• Geithner Says U.S. Insolvent

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    The U.S. government
    is insolvent. Who says so? Timothy F. Geithner, the U.S. Secretary
    of the Treasury.

    Geithner sent
    a letter to Congress on Jan. 6, 2011 asking for the debt limit to
    be raised. If it is not raised, he warned, the U.S. will default
    on its debt. In
    his words

    Never in
    our history has Congress failed to increase the debt limit when
    necessary. Failure to raise the limit would precipitate a default
    by the United States."

    He didn't say
    that the government will be inconvenienced. He didn't say that the
    government would be forced to muddle through by delaying payments,
    raising taxes, and cutting non-obligatory programs and services.
    He said the government will default. This means that the
    government doesn't have enough cash to pay its obligations to the
    many and sundry persons to whom it owes cash unless Congress
    authorizes an issue of even more debt.

    After the government
    issues the new debt, its overall debt will be even higher than before.
    Unless its obligations that require cash payments are reduced, or
    unless it finds new sources of revenue, or unless the interest rates
    that it pays decline, the same situation will surely occur again
    and occur even faster because its overall debt will have risen.
    It will run short of cash to pay its obligations.

    Suppose that
    you had a debt of $10,000 that required a payment of $500 in order
    to stave off your creditors' seizing your assets. Suppose that you
    didn't have the $500. One way out would be to borrow $500 from a
    new lender and use that $500 to pay off the old lenders. That buys
    you time. However, now you have debts of $10,500. You have to find
    ways of lowering this or else you will again be faced with an even
    worse situation.

    You are approaching
    insolvency when you begin to run out of new lenders who are willing
    to add to your debt. The willing lenders dry up because they know
    that they have to get in line to get their promised payments while
    you continually seek out new borrowers, all the while making your
    situation worse and worse.

    Knowing their
    precarious position, the new lenders are likely to demand rising
    default risk premiums.

    That means
    they demand higher interest rates.

    That means
    your cash payment obligations go up. That hastens your approach
    to insolvency.

    occurs when you cannot find enough cash from any source, even new
    lenders, in order to make required payments.

    The U.S. is
    approaching insolvency, according to its Treasury Secretary. He
    didn't put the matter in precisely that way, but he put it in words
    that are as close as you can get to it. He said that the U.S. would
    default, and its only way out at this moment is to issue more debt.

    increases in the debt limit
    have necessarily accompanied the
    increase in the government's overall debt. Those increases have
    been especially astonishing in the last 10 years. The ceiling is
    now $14.29 trillion. The ceiling was $5.73 trillion in September
    of 2001. That's a growth rate of over 10 percent a year.

    A few months
    back, Laurence
    wrote that "The U.S. is bankrupt." Using
    the government's numbers properly labeled, he found that the U.S.
    fiscal gap, which is the difference between the present value of
    projected spending and revenues, is $202 trillion. An IMF study
    of the U.S. finances found that it would have to double taxes to
    close its fiscal gap. This is an impossibility. It would destroy
    the struggling economy.

    statement confirms those of other analysts outside of the U.S. government.

    According to
    Kotlikoff, the government's sixty-year "massive Ponzi scheme"
    will end when there are not enough revenues to pay for Social Security,
    Medicare, and Medicaid. He sees large benefit cuts, large tax increases,
    and high inflation ahead when the government seeks to survive.

    How will the
    U.S. extricate itself from this situation? That's a matter of speculation
    because there are many interacting variables involved. There are
    lots of ifs, ands, and buts.

    When a state
    cannot meet its promised obligations, there is no bankruptcy code
    to guide a reorganization, as there is with a company. There is
    no court to oversee a restructuring. There is no judge or panel
    that decides on the priority of claims. Instead, the government
    itself decides how to handle its inability to pay cash to fulfill
    its promises.

