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.
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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.
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.
The 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 Kotlikoff 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.
Geithner's 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.
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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 afloat.
Therefore, 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 equal.
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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 metals.
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.
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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.
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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 yet.
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.
Furthermore, 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.
For 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 situations.
Unfortunately, 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.
January 10, 2011