INTRODUCTION
If the US Government were a family with a $100,000 income, it would spend $172,000 per year and have a $650,000 mortgage. To finance this lavish lifestyle the US is accumulating an unprecedented level of debt. This does not include future entitlement obligations, which dwarf these numbers by orders of magnitude. As with any family or business that holds too much debt, eventually creditors will be loath to lend more and will demand higher interest rates, or simply stop lending. This reflects the diminishing likelihood of being paid back as the overall debt level increases. Mathematically, there is a point where debt interest plus basic obligations can no longer be met with any reasonable or sustainable tax structure. Without the US’s ability to print money, this would lead to federal bankruptcy. The US is not to this point yet, but we might not be very far. Before this point is ever reached, debt burden will begin to stifle economic growth, and this is happening currently. There are a couple reasons for this.
1. Dollars must flow to paying interest on debt instead of to things that promote economic growth and activity. If interest were 2% or 3% of federal tax receipts as the result of temporary stimulus, it might be defensible. The US is at nearly 10% however, and just 8-9 years away from 20%.
2. We hear all the time that “taxes will go up” or “taxes must go up” to deal with our obligations. To varying degrees, this will make long term investment opportunities less attractive for businesses because it will reduce their Net Present Value.
From a Risk Management perspective, heavy debt loads make organizations, businesses or government, more prone to crisis. If organizations do not have a financial cushion, or at least headroom for additional debt, an expensive crisis can turn in to a catastrophe. Heavy debt loads invite catastrophic outcomes.
Spending on regulatory compliance is not something that is a direct burden on government and taxpayers. It is a burden on business that is created by government. Regulation is not altogether bad. It is often needed, but regulatory requirements that are either too complex or too vague will lead to massive compliance costs or defensive business practices, respectively. Unless regulation is clear, fair and intuitive, it will dampen investment, innovation and economic growth.
Finally, sound money that won’t be intentionally devalued or debased is a cornerstone on which our society is built, right along with freedom and liberty. Citizens must trust our government to be stewards of our currency, which is the output of our labor, investment and human capital. Holders of our debt must also rely on our government to be responsible stewards of our currency, as the loans they have made to us are denominated in our currency.
In the following pages I will dive deeper into these problems and begin to investigate some solutions. In the conclusion I will summarize the solutions and review their positive and negative aspects.
Tax policy is beyond the scope of this paper. I will merely present a couple of staggering facts about the US tax code and the following quote from U.S. Representative Rob Portman (R-OH).
"The income tax code and its associated regulations contain almost 5.6 million words -- seven times as many words as the Bible. Taxpayers now spend about 5.4 billion hours a year trying to comply with 2,500 pages of tax laws...."
The Tax Foundation estimates that US income tax code has annual compliance costs of over $300 billion. Many estimates I found are higher. With US GDP at roughly $15 trillion, this is equal to 2% of US GDP.
DEBT, SPENDING AND FINANCIAL OBLIGATIONS, PUT INTO PERSPECTIVE
Many people are concerned about federal spending and federal deficits, but it is not always easy to grasp the full scope of the problem. The scale of the numbers is breathtaking, and difficult to visualize. $100 billion is a tremendous amount of money, but it is far less than 1% of total federal debt. Government budgeting is also very different than corporate budgeting. Government budgeting is an opaque and highly political process and is often compared to “sausage making”. There is also a lack of accountability in the budgeting process because the CBO (Congressional Budget Office) operates under the assumption that laws will be enforced as written, even when there is no political will to enforce budget provisions that save money. Due to the opaque nature of government budgeting, it can be very useful to think of government finances in terms of a family budget. It is something that most of us can relate to, even us imperfect souls who do not operate a strict family budget.
To begin with, let's think of family finances in terms of income, spending and debt. Normally I would also include savings, but unfortunately this isn't something that's relevant for our government at this time. Income is what comes in. Spending is what goes out. Debt is how we close the gap when more is going out than coming in. The same is true for the government except that they call income "federal tax receipts". For simplicity though, we'll just stick with income.
The federal government has quite a healthy income. It was $2.1 trillion in 2009 and $2.165 trillion in 2010. Very impressive. Even more impressive is the spending. It was $3.52 trillion in 2009 and $3.72 trillion in 2010. When the current administration took over, spending was $2.9 trillion. The size of these numbers is truly awesome, but when viewed in terms of income and spending, it's actually very simple. It is also fair to point out that during the eight years of the previous Administration, spending grew from $1.86 trillion to $2.98 trillion. In the following figure it is interesting to observe the gap between income and spending over the past four years.
