The Sunset of Federal Government Guarantees

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Our federal officials have passed laws that guarantee an incredible variety of debt and debt-like obligations. The amounts run to 50—100 trillion dollars or so. If events occur such that they have to pay off a cluster of these guarantees, they cannot do so. They can pay off in paper but they can’t pay off in terms of real assets.

This means that federal government guarantees are not worth the paper they’re printed on. This fact has not yet been brought into the public consciousness. Most people still believe that government guarantees mean something. Correspondingly, outgoing President Bush and incoming President Obama are maintaining this fiction.

The guarantees cannot be honored without extracting real resources from the American people. A guarantee to pay the hospital and doctor and medicine bills for retirees requires actual medical services.

At some point, it will become necessary to guarantee failing pension plans, income, Medicare payments, mortgage payments, bank deposits, student loans, commercial paper, insurance policies, jobs, unemployment payments, old age payments, and much else, all at the same time. People will question the worth of shifting massive resources from one set of pockets to another set of pockets. They will see that the government guarantees nothing. It recycles resources it extracts from us back to us. This realization will mark the sunset of belief in federal guarantees.

A true guarantee has to be funded in advance by contributions. Suppose you wish to guarantee (insure) that when you die, you leave enough money to be buried so that you do not burden your relatives. You may form a burial society with others. You each contribute some amount per month. This creates a fund. If someone dies, the fund pays the burial expenses.

Most of the government guarantees have no such funds, and those that do are small compared to the amounts guaranteed. There is no Social Security fund, for example. All money paid in has been paid out already.

In a relatively short period of time, perhaps in the period 2012—2015, the U.S. will face so many problems that these empty guarantees will be impossible to honor. At that point, the system of guarantees stands a good chance of collapsing altogether. That will be the sunset of federal guarantees. They will be buried.

Naturally, this prediction has a wide margin of error. I make it, less to be a seer who is predicting the inevitable, than to focus attention on these guarantees.

When the system collapses, there will be a great deal of turmoil. In trying to save that system, the government will probably create even more turmoil and heartbreak.

But these guarantees have already caused very great suffering by changing incentives. The savings and loan industry failed in the 1980s. This could not have happened without the government guarantee of savings deposits in these thrift institutions. In conjunction with other policies that weakened the policing of malfeasance, the guarantee provided an incentive for bankruptcy for profit. A substantial portion of the S & L industry went into a phase of wrongdoing, abuse by company officials, and fraud. This ended up costing taxpayers at least $150 billion.

The recent financial troubles of a number of financial institutions resemble the S & L case in a number of ways. As time goes by and we learn more, we will discover that an important contributing factor is federal guarantees, and that they have again induced abuses that are very costly to our well-being.

Former Senator Fred Thompson recognizes the dangers of federal guarantees. I quote:

"The system induced borrowers to take on financial obligations they could not afford and lenders to lower lending standards. Fannie and Freddie went along because their managers’ compensation depended on the firms’ short term financial performance. And investors continued to buy complex security packages they didn’t understand, because the securities were viewed as government-backed. Heavy campaign contributions by those benefiting from this scheme induced Members of Congress to avert their gaze from the ugly mess that was unfolding.

"You’d think we’d have learned by now: when the backstop of the federal treasury makes it easier for politicians, lenders, borrowers, welfare recipients, government contractors, or anyone else, to serve their own self interest at the expense of the taxpayer, many will do just that.

"That is why we continue to see self-dealing, moral lapses, outright fraud and lack of management and oversight in a wide array of programs and government-sponsored entities, from housing to Medicare, education and the Small Business Administration, all costing taxpayers billions, even trillions of dollars."

Our officials, of course, pay no attention. They play the same tune on their fiddles while the country burns. Without missing a beat, they are replacing Fannie Mae and Freddie Mac with the Federal Housing Administration. Its mortgage guarantee growth is astounding.

President Obama and his administration now are attempting to guarantee the entire economy of the United States. He promises trillion dollar deficits this year and for "years to come." He brings the sunset of federal guarantees closer.

My guess is that this is the last go-round. The stimulus that debt brings to the U.S. economy is on a long-term downtrend. See here for a fascinating graphical view. The last recovery was weak, and the next may be weaker still.

The time is nearing when a cluster of demands will be placed on government that it is entirely incapable of meeting. The American people will turn away from government-as-they-know-it and necessarily seek alternatives. When that time arrives, I hope that they abandon their long-held model, which is Government as Guarantor. This model has never worked. It has always caused negative effects that people overlooked as they attempted to shift the cost of guarantees (insurance) onto others and away from themselves.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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