GOVERNMENT DEBT: Termites in the House

Financial Sense Online ^ | June 30, 2006 | Bud Conrad

[HopefulPatriot]

Casey Files: Government Debt – Termites in the House

As I write, gold has rebounded handsomely over the $600 mark, perhaps putting a stake through the heart of the recent steep correction.

Or, perhaps not.

After all, it isn’t the fundamentals, per se, that are currently causing gold to spike. It’s largely just the chattering of the trading community based on their reading of the tea leaves revealed in the Fed’s latest press release.

In order to make any real sense of where gold should be trading, and will be trading soon enough, you have to look deeper, much deeper, into the entrails of government spending. And few people are better at that than Bud Conrad, a senior researcher here at Casey Research.

Bud, who sports a degree from Yale and an MBA from Harvard, spends more time than any person I know looking intently under the hood at the hard data to take measure of the real state of the economy.

Bud recently had lunch with David M. Walker, head of the U.S. Government Accountability Office (GAO) and then followed up with him on the outlook for the U.S. economy, especially as it relates to deficit spending.

His report follows, below. It’s important. Read it. Pass it along.

Doug Casey
Chairman, Casey Research, LLC
Editor, the International Speculator

Government Debt: Termites in the House
By Bud Conrad

Recently I had the pleasure of having lunch with the Comptroller General of the United States, David M. Walker. He heads up the U.S. Government Accountability Office (GAO), the government’s internal watchdog. As he was about to give a talk on out-of-control government deficits, he had in his briefcase a chart on the size of the government’s obligations over time. Our discussion about those obligations over lunch was followed by an email exchange, and Walker kindly helped me source additional GAO data, all of which allowed me to confirm my analysis of the budget with projections from the Congressional Budget Office (CBO).

I have also met with Douglas Holtz-Eakin, head of CBO, who can competently recite the situation of six different budget projections without notes. The combined scenarios of the GAO and CBO provided me with the basis to create the following projection of the U.S. budget:

A clear picture emerges of a government completely out of control. The blue line is the history of the U.S. Federal Government debt. The green line shows the path we are now on, with debt soaring to impossible levels against projected GDP. Importantly, the source isn’t some crazy hand-waving blogger: these are the government’s own projections—and we all know they have every incentive to accent the positive. If this is the best they can do at this point, then you know things are not just bad, they are calamitous.

This glimpse at the future clearly shows that the debt of the U.S. will, in the foreseeable future, go from being a troubling yet manageable fraction of the economy to being several times the size of economy. That can’t happen without serious repercussions.

The government will be spending money they don’t have, which means creating more of it out of thin air and diluting the value of all the dollars that came before. It doesn’t take a Harvard MBA to know that the kind of deficits projected above guarantee a persistently weak dollar, higher inflation and higher interest rates going forward.

You may be right to criticize this analysis as only one of many scenarios being developed all the time and that there are other assumptions that lead to other estimates, and you would be right.

But I’ve looked at the assumptions, as has David Walker, and it is more likely that the assumptions have underestimated how serious the situation could become, maybe by a significant margin. For example, in the projections above, the interest rate paid by the government stays flat. Interest rates fell for 23 years and have only just recently bounced off of 45-year lows. The odds of interest rates staying at these low levels for decades into the future are, in my opinion, nil. I have analyzed the scenario of the impact of higher interest rates. The problem can get out of hand because it feeds on itself: higher interest rates lead to higher interest on debt, which leads to higher debt, which leads to greater loss in confidence in the dollar, which leads to higher interest rates… and the loop makes itself worse.

The Blame

Who is responsible for this sin of profligate spending? You could start by pointing a finger at the House of Representatives as they are constitutionally charged with holding the purse strings of the U.S. government. They voted for the spending and programs we are now saddled with, they pass tax programs, and vote in the big supplemental bills that fund the wars.

