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

[remember]

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

It doesn't include all future liabilities but it does include Social Security and Medicare liabilities through 2080. In fact, one useful thing about long-run budget projections is that it is harder to hide such liabilities. As I'm sure you know, the government is currently borrowing the Social Security surplus and this serves to make the deficit and publicly-held debt look smaller. However, Social Security is projected to stop running surpluses in 2018 (excluding interest) and to have cashed in all of its government bonds by 2040. Medicare stopped running surpluses just this year and is projected to have cashed in all of its bonds by 2018. Hence, the government will no longer be able to borrow Social Security's surpluses to mask the deficit after 2018 and the publicly-held debt will be very nearly equal to the gross federal debt (the one that's now over $8 trillion) by 2040. In any case, the following graph shows projected federal outlays through 2080:

As before, the actual numbers and sources are at http://home.att.net/~rdavis2/pro2007.html. Also, at that URL is a comparison of all of the long-run projections since Clinton's last budget. As bad as the current projections are, they've greatly improved over the last couple of budgets. The way in which they've improved makes me suspect that they may now be overly optimistic. I'll copy below one of the points from that URL that describes this improvement:

12) The deficit projected for 2080 rose sharply from 11.7% of GDP in the 2001 Budget to 33.5% of GDP in the 2004 Budget and dropped sharply to 13.7% of GDP in the 2007 Budget. The following table shows the makeup of the 21.8% of GDP increase from 2001 to 2004 and the 19.8% of GDP drop from 2004 to 2007:

COMPONENTS OF CHANGE IN DEFICIT PROJECTED FOR 2080

Component of change   2001-04  2004-07
--------------------- -------  -------
Receipts.............   -0.7      3.1
Discretionary Outlays   -3.2      0.4
Mandatory Outlays....    0.3      1.8
Net Interest.........  -18.1     14.5
---------------------  -----     ----
Deficit change.......  -21.7     19.8

As can be seen, the largest component of the rise and fall in the projected deficit is Net Interest. This shows how a relatively small difference in annual receipts or outlays can cause a much larger difference in net interest. This is because net interest is based on the debt which is the accumulation of all past deficits.

Points 13 and 10 on that page go on to look at the change in Receipts and Mandatory Outlays, the next two largest components in the recent fall of the projected deficit.

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.

I agree. The cost of the debt will have to be addressed one way or another. My point was that the lack of a proposal to address it will make doing so that much more difficult.

[remember]

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.

Thanks for clarifying that.

[HopefulPatriot]

I do not see the data from the Gokhale-Smetters Report reflected in your chart. If correct, your chart is similar to the accounting that turned a giant (Enron) into a dinosaur. Here are the words of the acknowledged father of the Constitution, James Madison, "Remember, democracy never lasts long. It soon wastes, exhausts, and murders itself. There never was a democracy yet that did not commit suicide."

The first nail in the US coffin was driven by the Federal Reserve Act. Here is what Thomas Jefferson had to say, "If the American people ever allow private banks to control the issue of their money, first by inflation and then by deflation, the banks and corporations that will grow up around them (around the banks), will deprive the people of their property until their children will wake up homeless on the continent their fathers conquered."

When I look at the Gokhale-Smetters Report, what I believe to be true (it has held for 25 centuries) about democracies when the public learns to vote itself benefits, and the warnings of the Founders, it should make anybody wonder how the United States is going to be the exception to the rule. History repeats because people always believe that it's different this time.

[remember]

I do not see the data from the Gokhale-Smetters Report reflected in your chart. If correct, your chart is similar to the accounting that turned a giant (Enron) into a dinosaur. Here are the words of the acknowledged father of the Constitution, James Madison, "Remember, democracy never lasts long. It soon wastes, exhausts, and murders itself. There never was a democracy yet that did not commit suicide."

The main problem is that the Gokhale-Smetters Report and the long-run projections (which came from the most recent U.S. Budget) measure different things. As I understand it, the Gokhale-Smetters Report measures the present value of government's total fiscal imbalance, that is, its total future unfunded liability in current dollars. The budget's long-run projections, on the other hand, just project federal revenues, outlays, and the resulting deficit and debt through 2080.

I do think that it's important to estimate the government's entire fiscal imbalance as the Gokhale-Smetters Report does. It gives us an idea of the total future problem that we face if we don't change policies. However, the whole concept of "present value" is lost on many people and many frankly are not overly concerned about what happens in the infinite future. For that reason, I think it's also useful to look at the long-run projections. They give an idea of how soon the fiscal pressures will hit over the next 75 years and how big they will be (although, as I said, I suspect they may be overly optimistic). Hence, I think it's useful to look at the Gokhale-Smetters Report AND long-run projections, just so long as it is remembered what each measures.

By the way, James Madison is known as the "father of the Constitution" but I believe that quote came from John Quincy Adams.

The first nail in the US coffin was driven by the Federal Reserve Act. Here is what Thomas Jefferson had to say, "If the American people ever allow private banks to control the issue of their money, first by inflation and then by deflation, the banks and corporations that will grow up around them (around the banks), will deprive the people of th eir property until their children will wake up homeless on the continent their fathers conquered."

When I look at the Gokhale-Smetters Report, what I believe to be true (it has held for 25 centuries) about democracies when the public learns to vote itself benefits, and the warnings of the Founders, it should make anybody wonder how the United States is going to be the exception to the rule. History repeats because people always believe that it's different this time.

I agree that far too many people seem to think that the U.S. is exempt from the rules of economics. I suspect that this was likewise the general belief in every superpower that preceded us. Unfortunately, it often seems to take a crisis to get the government and the electorate to respond. Hopefully, any such crisis will be small enough and occur early enough to allow us to respond effectively.