    In the immediate
    future, the U.S. government will not default on its bonds. They
    will have priority of payment. The reason the government will do
    that is to maintain its capacity to borrow at reasonable rates of
    interest so that it can maintain its size and programs. If the government
    defaulted on its bonds as a way of solving its financial problem,
    it would have immediately to cut back its spending severely. The
    government would shrink radically all at once. The government would
    take a big bath. Congress doesn't want to do that. It would rather
    stretch out the default process and inflict the pain over time and
    among more groups than bondholders. Congressmen prefer to maintain
    themselves in power while managing a large government. Other branches
    and bureaucracies also prefer to keep their pet programs and activities

    as usual, Congress will raise the debt limit again. That doesn't
    end the financial problem. It adds to it even as it postpones and
    enhances possible insolvency.

    The new lenders
    that the government seeks out to lend it new cash are likely to
    demand higher interest rates, except for one major lender, which
    is the Federal Reserve System.

    Bond yields
    are subject to numerous worldwide influences. They include the default
    risk premiums demanded by foreign lenders, including Asian central
    banks. Those risk premiums are likely to rise.

    In contrast,
    the Federal Reserve has committed itself to buying $600 billion
    of new government debt in the next few months. Its purchases tend
    to support bond prices and keep interest rates down, other things

    As the Federal
    Reserve keeps buying more and more government debt, with no prospect
    of reducing its holdings unless and until the government gets its
    house in order, bond yields are likely to rise, despite Fed
    buying, because yields also reflect inflation premiums. The prospect
    of inflation will rise as the Fed monetizes the debt. We would then
    see yields rising accompanied by firm prices of commodities and

    The inflationary
    participation by the Fed, which postpones the inevitable fiscal
    decisions of the government, harms all holders of fixed-dollar assets
    and all those whose receipts of dollars are fixed and lag behind
    the Fed's production of new dollars. In addition and more importantly,
    the inflation sets in motion another boom-bust cycle.

    Continued debt
    monetization by the Fed is quite likely for many reasons. One is
    that the Fed can act even when Congress is deadlocked. Another is
    the apparent necessity, in the Fed's view, to avoid the failure
    of government debt issues. A third is that the Fed rationalizes
    what it's doing by economic slack and low headline CPI inflation.
    Fourth, the banking system is still insolvent and the Fed wishes
    to raise asset prices. Fifth, the Fed doesn't connect its debt monetization
    to higher yields. When it starts to make that connection, either
    directly or because headline CPI inflation rises, then it may be
    more likely to alter its current policy.

    If the U.S.
    does not decrease the fiscal gap, rising yields will rapidly force
    it into taking action because rising yields raise the likelihood
    of insolvency and raise the likelihood of its occurring sooner rather
    than later.

    The effects
    of the Fed's inflation on stocks vary by individual company. They
    depend on the net monetary positions of the companies, the nature
    and location of its operations, its hedging, and other factors.
    There is no simple prognosis for the whole stock market.

    Since yields
    are likely to rise as lenders demand higher default risk premiums
    and as they demand higher inflation premiums (when the Fed monetizes
    debt), with the Fed's ability to keep rates down only a temporary
    and/or only a restraining phenomenon, and since these yield increases
    hasten the prospect of insolvency, the government can only avoid
    default by either slowing down its borrowing (and spending) or by
    raising revenues. Doing nothing means it will default.

    If government
    borrowing slows down, its spending will have to slow down. Many
    Americans will find this very unpleasant as benefits, now and prospective,
    are cut, and as various other programs are cut. If government raises
    taxes, the impact of its gargantuan borrowing will come home to
    Americans, again in a most unpleasant way. Their disposable incomes
    will fall sharply.

    Outright default
    on U.S. bonds is not in the cards because that immobilizes the entire
    U.S. government. The government won't do that. It will look after
    itself and its own survival first. The American public comes last.
    Default upon promises made to Americans is the more likely course
    of action.