Entrusted with allocating the biggest sums of funding in the world, they clamor for more and, in the process, act like termites chewing away at the fiscal underpinnings of the economy, assuring the future bankruptcy of the nation. And it is not just the modern politicos that are responsible, but a failure to pursue sound monetary policies that extends back decades. Why do they do it? That answer is easy and reflective of human nature… they do it to curry favor with their constituents in order to get reelected.

Which further points the finger at us, the American public, who instead of voting the bums out for wasting our money and handing a legacy of debt to our grandchildren’s grandchildren, happily pocket the pork belly doled out and reward the most prolific spenders with our votes.

The bottom line is that debt and deficits are baked into the cake, exacerbated by the demographics of retiring baby boomers and a government that not only shows no intention of slowing its spending, but quite the opposite. In fact, like a penniless smoker breaking a child’s piggy bank to buy a pack, the debt-addicted government has already spent the supposed “Trust Funds” of Social Security and Medicare.

The government is closer to bankruptcy than anyone who has not studied the situation can guess. You will hear government apologists claim that the government can’t go bankrupt because they are the government, and along with a complicit Federal Reserve, they can meet any debt obligation because they have the printing press. That is precisely the problem. They can print any amount of money they want. That has been theoretically possible since we went off the gold standard in 1971.

It is this loss of any constraint on government spending that has let the genie out of the bottle. The track is now laid. The long-term future of the dollar is not in question. And to the extent that it is the basis of all other currencies, the reserve currency of the world’s central banks, all currencies are doomed.

Gold and the quality companies that produce or competently explore for it should no longer be viewed as entertaining speculations, but as portfolio requisites.

AUTHOR BIO:

Bud Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl, and Tandem. Currently, he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University. Mr. Conrad, a futures investor for 25 years and a full-time investor for a decade, is also a regular lecturer for American Association of Individual Investors. As a senior researcher for Casey Research, LLC., he produces original research and analysis for the International Speculator.

© 2006 Bud Conrad
Editorial Archive  Email

[HopefulPatriot]

More than 25 centuries ago, the Greeks recognized that all democracies end in hyperinflation whenever the public learns to vote itself benefits. The chart above, derived from data provided by the Comptroller of the Currency, is prima-facie evidence that the United States is NOT going to be the exception to the rule and that the end of the United States is within sight for all but the oldest living Americans and could occur before today's pre-school kids graduate from high school. Is this the future you want for your self or your children?

This catastrophe can be avoided if Jim Robinson is willing to lead a discussion on this forum to restore the Constitution. On this Fourth of July, give your children the gift of FREEDOM by implementing this plan.

[MNJohnnie]

Bud Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard.

So oh Sage, please explain why the British have quite successful managed such a National Debt since the early 1600s to now?

[MNJohnnie]

Oh sage. Please explain to the people how you pay for capital investments in your business, your housing, your motor vehicles and other long term expense?

What is that? Oh do speak up.

What this YOU defecit spend! But you just got done telling us the Debt is this evil monster that is going to kill us all unless we buy your dogma! How can it be that YOU do not personally live your own fiscal dogma??????

[A Balrog of Morgoth]

Interesting "hockey stick" graph there.

Looks just like the global warming hoax.

[expat_panama]

Gold and the quality companies that produce or competently explore for it should no longer be viewed as entertaining speculations, but as portfolio requisites.

This catastrophe can be avoided if Jim Robinson is willing to...

---tell freepers to buy gold?

[nopardons]

Spot on!

[nopardons]

ROTFLOL

Yeah...that's the ticket....hehehehehehehehehehehehehehe

[1rudeboy]

---tell freepers to buy gold on credit?

[ClaireSolt]

All Western governments are having to adjusat. the dutch and some others have already done it. We are tardy like France and Germany.

[HopefulPatriot]

Buying gold will save their own personal wealth, if they are able to keep the United States from confiscating it. Buying gold will not save the United States.

[HopefulPatriot]

"..please explain why the British have quite successful managed such a National Debt since the early 1600s to now?"

