I was going over some of my older posts to review what was being discussed at the beginning of this year and what the perspectives were at that time. I found an interesting piece I wrote at the beginning of the year. I had just watched Janet Yellen’s inaugural panel hearing in front of the congressional finance committee members on Cspan. It’s basically a forum to allow the congressional financial committee members to directly pose comments and questions to the world’s most influential banker, namely, the US Fed chairman.
There were a few hardball questions but mostly just buttering up on Ms. Yellen from both sides of the aisle. Picking out a few of the interesting bits that came up in the course of discussion I was certain I saw a glimpse of honesty indicating that problems are on the horizon, from Ms. Yellen. The most notable commentary was her fairly forthright perspective that the CBO forward guidance depicted an imminent problem for America. What caught me a bit off guard was how easily the congressional finance committee members shrugged off the repetitive warnings from the Fed chair regarding this imminent problem. There was no discussion about possible solutions to the problem or even calls for further investigation to the warnings. It was simply dismissed. I found it incredibly ironic the one person in the world who is mandated to continuously increase leverage to the US was the one warning congress to get its fiscal house in order. Yet the congressional committee before her, acted as though they didn’t hear it.
However, subsequent to that initial committee hearing I’ve not heard any additional warnings from the Fed about getting the America’s fiscal house in order. It was a rare moment of honesty from a rookie chair and she apparently received a memo shortly thereafter informing her of the mistake. Now let’s take a look at specifically what Ms. Yellen was warning congress about. The CBO publishes annual long term forward guidance to give the world an idea of where things will be for the US 25 years out given where we are today. Forecasting so far into the future is no exact science and it relies heavily on assumptions. And so let’s take a look at the typical process.
The CBO runs historical trends and then ties that into the current state of the state and from there they get creative in their forecasting by assuming various policy changes will be made and these potential changes will have differing economic consequences. Eventually they get to some baseline forward guidance that may or may not be accurate but doesn’t send the country into a panic whilst also providing some legitimate underlying point. I think someone at the CBO really dropped the ball on the last two though because the reports look slightly apocalyptic. Because of my mistrust for all things government I wanted to validate the CBO projections.
So I replicated the CBO forward guidance using historical trends to guide me through the future of total debt and GDP. Rather than assuming specific policy changes I simply used quantitative positive and negative sensitivity testing. Policies change throughout the historical data and so it implicitly captures varying policies over time. As such, simple discount and premium sensitivity should be a more impartial method of scenario testing. Let’s have a look at the following forecast by the CBO. Note these projections do not include intra-governmental obligations (basically IOU’s government has from borrowing money from various social accounts like pensions and social security). If it did these percentages would be much higher. For instance, currently Total Federal Debt including intra-governmental debt is already about 106% of GDP rather than the 70% excluding intra-governmental debt. Yet there is nothing fake about those intra-governmental obligations, however, they are not explicit securities with maturities, etc. But understand the projections are not anywhere close to the true debt levels.
Here are the CBO projections:
So we see the CBO has Federal debt held by the public ranging from 42% to 183%, with a baseline of 111% of GDP by 2039.
The following are my projections using pure quantitative assumptions (+/- one standard deviation from baseline). All historical data for my projections were pulled from St. Loius Fed.
My projections had a debt to GDP range of 62% to 240% (vs 42% to 183% CBO), with a baseline of 123% (vs 111% CBO) of GDP. So slightly higher than the CBO and I would expect the CBO is going to be as conservative as they can even in there higher projections. But given these are predictions for 25 years forward I would say the results are similar enough, particularly the baseline, to assume these ratios are probably fairly accurate. Possibly averaging the CBO with my baseline and range intervals would give a reasonable indication. The CBO also provides an ever further out forecast for debt, spending and revenues. Let’s have a look.
The fact of the matter is that regardless how you spin these projections they are frightening. And this gets us back to Ms. Yellen’s quite forthright and appropriate warnings to the congressional finance committee members that the US must get its fiscal house in order. What she meant and explicitly said in the discussion was spending must be contained. The seriousness of even the baseline projections are simply not survivable (Yellen’s words were unsustainable). And that’s not superlative but literal. Just being America does not allow us to defy all economic principles forever. Let’s take a closer look at some of the implications of these projections.
