(57,240)

GDP 9/2009

14,242

Ratio

402%

As I commented in my piece The Biggest, Baddest Bubble of Them All:

This doesn?t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

That comment was originally written in October 2003.? As I commented at RealMoney a number of times, I felt that it was possible that the GSEs would fail — they held so little in reserve against mortgage losses.? Back then, the figure wasn’t $57 billion, it was $25 billion for fiscal year 2002, which would be 2.4x GDP.

The US Government has made a lot of promises to pay.? I have no idea how big the annual obligations for capital and operating leases are, but it would be cheaper for the Government? to borrow and buy their buildings, rather than hiding the debts through Credit Tenant Leases.? I also can’t quantify the full range of guarantees they have made, including implicit ones to bail out GSEs, big financials, allies, etc.

A reader wrote me asking: Would you please write a post on what will happen if the US goes bankrupt? This government spending continues to get worse and I am wondering what if anything I, a retired person, can do to get in front of this.

Okay, here goes.? Remember that the US Government has choices.? It can raise taxes, inflate, or default.? I don’t think default, even if it is only an external default, is the most likely option.? Also, the promises for Social Security and Medicare are not guaranteed — they can be reduced or canceled by Congress and the President.? Changing Social Security and Medicare would be political suicide, but suicide is an option.

An aside, why have I not mentioned cutting discretionary spending (or defense or entitlements)?? Because they aren’t that large a portion of the budget.? Defense and entitlements are large, but who could get a consensus on cutting those?? Our culture has a “more is better” mentality, even though spending money on “defense” has probably not made us more secure.

In order of highest likelihood, here is how I see the options:

    1. Borrow more
    2. Raise taxes
    3. Inflation
    4. Cut discretionary spending
    5. Cut defense spending
    6. External default
    7. Total default
    8. Cut entitlement spending
    9. Internal default

      Much as I would like to see the US Government reduced in size to only core functions, my views are not the consensus.? They will try to raise taxes, and failing that, inflate the currency.

      To the one who asked the question, I am not a tax expert, so consult one to limit your taxes.? On inflation, you probably know the drill: Money market funds, TIPS, commodities, and equities with hard assets or pricing power.

      The US government talks about cutting discretionary spending, but rarely does so.? Defense is worse; it always expands.? For the US to cut defense spending would be a mindshift requiring closing overseas bases, and a quiet surrender of the idea that the world is ours to guard/rule.? We think we are neutral, when we are genuinely self-interested.

      External default would not be enough to solve the problems the US faces, and, it would enrage the rest of the world.? We would find our assets abroad seized by foreign governments.? Say goodbye to goodwill and globalization.

      I don’t know what to say about total default, aside from depression everywhere, with many financial institutions failing in the US and abroad.? If the global reserve currency fails, well, those that rely on it will fail.

      I don’t view cutting entitlement spending or an internal default only as likely.? They are political suicide for whoever does it.

      My sense is when the ability to raise taxes fails, inflation will be the solution.? If/when the political outcry becomes too great against inflation, then the lesser remedies will be considered.

      The pain has to go somewhere — we’ve been really good at ignoring the problem, delaying the payment, etc., but it has only had the effect of building up the eventual pain that will have to be taken.? Our leaders are seemingly opting for a Japan-style solution — stagnation for two-plus decades with debt shifted from private to public entities.? We have better much better demographics, but Japan has had better saving in the past — more of their explicit debts are internally funded compared to the US.

      The trouble with offering advice in a situation like this is that the right answer depends on what our officials do.? The best or worst investment could be long Treasury zero coupon bonds.? Or it could be gold.? Remember, many thought the Great Depression would end with inflation, but it didn’t, at least not to the degree that many feared.? Me?? I am invested in a mix of well financed businesses that generate a lot of cash and would be difficult to do without, and some money market funds, where I suffer the punishment of a saver, while retaining flexibility.

      There are no easy answers here.

      11 thoughts on “The Pain Has To Go Somewhere, But Where?

      1. I disagree about putting entitlement cuts as less likely than a default. A default is a pretty binary situation with clear ramifications, but a cut doesn’t have to look like a cut: control can be given to external or future events. E.g., the cost of living adjustments can be changed so that the real value of payments ‘automatically’ reduces over time. Retirement ages can be raised (for those now below 50).

        There have been overhauls of SS over the years, just not very many; you can expect the handling to be cowardly, and late.

      2. Great post!

        One governor is showing the courage to address the problem his state faces, Gov. Christie of NJ. Of course, his list of options is shorter and most of them have run out. He is now cutting spending and seeking to change the laws re state employee contracts so that those wages & benefits can be better controlled.

        He made a really courageous speech on this to NJ’s mayors a week or so ago. Mish has a partial transcript (http://globaleconomicanalysis.blogspot.com/2010/03/governor-christie-time-to-hold-hands.html )and the 25-min. video is here: http://njn.net/television/webcast/ontherecord.html

        If only Pres. Obama and the Congress (Rs & Ds) would have some of the same courage, our country would have a more confident, if restrained, future.