I lived in England for two years. To an extent, England is a microcosm of what has been happening in the US for the last 30+ years. It was the early 70's when we moved there. It was like stepping back in time thirty years. We rented a house on a street at the edge of a small town, about 14,000 people. The house had been an investment for a small business man who rented to American military officers. It was the only house on the street that had central heat; the rest heated with small fire places that primarily burned coal. The richest man on the street was a small farmer. He had the only modern and most expensive home on the street, but it was heated by fireplace. Their hot water heater was a tank built into the wall above the fireplace which was the source of most of its heat. The tank contained a electric coil that could be used if hot water was needed more quickly, but union strikes made electricity something that could not be counted on as an always on utility. During the winter, they used many blankets and vividly described waking up in the morning with a large layer of frost on the blankets where their breaths condensed and froze. Normally, it would be close to ten before the water in the toilet thawed enough to flush. The oldest couple that lived on the street did not have running water inside the house. The had a faucet outside from which they filled containers to carry what water they used indoors. I became good friends with a large farmer who was certainly in the top 20% of income in England. He cultivated Americans because he was renovating a 300 year old manor house and was furnishing it through the Sears catalog via the Americans he cultivated. At that time fewer than 1% of all English households had a dishwasher. My next door neighbor hated Americans. I was astounded when he came over late one evening and wanted to ask me some questions. He knew I was a doctor and wanted some medical advice. From the story he told, it was clear to me that he almost certainly had colon cancer. He, as most English people could not afford private medical care and was stuck with the National Health. He had been to see his primary care doctor who also believed my neighbor had colon cancer. The problem was he was a general practitioner and could not order a barium enema to confirm the diagnosis. Only a specialist could order the needed xrays. It was going to take six weeks before his appointment with the specialist. It was going to be another 6 weeks before he could get an appointment with a surgeon and three months after that before he could get on the surgery schedule.

When we were there, there was not much of a middle class in England. There was some old money and a few super rich with millions of lower middle class or poor, but there was almost no one living in abject poverty because of the dole. As a child for a time, I lived in town that was barely more a thousand. It's land area was several times that of the village where we lived in England in spite of the fact the village had more than 10 times as many people. Throughout England there are countless rows of narrow three story joined houses much like the row houses in some New England cities in the US. One family occupied a unit on each story. You could cram a lot of families into such places. The English had a name for them, but I have forgotten it. In thinking or ideology, it was something along the lines of "the project", but more descriptive. Our rich farmer friend rented his land and manor house from the Church of England. Most of the old family manor houses and farm land was owned by the Church or the National Trust. Estate taxes were prohibitive, for all but the very rich. By "donating" their estates to the church or National Trust, they could continue to live in their home and their heir would get right of first refusal on future leases for at least one generation. Leases were granted by sealed bids and generally were renewable for a fixed period as long as you could pay the rent.

The middle class is systematically being destroyed in this country as well. The people don't go broke overnight or even over a generation or two. They just get gradually ground down until everybody is equally poor if not impoverished and they live a subsistence standard of living.

When debt is used to temporarily increase your consumption, the long term net effect is to lower your total net worth and lifetime total consumption by the amount of interest that is paid. The short term increase in standard of living is paid for by means of ultimately lowering your lifetime total consumption amount. Debt used to finance an increase of production increases both income and ultimately net worth. Debt used to finance consumption may be common or even almost universal, but it is still foolish. When government taxes too much whether you call it FICA or IRS income taxes, the bottom line is the same, the middle class is squeezed into using debt to maintain their standards of living gradually impoverishing everybody. If it happens slowly enough people tend not to notice and don't complain as much as you would think. Worse, there is a constant propaganda barrage that blames businesses for high prices or the rich who are getting richer for not paying their fair share. People don't blame the politicians in government who are actually to blame, but instead blame the very people who are supporting what economy is left and look to the politicians as their saviors and for more benefits. It becomes a slow vicious cycle gradually grinding everybody down until nothing is left. Even the wealth of the rich becomes an illusion because politicians will print whatever money is needed to cover "government benefits" not paid for through taxes or the growing national debt. Because it happens so slowly over the lifetimes of generations most people are ignorant of what is happening to them much like the frog placed in a pot of slowly warming water. Sooner or later his goose is going to get cooked.