If we face the worse case projection, let’s call it 200% debt to GDP by 2039, 10 yr Treasuries cannot be more than around 2% yield in order to remain within the historical debt service to GDP range. This is where things really break down. Because if we cannot entice lenders today at 2.5% or 3% interest with 70% debt to GDP there is simply no way lenders will be attracted at 2% with debt to GDP at 200%. So let’s think about what this means. Now the CBO budget projections predict deficits will increase forever after 2018. And we will see why this is true shortly. This will require massive amounts of debt over the next 25 years. And if we don’t have willing lenders we’re back to monetizing most of that debt as we’ve done for the past several years. This means massive amounts of money printing. And so we put ourselves into a downward spiral of devaluation, which means inflation. Inflation perpetuates larger deficits as spending increases and even more money printing and so the downward spiral worsens. This will be made much worse by the winding down currently taking place of the petrodollar as demand for dollars will see significant declines.
Alternatively to monetizing debt, we can raise interest rates to attract lenders to the market. Let’s say we get to the 20 year average of 7.5%. That means 7.5% of 200% of GDP, so 15% of GDP. Well we’ve already stated that total tax revenues equate to about 17% of GDP. This means total debt service will eat up virtually every bit of tax revenue, again leading to massive deficits so even more debt will be required to cover all other expenditures. That leads to more borrowing and worsening balance sheet metrics requiring even higher interest rates. And so we can see very quickly this alternative also leads to a downward spiral. Further, we see that under both scenarios of monetizing debt or incentivizing lenders, a debt driven economy will result in endlessly rising deficits requiring ever more debt. There is simply no way to escape the need for ever more debt once you get locked into this economic catch 22. The CBO quite rightly projected this to be the case for the US.
The alternative to a debt led economy is organic growth. Meaning we find a way to create value from investing in human and fixed capital. We innovate, increase productivity, improve efficiencies and create value. The end result is income growth. And it is the next decision that is of particular importance as it either makes or breaks the economy. What I mean by that is we can take that earnings growth and move it outside of the economy into financial investments or we can put that money back to work inside the economy. If we choose to move those gains into financial investments we forego any hope of economic growth. That is, we begin a cycle of narrowing income distribution.
As I’ve discussed many times recently, below a certain point of income distribution there is nothing that can be done to boost economic growth. That is, no amount of money injections, no duration of costless borrowing, absolutely nothing other than widening the income distribution will prevent economic implosion. And I believe that is exactly where we are today. We’ve printed trillions upon trillions while keeping borrowing costs at zero for 6 years and we are yet to get back to 3% economic growth. The shocker is going to be when economists catch on that 3% growth is no longer sufficient given the doubling of our debt. Like you or me, if we double our debt levels are annual 3% raise no longer covers the bills.
Private fixed capital investment has been deteriorating for at least 15 years now and continues. The past 6 years have been notably devoid of capital expenditures. The effects of that have and will continue to manifest through poor employment and further declining real median incomes. That results in further demand deterioration and again, here, we see another ugly downward spiral. Since the effects of capex are lagged we are yet to feel the real impact of the massive reductions to private investment here in the US but we will begin to over the next several years.
I guess what I’ve been trying to get across to everyone over the past month or two in my writing is that this all time high market has absolutely no positive impact on the economy whatsoever. The reason I would suggest is because secondary financial markets are actually outside of the economy. They are entirely irrelevant to the health of America. It certainly is making some rich folks richer. And that’s not a bad thing on its own. However, it has created such a devastating misallocation of resources within our economy which had already lost any sense of the economic efficiencies we boast of from the 1990’s. And it is because of these misallocations that the American consumer has suffered. We’ve masked the problem of deteriorating demand by flooding consumers with debt but all we’ve done is to cannibalize future consumption while burying and already struggling consumer in debt. Compounding this problem over the next 30 years is an increasingly difficult demographic landscape in the US with the baby boomers moving from net payers to net payees.
Where does this leave us? Well in a very bad spot. We have the information right before us that essentially spells out the end of American economic prowess. The info isn’t from some obscure source, it is the Congressional Budget Office projecting such things. Now in order to avoid panic, the CBO isn’t going to say it like I am that such projections are not survivable. But one who understands the projections understands the implications. However, as did the congressional finance committee members, Americans are unwilling to accept the fact that we are facing an incredibly precarious economic landscape going forward. And our policymakers have done everything in their power to exasperate the problem.
I expect being America has created a moral hazard for all Americans in that we feel we always have a fail safe no matter what we do because we’ve always succeeded. But so too had every other great dynasty until it didn’t. If we do not force a change in our economic policies we are very close to and perhaps already past the point of no return. I have no witting quip to end this article. The economic landscape we face today is nothing short of dire. And at the risk of sounding overdramatic we either force a policy change, suffer the short term pain and restructure or we and all future generations will live in a very different America from the one our folks left us. And that my friends is what, as teenagers, we would have called the balls-out-truth back in my small Canadian hometown.