    Thus, the government
    will slow budget increases, or stop them altogether, or cut its
    spending in absolute terms. Like any borrower, its borrowing capacity
    is not unlimited. Its borrowing capacity depends on its taxing power
    which, in turn, depends on the productivity of those whom it taxes.
    Causation runs in both directions. The productivity also depends
    on the tax and regulatory structures. It's inconceivable that the
    government could double taxes. If it did, most of the economy would
    attempt to go underground. Whatever remained above ground would
    have vastly reduced incentives to produce.

    Which groups
    and programs will be the object of government cutbacks? That is
    again a matter of speculation. It depends on which groups have the
    firmest control over the government's purse, which groups make the
    largest protests, and which groups have the greatest influence on
    votes for key Congressmen and campaign contributions. I agree with
    Kotlikoff and Gary North that the most likely targets are the largest
    ones, and they are the social welfare programs.

    Some groups
    are going to experience the brunt of the actions taken to avoid
    default. Others are likely to go relatively unscathed. Government
    bureaucrats will try to protect themselves. This is going to create
    domestic conflict, protests, and dissension. Life is going to be
    much harder for Americans in the future, unless increased productivity
    from some unknown sources of invention or technology offsets the
    impact of government promises that are going to be defaulted upon.

    Congress has
    another option, which is to seize the assets of Americans. This
    is a form of taxation. Congress can force pension funds to take
    its bond issues. This would force down the prices of corporate stocks
    and bonds. It would devastate the economy. A large-scale program
    of bond cram-downs is almost tantamount to making the Fed absorb
    bonds. It puts pressure on the Fed to create more money so as to
    keep asset prices up. Such a program would be an act of desperation
    by the government that simply beggared the population. It would
    certainly not resolve the insolvency.

    When, if ever,
    will Congress start to act in size, that is, with cutbacks large
    enough to avoid defaulting on its bonds? My answer is this: Not

    The prospect
    of rising yields is not yet felt in the minds of those in government.
    The prospect of a budget out of control due to a huge and rising
    bond interest payment obligation hasn't yet hit home among government
    officials. They can't see the tidal wave. They don't believe it's
    coming. The Fed's purchase program is obscuring their vision. The
    slow economy is helping to hold down bond yields for the moment.
    The foreign central banks, as a group, are still supporting the
    U.S. bond market. People who are afraid of going back into stocks
    are still supporting the U.S. debt market.

    the two parties are both enamored of big government. Nearly all
    politicians are sensitive to public demands for free lunches. That
    is one reason why the fiscal gap is so huge in the first place.
    America did not exactly fall all over itself in trying to stop a
    prescription drug benefit. Consequently, the government is postponing
    actions to close the fiscal gap.

    One fine day,
    there will be a discontinuity. There will be a many-sigma event.
    There will be a fiscal earthquake or a market earthquake or some
    combination of both. This will not be a pleasant experience for
    Americans, but those in government have little reason to fear it.
    They can label it a crisis, as if we do not already have a crisis.
    They can use such a "crisis" as the excuse for more radical
    government action. The government can demand even more power or
    simply exercise it, even if the results are to make matters worse
    for Americans.

    governments, crises are opportunities, a fact well known among analysts
    of government. This fact is one reason why governments postpone
    taking actions to remedy what appear to the rest of us to be bad

    the fact that governments batten on crises and see them as opportunities
    is not well known among the general population which still looks
    to government to handle crises.

    Since the insolvency
    of the U.S. is a fact and a fact that implies hard times ahead for
    anyone who depends on government, it is prudent to take measures
    to make oneself as independent of government as one possibly can.

    10, 2011

    S. Rozeff [send him mail]
    is a retired Professor of Finance living in East Amherst, New York.
    He is the author of the free e-book Essays on American Empire: Liberty
    vs. Domination and the free e-book The
    U.S. Constitution and Money: Corruption and Decline
    and the
    free e-book Essays
    on American Empire

    Best of Michael S. Rozeff

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