Politicians have been overtaxing Americans since 1913. Through the socialism created by the politicians income and wealth are being transferred and consumed instead of being saved and invested. For the middle class is means either a declining standard of living or decline in net worth plus a larger debt burden. More people have a deed to house now than ever before, but total housing equity net worth has been slowly declining for American families for 50 years. There was a time when most families could pay cash for a car or finance it for no more than 36 months. Most families that had two cars had at least one that was paid for.

For the first century+, it was production that made America great. We built more things, made them better, made them more efficiently making them cheaper and more people could afford to buy more of them creating even more profit. Made in America actually meant something instead of being a wishful thinking slogan. America had the largest store of saved capital ever accumulated in history. When politicians began introducing socialism in 1913, government started transferring that pool of saved capital to voters for consumption. Less than a century later, the capital pool is no longer large enough to accommodate sufficiently skilled workers or technologically enhanced factories to make up for lower wages in other localities. Manufacturing, and with it the good jobs it provided are transferred to lower cost centers of production. The erosion of our pool of saved capital means that we can no longer improve efficiency enough to compete. The cycle of decline is becoming noticeable. MNJohnnie acknowledges that most people can't afford to pay for a car, let alone a house. And he has noticed that business is having some trouble financing its capital needs as well. The graph tells you what is going to happen over the next 20 years if the US actually lasts that long. It's not the debt or even the consumption that does it. Remember the slogan that elected Bill Clinton? It's the SOCIALISM, stupid!

[Toddsterpatriot]

Buying gold will save their own personal wealth,

Hmmmmmm.......how did that work out in the early 80s?

Looks like buying gold lost personal wealth for a lot of people.

[HopefulPatriot]

Markets for everything go up and down because many if not most people behave irrationally at times. Governments rarely behave rationally and most of the time it is government's irrational behavior that causes people under their control to behave irrationally. From the mid-thirties FDR decreed that Americans could not own gold. Ford removed the ban on Americans owning gold. There was a lot of pent up demand that drove the price to levels that proved to be irrational at the time. Try to think of gold in terms of purchasing power. Back in Moses's day, an ounce of gold was said to buy 300 loaves of bread. We're not too far off that mark today. In 1912, before Wilson created the Federal Reserve, an ounce of gold would buy twenty dollar bills. What has actually changed, the purchasing power of gold or of the dollar bill? In terms of the 1912 dollar, today's dollar is worth less than a nickel. It is said that our government wants to the dollar to devalue against other currencies. What rational person wants the value of their money to become worth less? In terms of the 1912 dollar, the present dollar is already almost worthless. If the trend continues and you have nothing to spend but dollars, how much or even what are you going to be able to buy?

[Toddsterpatriot]

Markets for everything go up and down because many if not most people behave irrationally at times.

So when you said this: Buying gold will save their own personal wealth, you were wrong. Got it.

Try to think of gold in terms of purchasing power.

Okay. In 1980, an ounce of gold bought 800 dollar bills. In 1999, an ounce of gold bought 255 dollar bills.

[Mase]

The middle class is systematically being destroyed in this country as well. The people don't go broke overnight or even over a generation or two.

People are going broke? Have you ever seen the household net worth numbers? Our private net worth has more than doubled since 1995. How does that happen when you're going broke? If the middle class is being destroyed, how is this destruction being accomplished since their earnings have been increasing for more than 30 years.

They just get gradually ground down until everybody is equally poor if not impoverished and they live a subsistence standard of living.

LOL!! We hear this claim on FR all the time but no one ever manages to prove it other than offering some isolated anecdotes. Let's look at the gradual grinding down of the middle class since 1967:

• in 1967 only one in 25 families earned an income of $100,000 or more in real income, whereas now, one in six do. The percentage of families that have an income of more than $75,000 a year has tripled from 9% to 27%.

• The percentage of families with real incomes between $5,000 and $50,000 has been falling as more families move into higher income categories -- the figure has dropped by 19 percentage points since 1967.