FIGURE 1
Another important number is debt. At the end of 2010 this number was nearly $14 trillion. This is similar to a home mortgage. So, with an income of $2.16 trillion, and debt of $14 trillion, that means that the government's mortgage is six and a half times its income. That would be like a family with a combined income of $100,000 carrying a mortgage of $650,000, while also spending $172,000 per year. This is also a mortgage that gets bigger every year. By 2015, our cash strapped family with an income of $100,000 is going to have a mortgage of $900,000. Although the family’s income is projected to have increased by that time, the size of the mortgage is still growing ever larger, and an increasing portion of the family’s income will need to be spent on interest expenses. Currently, mortgage interest is equal to 9% of this family’s income. By 2020, this number is projected to reach 20% (2). Interest expenses will increasingly “crowd out” other kinds of spending and reduce living standards.
As bad as things are for this family when we look at their spending and debt situation, there is still more, a lot more. The best estimate for the cost of Social Security and Medicare obligations, represented as the present value of these future commitments, is $106.4 trillion. Here is what that number looks like. $106,400,000,000,000.00. This means that our hypothetical family, with 100k of annual income, 172k in annual spending, and a growing 650k mortgage, will also have to find a way to pay off another $5 million during the next 30-40 years. Think of it as a very expensive new roof.
Because it can be difficult to grasp the scope of the problem, politicians may try gimmicks on us. They may say "we're getting tough on spending and are trimming $100 million from federal spending". The White House tried this in April 2009 when there started to be alarm over stimulus spending. Let's put a $100 million spending cut in to perspective. For our hypothetical family with a $100,000 income, this would be the equivalent of cutting annual spending from $170,000 down to $169,995,41, or by $4.59. The family could buy a cup of coffee at Starbucks with their savings, probably even a latte, as long as it didn't have any extra shots and was one of the modestly sized ones.
Our family is obviously a little bit unusual. The head of the household is elected, and nobody wants to cut back on the goodies. Merely suggesting this could cost the head of household his job. His family has been the richest and most powerful family around for three generations. They feel entitled to the finer things in life, and want more. What used to be paid for with savings however is now paid for with debt, and there is increasing awareness that something isn’t right. Spending and debt are now being broadly identified as serious problems.
Before we move on, here are a few more numbers to better put things in perspective. Projected federal tax revenue for 2011 and 2012 is $2.57 trillion and $2.93 trillion. Projected spending in these years is $3.83 trillion and $3.76 trillion. The difference between inflows and outflows for these two years alone is about $2.1 trillion.
Something interesting about these numbers is that Federal Spending, according to projections from the US Government Budget, is forecasted to decrease very moderately from 2011 to 2012. I suppose this is possible, but this has never once happened during the past 50 years. Between 1960 and 2010, federal spending has never decreased. The following graph puts a finer point on the issue.
FIGURE 2
In 2015, projected spending and revenue are $4.39 trillion and $3.63 trillion. It is projected that by this time, the total federal deficit will be $19.68 trillion.
Continuing with the example of our hypothetical family with a $100,000 income, let’s imagine what the conversation might be like if this family were to apply for a loan. Following is a dialog that might occur between the United States and foreign countries that lend money to the United States such as like China, Japan and major oil exporting nations. In our imaginary dialog, let’s call the United States “Sam”, and the lending countries, “Mary”. Sam is applying for a loan to cover the difference between what he earns and what he spends in a single year. Keep in mind that although this dialog seems silly, the numbers are scaled accurately, although not to a high degree of precision.
Mary: Hi Sam, nice to see you again. We sure have gotten to know each other over these past 20 years
Sam: Thanks Mary, that’s nice of you to say. It’s always a pleasure to see you. You always make things so easy. Now, I’d like a $50,000 loan. You know I’m good for it.
Mary: Sam, the water is getting pretty deep here. Why don’t we just review some of the basics. So you’d like $50,000. What is your current income and debt level.
Sam: I make $100,000 per year and I have a $650,000 mortgage.
Mary: (long pause)…. Well, how about any other financial obligations?
Sam: It took $172,000 just to pay for the basics last year,,, and a few nice vacations of course.
Mary: I see…. Any savings?
Sam: What?
Mary: Savings.
Sam: Yeah, I don’t have any of that.
Mary: Right, well umm, at least you don’t have any other dark clouds on the horizon (nervous chuckle),,, right? No judgments, or other claims against your future income?
Sam: Not really. Nothing set in stone anyway.
Mary: What do you mean not really?
Sam: Well I’m pretty sure that I’ll be able to work something out.
Mary: Sam, spit it out. What are you talking about?
Sam: I uhh, well…. I promised my family I’d give them $5 million over the next 40 years or so. If they start thinking that they won’t get it, I could lose my job. My friends would probably lose their jobs too. It would be really bad.
Mary: You’re in a pickle, Sam.
Sam: That’s why I’m here. You always come through Mary. And hey, you know my family buys a whole lot of stuff from your bank. We’re loyal customers. (imagine that banks sell oil, clothes and electronics)
Mary: Sure Sam, but we can’t keep doing this forever. We can’t keep giving you money to just turn around and buy stuff from us. You can’t keep borrowing more and more and never pay it back. What if banks like mine all started charging you a lot more for loans? What if there were some kind if crisis in your family and we decided it was too risky to bail you out?
