I wanted to move on from our last discussion but I’ve had a few people ask me to dig a little deeper into the ‘imminent’ problem that our Fed chair was so diligently attempting to bring forth to the attention of the zombie congressional finance committee. If you haven’t read the first part of Money Woes you might want to do so before reading on here. So after a bit of research using sources available to all and a bit of number crunching I was able to determine the following…..
We are so puckered. And that’s basically paraphrasing the actual CBO report.
And here’s why. 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 certain policy changes will be made and these potential changes will have assumed (positive) economic consequences. Eventually they get to some forward guidance that may or may not be accurate but doesn’t put the country into a panic whilst also providing some underlying point. I think someone at the CBO really dropped the ball on this one though because the report actually should have brought the country to a panic. Despite the watered down direness of things it still sounds apocalyptic, like it was pulled from revelations. But the reality is that things may be even worse.
Using just the historical trends to guide us through the future of total debt and GDP and even making some adjustments in favour of our future to dilute some of the negative impacts of the past 5 years (as I know many of you patriots will say “but the last 5 years are not typical”) we regardless get to 2038 levels that seem unfathomable. And let me just say that the past 5 years are not that irregular if one goes back through time. The difference is we may have crossed that point of no return as debt sets off to dwarf GDP given the exponential nature of its growth and the fact that we as a nation do not appear concerned running continuous budget and trade deficits. Ok ok so what are the numbers?? Well do you want the good news or the bad news first??
Let’s start on a positive note. By 2038 GDP could grow to over $31T. The bad news is that total debt will likely grow to $96T. So let’s take a closer look at these figures. The CBO indicated total debt could be as much as 190% of GDP, however, if we don’t assume any miraculous policy changes (remember there are policy changes over time and the historical figures inherently have the effects of all the various policy changes overtime imbedded within them) we see that total debt will actually be somewhere around 300% of GDP. The one caveat I may be willing to concede is that I’m not sure there will be any demand for our debt beyond 190% debt to GDP and so maybe it does stop there. Now let’s go over again why this is a bad thing. Remember we have to service this debt. So let’s say conservatively interest on debt by 2038 is the current 40 yr average of around 7.5%. Let’s also assume the government continues to take 25% of GDP as revenue by way of income tax (the problem with increasing the tax rate is that you stifle GDP and we didn’t adjust for that as we wanted to keep GDP growing as much as we could reasonably assume). The math here is quite simple now. The government will generate 25% of $31T (GDP), so around $7.8T, which is what will be available to service debt and all other government expenditures. The debt service we said will be 7.5% of $96T (total debt), so around $7.2T. This means that by 2038 the US will have an interest coverage ratio of 1x. Here is where the assumptions tend to break down. At what point do US Treasuries no longer represent risk free assets? And how do we price Treasuries and other bonds at that point?
The reality is at some point the rest of the world will not consider US debt as risk free and when that happens there will be a material upward shift in what the US is forced to pay in interest. So the 7.5% is not a realistic rate by 2038 if we continue on course. Given current risk free rates and current spreads on corporate debt with interest coverage ratios of 1x we would be paying at least 11.5% interest. However as US Treasuries become riskier the risk free rate will move up as well. Let’s assume the current 40 yr average will be the risk free rate and so given the spread we’re looking at 15% average interest on total debt by 2038 (even that assumes the spread value doesn’t increase so this is a very best case scenario). That would result in debt service of 15% of $96T, so around $14T in interest. So given the numbers and letting the historical trends guide where we will be given where we are, we truly might be dead in the water. These are real models derived from actual historical data and current fiscal condition. This was not done to make some scary stress test worst case scenario I could possibly come up with for dramatic effect. I simply ran the numbers and this is what they are telling us. And this is what the CBO and the Fed too are telling us. And yet still we have no major US media outlets spoon feeding us this dire reality. Nope they just continue telling us the markets are great and profits are at all time highs. Nor can the Fed chair seem to shake our zombie legislators of their thirst for additional monetary easing and fiscal stimulation. The legislators prefer us suckling at the teat and the media will make sure our lips are firmly attached. While we are distracted filling our bellies with our children’s future there are those that are accumulating extraordinary wealth from our current policies and one can hardly blame them except for the fact that these great accumulators are pursuing our policy makers for such favourable policies as only those with extraordinary wealth can do. Well I don’t know about you but I am ready to seek my next teat so I say to you, as goes our debt, onward and upward to you all.