It’s easy to get lost in numbers so large that your calculator simply runs out of space to display them. Hey, maybe that’s why almost nobody in Washington seems to understand the basic financial problem that we are facing.
A good example of this was provided by an article passed along by my brother yesterday (see it here if you want), which asserts (yet again) that our debt problem is nowhere near as dire as that faced by Greece. While it is true that there are fundamental differences between the American and Greek situations, the bottom line is still the same.
In a nutshell, Greece is in crisis in large part because their creditors want a higher rate of return on their loans. It really is that simple. Yes, of course, they do have a spending problem, but their death knell is being sounded by the credit market.
As it would be for any debt-swamped household, it’s merely a simple business decision on the part of their bankers. Lenders charge interest rates that are intended to: a) reflect “real” returns (i.e. greater than the rate of inflation), and b) reflect the risk of default, whether real or imagined. When you’re in over your head, your bank will charge you more (just before cutting you off altogether).
So, today, 10-Year Greek bonds are selling at a price that reflects a yield rate of roughly 17%, up from 9% or so in November of last year after the bailout plan for Ireland calmed the market down a bit. But, how quickly things can change in the world of revolving debt. And, when you’re financing with short-term money, that’s pretty much what you’re using.
For comparison, US 10-Year treasuries are currently selling at prices that correspond to a 2.9% yield, a rate that must be understood to be “artificially” low. By that, I mean that these yields are not being set by the market. Rather, they are being set through collusion between the US Treasury and the Federal Reserve, who has become the largest buyer….using freshly minted (and, therefore, significantly devalued) dollars.
As you might guess, this arrangement, is temporary at best. Greece, being a member of the European Union, can’t (by itself) take this approach. But, even if it could, the market would – eventually – repudiate it too, as it will with the US at some point in the near future. Why? Well, simply enough, if the only means you have of raising money is to (in effect) print it up yourself, you have done nothing other than to: a) devalue the existing money supply and foster inflation, b) artificially inflate (and misrepresent) your real income, and c) undermine the value of the bonds already held by your lenders.
Simple, really. Actually, you could say that there is really only one reason that the Fed is buying US debt. The real purpose is to forestall, avoid, and pretend that the value of our bonds isn’t quite a bit lower than they’ve been represented to be. And, this is critical. Without this little charade, the market would insist on higher yields and, as the Greek drama clearly demonstrates, that creates a whole new set of problems.
As amply studied by scholars Reinhart and Rogoff in their seminal work “This Time is Different“, debt becomes a problem when it is large enough to trigger a cascade effect of rising interest costs (among other risks). This happens whenever demand for that debt is simply overcome by the supply of it on the market or, of course, when that supply is also growing so fast as to give the lender reason to suspect the borrowers ability to repay it. And, when the borrower is able to simply print up the money to repay those debts, well, that’s a whole new kettle of fish.
Reinhard and Rogoff’s study indicated that this triggering threshold is typically in the range of 90% debt to GDP. Thus, while Greece (and several other nations) have a bigger debt problem, our own 100% debt-to-GDP ratio is still beyond that critical threshold….and rising, rather rapidly now, at a rate north of 12% per year. But, let’s take a quick look to see why it is such a problem.
Whether or not this is an over-simplification, let’s just try to put the huge numbers of our income, expenses, and debt into a more manageable “household scale”. The following numbers reflect the current (2011) US Federal OMB data on a “per household” basis.
Note: US Households estimated by linear trending to approximately 130 million, from the latest (2009) data from the US Census.
OK, then, here’s a quick review of these figures. Our average “federal household”, as it were, “earns” roughly $16,700 per year, spends roughly $29,300 per year, and owes roughly $103,800.
The annual interest on this debt is approximately $1,600, with an effective interest rate of only 1.5%, which is kind of like the teaser rate banks will give you to sign up for their credit cards, just before they raise those rates. As noted above, one reason these rates are as low as they are is the fact that we’re printing up the new money to lend to ourselves….something the average household can’t do, obviously. So, while we’re flooding the market with our supply of debt, we’re also providing the money needed to buy it.
Another reason these rates are so low is the fact that most of this debt is of relatively short duration, with the current average maturity date in the range of 70 months or a little less than 6 years. This is a two-edged sword, as they say, since it rolls over frequently enough to respond to near-term changes in the market rate. Naturally, that’s the reason short-term debt commands lower rates; the risk of interest rates rising in the future is reduced over a shorter period of time.
Now, the real question is what rate would (or should) we be paying if the Fed weren’t printing up new money to help buy all this debt? Well, as stated earlier, most (intelligent) investors require rates that are, at the very least, modestly higher than the rate of inflation. We like to call that a “real return”. Otherwise, you might as well just store your cash in your mattress.
Given the (rather dubious) CPI data (calculated, in this case, by the borrower), that threshold would normally be at 3.6%, based on the past 12 months inflation. So, providing a “real return” on an investment of average maturity (say 10 years) US Treasury debt should, very probably, require rates nearer to or even above 5% or so.
