US 'could be going bankrupt'

The United States is heading for bankruptcy, according to an extraordinary paper published by one of the key members of the country's central bank.

A ballooning budget deficit and a pensions and welfare timebomb could send the economic superpower into insolvency, according to research by Professor Laurence Kotlikoff for the Federal Reserve Bank of St Louis, a leading constituent of the US Federal Reserve.

Prof Kotlikoff said that, by some measures, the US is already bankrupt. "To paraphrase the Oxford English Dictionary, is the United States at the end of its resources, exhausted, stripped bare, destitute, bereft, wanting in property, or wrecked in consequence of failure to pay its creditors," he asked.

According to his central analysis, "the US government is, indeed, bankrupt, insofar as it will be unable to pay its creditors, who, in this context, are current and future generations to whom it has explicitly or implicitly promised future net payments of various kinds''.

The budget deficit in the US is not massive. The Bush administration this week cut its forecasts for the fiscal shortfall this year by almost a third, saying it will come in at 2.3pc of gross domestic product. This is smaller than most European countries - including the UK - which have deficits north of 3pc of GDP.

Prof Kotlikoff, who teaches at Boston University, says: "The proper way to consider a country's solvency is to examine the lifetime fiscal burdens facing current and future generations. If these burdens exceed the resources of those generations, get close to doing so, or simply get so high as to preclude their full collection, the country's policy will be unsustainable and can constitute or lead to national bankruptcy.

"Does the United States fit this bill? No one knows for sure, but there are strong reasons to believe the United States may be going broke."

Experts have calculated that the country's long-term "fiscal gap" between all future government spending and all future receipts will widen immensely as the Baby Boomer generation retires, and as the amount the state will have to spend on healthcare and pensions soars. The total fiscal gap could be an almost incomprehensible $65.9 trillion, according to a study by Professors Gokhale and Smetters.

The figure is massive because President George W Bush has made major tax cuts in recent years, and because the bill for Medicare, which provides health insurance for the elderly, and Medicaid, which does likewise for the poor, will increase greatly due to demographics.

Prof Kotlikoff said: "This figure is more than five times US GDP and almost twice the size of national wealth. One way to wrap one's head around $65.9trillion is to ask what fiscal adjustments are needed to eliminate this red hole. The answers are terrifying. One solution is an immediate and permanent doubling of personal and corporate income taxes. Another is an immediate and permanent two-thirds cut in Social Security and Medicare benefits. A third alternative, were it feasible, would be to immediately and permanently cut all federal discretionary spending by 143pc."

The scenario has serious implications for the dollar. If investors lose confidence in the US's future, and suspect the country may at some point allow inflation to erode away its debts, they may reduce their holdings of US Treasury bonds.

Prof Kotlikoff said: "The United States has experienced high rates of inflation in the past and appears to be running the same type of fiscal policies that engendered hyperinflations in 20 countries over the past century."

Paul Ashworth, of Capital Economics, was more sanguine about the coming retirement of the Baby Boomer generation. "For a start, the expected deterioration in the Federal budget owes more to rising per capita spending on health care than to changing demographics," he said.

"This can be contained if the political will is there. Similarly, the expected increase in social security spending can be controlled by reducing the growth rate of benefits. Expecting a fix now is probably asking too much of short-sighted politicians who have no incentives to do so. But a fix, or at least a succession of patches, will come when the problem becomes more pressing."

Part of the problem looking at this is the issue of cash vs. accrual accounting. I read the professor's effort several days ago but it has faded into nothing except these concerns.

We are on a cash basis budget. No allowance for capital expenditures and borrowing like most businesses and states. When we buy an aircraft carrier and the airplanes we expense it in the year we received it.

There is no way an entity as big as the US can expense everything, tax to make a zero balance and then expect the economy not to collapse because of lack of funds.

On the other hand, being on a cash basis conceals social security and Medicare future costs. Only an accrual statement would do this. This is especially necessary since in the Johnson Administration we plopped social security into a "unified budget."

Ever since we have had a unified budget the social security surplus has been considered revenues to the federal government rather than as defraying future costs.

I always tried to remember that as a percent of GDP federal revenues were 20-22%. I guess they are 16% now.

By the way, our economy is huge and some of our bigger metropolitan areas have bigger GDPs than governments. For example the NYC metro area has a bigger GDP than Russia. Ditto for Cleveland being bigger than Iran. And so on and so on.

You can measure a country by gold in the vault, accrual book keeping or actual production of goods and services. It is true currencies, including the dollar, have been severely depreciated but no one is going to allow the federal government to go broke. Long before that occurs we will escape our debts like the Europeans--inflate away and reset the currency by knocking off zeros. New francs for old francs for example.

There is a certain type of personality that wants to terrify themselves and others with doom and gloom. They serve a purpose like canaries in the mine, but they are not the future of the economy or the species.

One can safely ignore all the rhetoric trying to blame the mess on the latest administration or Congress (although they have indeed added to it). This imbalance has been building for decades, and will be solved by some form of default on the obligations incurred. Count on it. The most probable form will be a sharp resumption of inflation and continued attrition in the benefit amounts paid. The commentary at the end of the appended items below suggests that some of the US's foreign creditors are taking steps to reduce their exposure to our mess. Domestic creditors (holders of Treasury paper, or those relying on future governement payment promises) will just be "out of luck" to the extent they fail to do the same (reduce their exposure to the dollar).

