I recently found myself watching Janet Yellen’s inaugural panel hearing in front of the congressional finance committee members (yes I catch Cspan now and again, zip it). 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 now known as Janet Yellen. 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’m certain I saw glimpses of a recognition that problems are on the horizon, at least from Ms. Yellen.
The most notable commentary from Janet was her fairly forthright perspective that the now infamous CBO forward guidance on growing deficits report depicts an imminent problem for America. What caught me a bit off guard was how easily the congressional members shrugged off the repetitive warnings from the good 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 as something that may be acknowledged but certainly nothing to focus on. The one person in the world who is entirely mandated by her shareholders to continuously increase leverage to the US is warning the US congress to get its fiscal house in order. Yet the congressional committee before her completely missed the message altogether. Truly unbelievable. So let’s you and I take a look at what our dear friend Janet was banging on about.
The CBO is projecting a growing deficit gap between US revenues and expenditures. In fact by 2038, in the very best case scenario the CBO could theorize suggests that we will have a budget deficit of approximately $1.5 trillion and debt held by the public will grow to 190% of GDP. Currently total debt exceeds GDP by a few hundred billion. This brings up an interesting point. We recently realized a very important moment fiscally speaking. When total debt surpassed total GDP. This happened so quietly that if you weren’t already aware it was going to happen you may have missed it altogether.
So what does it matter when total debt surpasses total GDP? Well the same way your folks taught you as a kid the delights of compound interest in your savings account the compound interest against total debt moves up exponentially. Let’s review the basics of an exponential function. It is quite flat (horizontal) for a period of time but as time goes by the slope of the line steepens and at an accelerating rate. That is it curves from a horizontal to vertical slope or line and at some point it does so very quickly. The real downside to total debt is that it must be serviced. And by serviced I mean we pay interest on that total debt. For many years the interest rate as it pertained to our ability to pay the interest on total debt was immaterial. Meaning that when total debt was a very small fraction of the nation’s total income each additional interest point had a very small impact on our ability to service our total debt. If I make a million dollars a year and I’ve borrowed a hundred dollars that I owe 3% interest on I really don’t get nervous if the interest moves up to 8%. However, if I choose never to pay down the hundred dollars and in fact spend all of my million dollars income before I pay the interest I have to borrow additional funds now to cover the interest I didn’t pay with my income. So now my hundred dollars of debt increases to $103 of debt. Given the same behaviour next year I must borrow so that my total debt increases to $106.09. You can see that given a long enough period of time with this behaviour my amount borrowed will reach one million dollars. The significance of total debt equating to my total income (or total GDP) is that now the interest rate on my debt exactly matches the percentage of my income that is going to service my debt. At this point (and really much before this point but this is a psychological moment of realization) I become very concerned with each additional higher move in interest rate. The same 5% increase that didn’t concern me at $100 of debt now has me freaking out because it increases the percentage of my income going to service my debt by 167% just based on the interest hike. The reality is that as the compounding was taking place the amount of my income going to service debt moved from $3 to $30K. The obvious answer here is that you would NEVER let that happen so this is just one of those idiot thought experiments of which you are so fond, right?
Well unfortunately it’s exactly what’s happened in the US. Last year we saw our total debt reach the level of total income somewhere around $16.8T. Fortunately we had a credit crisis of some proportion which handily led to a severe easing of monetary policy whereby interest rates will now be held at the lowest rates ever and will remain there for the foreseeable future if the Fed has anything to do with it. Our average interest rate on total US debt since 2000 is around 5.7%. Since 2008 the Fed has driven our average rate down to its current 2.3%. Again the difference seems only a couple percent, however, when taken into context of total income it means we only pay 2.3% of our total income to service our debt as opposed to what would be 5.7% had the Fed not driven interest rates down. But hey 2.3% or 5.7% both are still pretty low percentages of total income right?
Well herein lies the unspoken problem. The experts like to peg debt to GDP (total income) because GDP theoretically could be taxed at 100% and so the government theoretically could use all income to cover its debt service obligations (interest). There is little point going into the absurdities of that scenario. So what really is the government’s income from which it can service its debt if it’s not GDP? The government must service its debt not from GDP but from total revenues (taxes on income). Total revenues are about 23% of GDP this year and so now we see the 2.3% of total income is actually 10% of total revenues available to service debt. Taking the 14 year average interest rate of 5.7% the government would be paying about 25% of its total revenues to cover interest on its debt. It becomes glaringly apparent now why interest rates must remain low for as far as we can see into the future. The problem becomes a loss of control of interest rates. The Fed can manage short term rates but will have an incredibly difficult time managing long term rates as the total debt reaches far beyond GDP. By 2038 our fiscal house could easily drive interest to those double digit rates we saw in the 1980′s and total debt could double. If you don’t fancy that scenario not to worry I’ve a more likely one for you. Prior to 2038 I reckon we’re handed the straw that breaks Uncle Sams’s back when the Chinese begin purchasing commodities in non USD notes, which will collapse global demand for USD driving long term rates to all time highs and then it’s goodnight and good luck (I will talk more about this scenario another day). So dust off your Dark Side of the Moon LP, set the needle to B side, pour yourself a bloody mary, kiss your wife and watch the sunset while the world still smiles back at you. But don’t be the fool to think this goes on forever. It cannot and will not and if you know that then perhaps there is time to get this train back on track. The issue very much is being left up to you and to me. Giddy up JG…