• The middle class has not been "shrinking" or losing ground, it has been getting richer. For example, the Census data indicate that the income cutoff to be considered "middle class" has risen steadily. Back in 1967, the income range for the middle class (i.e., the middle-income quintile) was between $28,000 and $39,500 a year (in today's dollars). Now that income range is between $38,000 and $59,000 a year, which is to say that the middle class is now roughly $11,000 a year richer than 25 to 30 years ago.

• The upper-middle class is also richer. Those falling within the 60th to 80th percentile in family income have an income range today of between $55,000 and $88,000 a year, which is about $24,000 a year higher than in 1967.

• Median household wealth for 2004, is estimated at $105,000 in 2004. This is almost double the median family-wealth level of 1983 and nearly triple the level of 1962.

• The media and the poverty lobby have seized upon the news that the poverty rate has spiked upward to 12.7% in 2004, up from 11.3% before the recession. This rise was widely reported and condemned, but again this is a short-term phenomenon attributable to the aftershocks of the recession. What was not widely reported was that the 12.7% poverty rate was the lowest coming out of any recession in the last 25 years, and that the poverty rate has been lower than 12.7% in only five of the last 25 years. It certainly is better than the 15.1% rate poverty-rate peak in 1993.

Source: WSJ (subscription required)

[HopefulPatriot]

I wish I had the time to refute your arguments and the data on which they are based. I don't. One of the fundamental problems of determining real wealth, is that there are few if any meaningful standards to use. Net worth depends on the price that will be paid for any asset including cash at the time. It is easy to put down a price and add those current prices to determine net worth. Are you going to determine those values in dollars or ounces of gold or some other unit of measure. Since the "price" or even the value of each of those things changes from second to second and over long periods of time there have been immense changes in each of those potential units of measure, necessity created an accountng need to use a "factor" to adjust prices at various points of time. These become statistics subject to fudging in order to present the best possible picture or to portray the picture desired by the adjuster.

That said, let's look at Net Worth from a slightly different perspective. Stock X has a price of $100/share and you have a thousand shares on margin. At the moment, your net worth is 50k, but the stock begins to fall and you start having a series of margin calls. Your 50k can become a negative net worth in a matter of days. Your stock will be all gone because your broker will sell it, but you could still be left with some margin debt, possibly even a lot of margin debt if the price crashed sufficiently quickly. Real estate has the same potential. Contrary to what a lot of Americans believe, real estate prices can and do fall. I have bought a significant number of foreclosed properties over the years, some for as little as 15 cents on the dollar that was originaly used to buy them with a mortgage. If the price of the RE falls, the debt doesn't. The leverage works in reverse if the price of the asset falls instead of rising.

Based on past Presidential election cycles in the stock markets, we have the bottom of the four year cycle coming up this year or early next year. Using history only as a guide, the average conditions of the past as compared with current conditions, say that on the average the market should correct by 35-40% with this presidential election year cycle. When the Fed is raising rates, history says that a 20% or more correction in RE prices could be dead ahead. Go to the Grandfather's Economic Report website and check out his statistics on debt and family income/net worth data. Factor in a 20% decline in real estate and 30% decline in stock and bonds. Consider the impact on an economy that could be job starved and burdened by soaring unemployment. Will it look a lot like a depression? When the assets have been sold at deep discounts to get rid of them, and the debt remains, what will American family net worths look like then?

The ability to be able to afford taking on more debt, is not equivalent to increasing your net worth. Real net worth can not be measured because there is no standard by which to measure it. Factors used to adjust standards over time are accounting fictions. Warren Buffet has often been quoted as saying, "It is only when the tide goes out, that we learn who has been swimming naked." The evidence is fairly compelling that tide is about to go out. If it does, a very large number of Americans are going to find out that they themselves have been swimming naked and didn't even know it.