David Walker, Comptroller General of the US, in testimony before Congress, lays out the mess pretty decisively:
http://www.gao.gov/new.items/d06406t.pdf

Further commentary about the same basic data for those who don't like to dig through the "official description" of the mess:

http://www.321gold.com/editorials/casey/casey033106.html

The feds take a stab at reporting their accounts according to "generally accepted accounting principles," or GAAP. Although the numbers include "all sorts of disclaimers," and exclude Social Security, Medicare, Medicaid and similar accounts, "They at least do put out a financial statement. It's the best they can come up with."

However, "The budget deficit numbers you hear announced at White House press conferences are from accounts kept on a cash basis, with no accruals made for monies owed by or due to the government in the future."

What's the difference? A lot. In 2004, the deficit was reported at $412 billion. The official GAAP-based number published by the Treasury Dept. was $616 billion. Add in the net present value of the underfunding of Social Security and Medicare, and what you get is $3.4 trillion. Yes, trillion. And that's if you ignore a one-time spike from the setting up of the new, utterly unfunded Medicare drug benefit.

The true GAAP-based deficit has been holding steady in that range. $3.7 trillion in 2003, $3.4 in 2004, $3.5 in 2005.

"[T]otal federal obligations at the end of September were $51 trillion," says Williams, "over four times the level of GDP. It is unprecedented for a major country to have its actual obligations so far out of whack."

http://www.riskcenter.com/story.php?id=13166

July 13: Commentary - Oil, the Dollar, and National Reserves
Location: New York
Author: Bhavna Gupta
Date: Thursday, July 13, 2006

Both oil and the dollar have made the headlines in recent months. While oil prices have shot up, the dollar has nosedived against the Euro.

The dollar has depreciated by seven percent against the Euro since the start of the year. According to some estimates the amount that the United States owes the rest of the world now stands at U.S.$3 trillion. This, in my opinion, is the primary reason why the dollar has fallen by so much.

Although it would be a nightmare for the Federal Reserve to see the dollar collapse, its devaluation is in a way a convenient alternative to partially redress the United States’ huge current-account deficit. A decline in dollar translates to a fall in the "value" of the deficit.

However, every fall in the dollar is bad news for the Gulf Cooperation Council (GCC). European and Japanese goods become dearer in relative terms and there is a depreciation of the "real" value of the region's foreign (dollar) reserve holdings. In other words, this phenomenon aggravates inflation. The GCC are also losing out on impending revenues in this respect as well because oil and gas are priced and sold in dollars. As a result, while the rise in oil prices was 162 percent in dollar terms, from their low point in January 2002, they actually climbed by less than half that rate when measured in Euros, 77 percent. If the dollar’s value did not change the oil prices would have only risen to U.S.$34 per barrel in October 2004, instead of the actual U.S.$52. As per a study, the correlation coefficient between oil and dollar is -0.7. That is, most of the time, when the dollar fell against the Euro, oil prices rose.

In this light the International Monetary Fund (IMF) has called on the GCC to put an end to its decades-old pegging of the dirham to the dollar. The UAE is one of six members of the GCC, which has pledged to create a single currency by 2010. Mohsin Khan, head of the IMF’s Middle East and North Africa unit, said Gulf States should consider pegging their currencies to a basket of currencies including the Euro and Japanese yen.

Several of the region’s central bankers have been discussing the possibility of shifting their foreign reserve holdings but as yet no substantial action has been announced. The only logical reason given for maintaining the dollar peg is that it is a provisional step towards forming a single GCC currency. This is a good thing but could just as straightforwardly be achieved with a peg to the Euro.

However simple a solution this may sound, its timing is of utmost importance. One should not forget that the Asian central banks have considerable dollar holdings too and if the Gulf central banks lag behind in selling off their dollars they would get much worse exchange rates than what they might get if they are first to sell off their dollars and buy Euros. A very simple play of price based on the demand and supply of Euros. The current state of affairs is a bit like the classic 'prisoner's dilemma.' If any one Asian central bank toggled its reserves into Euros tomorrow it would undoubtedly benefit, but if this is done collectively they would see the value of their reserves fall massively, as a fall in the dollar would adversely affect them all. If they all decide to sell some of their reserves simultaneously, there can be a huge risk of a total collapse in the dollar. It is now estimated that the United States’ U.S.$3 trillion deficit consumes more than 60% of the world’s total current account surplus. Joseph Stiglitz, a former Chief Economist of the World Bank, commented that there is obviously something peculiar about a global financial system in which America borrows more than U.S.$2bn each and every day from other countries (in March the U.S. trade deficit was U.S.$62bn) whilst lecturing them on fiscal responsibility.

It is surely worth the while of the GCC’s central bankers to seriously consider alternative options to the current status quo, as it would be a shame if the considerable economic achievements of the past few years are washed away by maintaining a rigid dollar peg that may be extremely expensive to maintain.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).

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