As you can see in the above calculation, this single adjustment to our collective interest costs would, in of itself, increase that particular line item by a factor of 3, from roughly 9.5% of our current “income” to roughly 31%. It would also increase the current annual deficit by a corresponding amount…in this case another $3,600 per household. In the real world, this would be closer to $470 billion, ratcheting up our current projected budget from $1.65 trillion to $2.12 trillion.
More worrisome, of course, is the growing evidence that the 3.6% CPI inflation rate is, shall we say, completely and utterly bogus. Think about this for a moment:
We’re currently borrowing, printing, and spending a $1.65 trillion annual federal deficit. This spending, as you may or may not know, is included in our annual GDP. That’s right. The more money we “create” in this fashion, the more supposed “growth” we can point to. Were it not for this practice, our GDP would be correspondingly smaller.
How much smaller? Well, about 12% smaller. Our “friends” at the BLS and the OMB tell us that our GDP is now, in 2011, estimated to be roughly $15 trillion. So, subtract that $1.65 from that and you get $13.4 trillion, which we might conclude to be closer to the real size of our “sustainable” economy.
Now, it’s interesting to note that this $15 trillion represent an increase of $571 billion larger (3.9%) over 2010. But, of course, our deficit spending also grew by $351 billion over the same period, accounting for roughly 60% of that increase. This would suggest that the net increase in productivity was actually only $220 billion or 1.5%. Being well lower than the (bogus) rate of inflation of 3.6%, we ought to conclude that our “real” (inflation adjusted) GDP is still shrinking, probably by 2% or so per year.
What’s that, you “creative types” might say, “why not just double our annual output by printing up $15 trillion instead of a measly $1.6 trillion?” Well, it seems that Keynesian weasels like Paul Krugman might think that’s a good idea.
But, here’s the problem. All of this deficit spending (and associated money printing) is exactly where inflation comes from. It’s likely true that some portion of that “new” pile of money would actually end up paying for the production of real goods and services. But, in actual practice, most of it is simply redistributed to the government’s “favored” constituents, whether they are bankers, unions, or defense contractors. In most cases, this is money that is merely distributed to shore up all of the various interests for which the “real economy” has no legitimate use.
And, as an added bonus, the rest of us (you and me), get to bid against these lucky lotto winners in the real marketplace for whatever goods and services we actually need, say food, gasoline, electricity, and housing. While they get spanking new checkbooks with large balances, we get to bid just with the few paltry dollars we’ve managed to earn, and after paying our taxes, managed to save. And, that, my friends, is but one one reason the price of tea (and gasoline) is going up right here at home. Sadly, there are others reasons too, but let’s just keep moving here.
So, even if we were increasing the effective buying power in our economy only through our government’s deficit spending (of this $1.65 trillion), chances are pretty good that the real rate of inflation is very probably nearer to 12% or so. Why? Well, that’s roughly the present rate of the supposed “contribution” to GDP that’s coming from that deficit spending, that’s why.
When your government can’t balance it’s books, it necessarily consumes the savings of the nation and drives up interest rates, unless, of course, the Fed steps in to “normalize” those rates. But, hey, what’s the harm, right? Well, even a (Bernanke mandated) inflation target of “only” 2% compounds to 80% over 30 years and will, therefore, diminish the value of your savings by 45%.
In a nutshell, any sustained deficit spending is a problem. It will always get out of hand, increasing to the point we now find ourselves facing. And that point is that we’ve got a ficticious 12% slice of GDP being conjured up with all-to-real dollars that are, without question, devaluing the dollars in your wallet and creating a corresponding rise in the prices you are paying for the food and energy you need.
Hey, enough already, let’s wrap this up. As some very credible sources seem to believe, and as my own “simple math” would suggest, the real rate of inflation is almost certainly north of 10%. So, shouldn’t the real market be insisting that US treasury debt have correspondingly higher yield rates? Why, yes, the “real market” should be doing exactly that. And, eventually, they will, especially if/when the risk of default (either soft or hard) rears its ugly head in the market’s consciousness.
But, of course, that should have happened long before the Fed started buying all that Treasury debt. When they started doing that, it should have told anyone with half a brain that the jig was up. Printing money to buy your own debt is, in point of fact, a default on that debt, don’t you think? Yeah, I think.
So, referring back to my simple calculations above, if/when our government’s interest cost rise to say 15%, well, the math is what it is. Interest costs would become quite close to 100% of our current federal “income”. Don’t believe the teaser rate, a big surprise is coming in the mail soon. And, yeah, go ahead and watch how much fun the Greeks are having with this exact problem.
Afterthought: All of the above, of course, ignores a rather wide range of other factors, notably the rate of growth in our various entitlement costs and, truthfully, the fact that GDP is, in my opinion, still shrinking. Bottom line: our budget is growing more rapidly than our income, regardless of the interest carry issue. As a single risk vector, however, this one is still rather significant all by itself.