[remember]

That said, let's look at Net Worth from a slightly different perspective. Stock X has a price of $100/share and you have a thousand shares on margin. At the moment, your net worth is 50k, but the stock begins to fall and you start having a series of margin calls. Your 50k can become a negative net worth in a matter of days. Your stock will be all gone because your broker will sell it, but you could still be left with some margin debt, possibly even a lot of margin debt if the price crashed sufficiently quickly. Real estate has the same potential. Contrary to what a lot of Americans believe, real estate prices can and do fall.

I agree that you have to be careful in judging the recent increase in household net worth. As the first graph at http://home.att.net/~rdavis2/worth.html shows, stocks rose rapidly from 1994 to 1999 but then plummeted until 2003. Real estate values began rising sharply in the late 90s. Only time will tell if and to what degree they may stagnate or even decline.

In any case, bringing up household net worth when discussing government debt is a little like mentioning your rich neighbor when discussing your own debt. There are currently no proposals to use that household net worth to service the federal debt. The following graph shows the projected growth in government debt through 2080 according to the most recent budget:

The actual numbers and sources are at http://home.att.net/~rdavis2/pro2007.html. As can be seen, the debt is projected to rise to 177% of GDP by 2080. This is well above the previous maximum of 122% of GDP reached at the end of World War II. This level of debt assumes the collection of all taxes authorized under current law. Hence, unless those who point the the household net worth are proposing new taxes on that wealth, it will not help us to deal with the rapidly increasing government debt.

[HopefulPatriot]

The graph you have shown for government projected debt does not include the government's largest liabilities, Social Security and Medicare.

You made the comment: "There are currently no proposals to use that household net worth to service the federal debt."

The use of the words "no proposals" is a bit misleading. Governments generate no income; taxpayers inevitably pay all liabilities of government , if those liabilities actually get paid rather than defaulted. The absence of a plan or a specific proposal of how or when does not negate the realities that are going to be dealt with by payment, default or a compromise that involves both.

Make no mistake, it is not economically or politically possible to pay the accruing, but unfunded liabilities of the entitlement programs. Default is inevitable; the questions are only how, how much, and when.

[Toddsterpatriot]

I wish I had the time to refute your arguments and the data on which they are based. I don't.

You don't have the ability. Take your time. Think really hard. We'll be waiting.

One of the fundamental problems of determining real wealth, is that there are few if any meaningful standards to use. Net worth depends on the price that will be paid for any asset including cash at the time.

First you say there is no meaningful standard, then you mention price. You refute your own argument in the very next sentence.

Since the "price" or even the value of each of those things changes from second to second and over long periods of time there have been immense changes in each of those potential units of measure, necessity created an accountng need to use a "factor" to adjust prices at various points of time.

You have a source that discusses this mystery "factor"?

That said, let's look at Net Worth from a slightly different perspective. Stock X has a price of $100/share and you have a thousand shares on margin.

See, you've got it. You add the $100,000 of stock and the $50,000 of margin debt to get your net worth. How hard is that? Next quarter, repeat.

Using history only as a guide, the average conditions of the past as compared with current conditions, say that on the average the market should correct by 35-40% with this presidential election year cycle.

Really? How short are you? Since the market should drop by 35-40%.

When the Fed is raising rates, history says that a 20% or more correction in RE prices could be dead ahead.

Really? Didn't the Fed Funds rate double between 1993 and 1995? I don't remember RE prices dropping 20%. Maybe you have a link?

Real net worth can not be measured because there is no standard by which to measure it.

And therefore, we are obviously doomed. LOL!

The evidence is fairly compelling that tide is about to go out.

Yeah, okay. Buy gold! I just hope it doesn't drop 60% like it did in the early 1980s.

[Toddsterpatriot]

In any case, bringing up household net worth when discussing government debt is a little like mentioning your rich neighbor when discussing your own debt.

Household net worth was brought up because of HopefulPatriot's following gem:

The middle class is systematically being destroyed in this country as well. The people don't go broke overnight or even over a generation or two. They just get gradually ground down until everybody is equally poor if not impoverished and they live a subsistence standard of living.

When debt is used to temporarily increase your consumption, the long term net effect is to lower your total net worth and lifetime total consumption by the amount of interest that is paid.