      3. I remember reading an essay not long ago (don’t remember the where/when), there are limits to how much we can inflate our way out of this mess because some many of our liabilities are real not nominal. The off balance sheet liabilities you show above constitute 80% of the overall liabilities and these are linked to inflation (whether formally or informally). In a higher inflationary environment, those liabilities would also increase in value. Inflation would only decrease the value of the 20% formal credit market instruments (and only a subset of those, after excluding bills and TIPs).

      4. If there is severe inflation, say 1970s style ca. 10%, will money market funds really offer protection? I mean, do the rates keep pace?

        The problem I have with the “inflation driving up rates” scenario is that it would seem to be self-correcting. For instance, some are predicting commodities will jump again, with oil hitting $100. But if oil hits just $90, we’re back in recession and commodity inventories will be even more bloated.

        (check out world copper inventories: http://www.investmenttools.com/futures/metals/Base_Metals_Inventory_London_and_Shanghai.htm#total_copper )

        Likewise with bond yields. Some are predicting 10-year Treasuries in the 5-6% range, but at 4.5%, housing is back in the toilet.

        People point to inflationary pressure from China et al., but inflation there is still muted, even after a 30% jump in lending last year.

      5. Very nice overview of the situation!

        Toptick is right, of course, both that there will be some adjustments to entitlements, and that they will be cowardly and late. I don’t think this changes the likelihood of inflation very much.

        Regarding the liability hiding in the GSEs, John Hempton at Bronte Capital wrote a series of posts last year attempting to show that the GSEs are actually more or less solvent (the key one is at http://brontecapital.blogspot.com/2009/08/modelling-fannie-mae-and-freddie-mac_15.html). I don’t fully agree with the analysis, but Hempton does know what he is talking about, so perhaps the losses will not be too great.

        More generally, all the government guarantees related to the crisis are regularly summarized by Bloomberg, though of course it is hard to go from this to any reasonable estimate of the eventual cost.

        One further thought on investments: If and when one is convinced that inflation is a real threat, then leverage is a good idea, because one’s debt is likely to be reduced. So owning a house with little equity, or buying REITs. Of course this is a dangerous game. If deflation is the outcome instead, you lose. And if you wait too long the debt will be expensive.

        Jim Fickett
        ClearOnMoney.com

      6. Sorry, the above link to Bronte Capital doesn’t work. If you are interested in his analysis, just go to his archive for last August.

      7. David, have you (or someone else) calculated how much less has been paid out since the CPI was recalculated? Or alternately how much less is projected to be owed due to the recalculation?

      8. sg: some writers say CPI is 0.6 percent lower p.a. than it would have been without the adjustment. Back of the envelope calculation would indicate that inflation indexed benefits in retirement are on the order of 15 to 25 percent lower? The whole thing seems to me like a redistribution game – old vs. young. It is easy to give generous benefits to old as long as there are few of them. But is it in the interest of the old to strangle the young? Lots of fascinating thought experiments.

      9. I’ve got to agree with Sami. Inflation isn’t going to help much. Medicare, and Social Security are both linked to inflation one way or another. Inflation would help with explicit debt, but that’s not the real problem, the real problems is Medicare. I personally think that unless we get hit with enormous additional losses from FDIC bank closings and AIG and Fannie Mae and Freddie Mac, the argument for inflating their way out of this mess doesn’t hold up.

        I could see a faked-up war with China as an excuse to repudiate the debt they hold, but that would only take care of about 1Trillion. Hardly worth bothering about.

        Which means they are going to have to choose between pissing off Medicare recipients who get benefits cut or taxpayers who get taxes raised.

        The Democrats have nailed their flag to the masthead on being the party of more and better health care, which means the Republicans will end up being the party of ‘cutting benefits’. If the Republicans move back to the right in response to the tea-party groups maybe they will even become credible again as the party of smaller government, lower taxes, and balanced budgets. I dream of course, but at least they would enjoy gutting Medicare, so…

        I’ve lost all incentive to vote for the Democrats – now that they are in power they have done nothing to decrease military spending, repeal the patriot act, reclaim our civil liberties, prosecute torturers, or get up out of the mess in the Middle East. The latest I’ve heard is that Obama is going to withdraw 90,000 troops from Iraq (and leave 35,000 troops in country). He’s already said that he is going to hold at least 50 people from Guantanamo indefinitely without trial. The only thing he has fought for since he got in office was unions, health care, and bailouts for banks. So, he will lose in 2012. Who would drive all the way down to the polling station to cast a vote for twiddledum?

        Which means, I am going to predict that Medicare gets gutted in 2012-2016.

      10. Remember, my list is what I think the politicians will do, not what they should do. Entitlements are sacred cows to both parties. Bush II, far from reforming entitlements made the situation far worse. I have no idea why anyone called him a conservative.

      11. Inflation won’t work: payments are indexed, revenues are indexed, liabilities are short/term and 10% are in TIPs.

        In the ’70s, none of those things were true. What worked then won’t work now. Treasury knows this, as does the Fed.

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