Sam: yadda, yadda, yadda. Look, just give me the money.
Mary: Ok, go pick it up from the teller over there.
The obvious question here is, why does Sam get the loan? There are a few reasons, and this is not an exhaustive list.
1. Sam has always paid back his loans before
2. Sam can print money when he runs out.
3. The money Sam prints is the world’s reserve currency, so it is unlikely that countries around the world would allow this currency to crash. Foreign countries would likely purchase more of the currency to prop up its value before seeing it crash.
4. Sam indeed buys a lot of stuff from Mary.
There are also some good reasons that Sam will not continue to get such silly loans forever. Here are a few of them, and again, this is not an exhaustive list.
1. Countries around the world are searching for alternatives to a US Dollar reserve currency
2. Sam’s financials are obviously in very bad shape
3. The US economy is shrinking relative to the rest of the world’s economy and becoming less important globally.
4. Countries like China, Japan and major oil exporting countries are aware of the precarious financial position the US is in, and recognize the importance of diversifying in terms if their trading partners and investments.
This cycle of foreign borrowing will come to an end for the United States. It will end either by the United States becoming responsible, or by foreign countries losing confidence in our ability repay our debt, which will lead to a failed bond auction, rapid inflation and a currency crisis.
RISK MANAGEMENT
Over the long term, markets are pretty good evaluators of risk. Just as the market will punish a firm for excessive credit exposure, the market will punish a market index when its host country exhibits structural problems such as excessive credit risk, large unfunded liabilities, or systemic misallocation of capital.
Deficit spending during recessionary times is sensible, but the Fed and Treasury have gone completely out of control, and the market is suitably punishing us. Even though the equity markets have nearly doubled from the apocalyptic lows of a couple years ago, companies are still valued at about the same level today as 10 years ago. Have US companies really not increased in value during that time?
Given the roots of our current recession, money printing and profligate borrowing at all levels of the economy as the main pillars of economic recovery is like trying to extinguish a bonfire with gasoline. It’s true that the government has a limited number of tools but this behavior defies reason. Although the metaphor is overused, the US is really just throwing down more drinks to keep the party going and to avoid a hangover. Expectations of future tax and debt burdens affect the attractiveness of financial assets, the attractiveness and perceived safety of the US market, and the overall demand for financial assets. Tax, debt, and other financial obligations continue to mount and the market is paying attention. If the White House has a Risk Management Czar, I’d love to hear the explanation for this.
Government Sponsored Entities (GSEs) led the rest of the mortgage market into the abyss. They tightened credit spreads by paying too much for risky loans because they were guaranteed by the full faith and credit of the US government. Easy lending standards followed because predatory lenders understood that the GSAs were vacuum cleaners for their garbage loans, and loose monetary policy stoked the flames. Such guarantees encourage risk taking because profit accrues to the investor or financier and any losses accrue to taxpayers. Crisis is practically inevitable.
Guarantees are structurally very similar to debt, except that the size of the future liability is not known. When organizations of any kind take on heavy debt loads they become less tolerant of shocks and disruptions. When households carry heavy debt, a job loss can be devastating. When a nation carries heavy debt, crisis can turn to catastrophe. Right now our nation’s debt is at historic highs, and the list of potential shocks is longer than ever before.
Let’s consider some unlikely, but not unimaginable events: A dirty bomb detonation in Chicago, a nuclear warhead detonation in New York City, a tsunami in Los Angeles, or a massive earthquake in Seattle. These events all could have an economic impact that dwarf the impact of Hurricane Katrina or 9/11. In risk management, these are called ‘tail’ events, because they exist in the far off and unlikely tail areas of probability distributions. Such events actually occur with surprising frequency however.
Given the current levels of federal debt, here is what might happen if such an event came to pass. First, the president tries to calm everyone down on television and says many positive things. Next, the Fed issues more debt to China and Japan so that we can start paying to rebuild. Unfortunately, they don’t want any more of our debt because they already have so much of it and are afraid that we might not be able to repay it, especially since we’ve just had 2 to 5 percent of our productive economy wiped out. Our lender’s existing debt would be subordinated by our need to rebuild a major city, so our credit rating would fall. Next, the US would lose reserve currency status and would have to pay 3rd world interest rates to issue new debt. As people around the globe lose confidence in the US and dump their dollar denominated assets, the costs of goods and services in the US would skyrocket and dollar denominated savings and investments would wilt. Savings and 401ks would vanish.
Tail events are surprisingly common. Part of the reason for this is the techniques that are used to measure risk. A common way to measure risk is “Value at Risk”, or VAR. (3) Given a time horizon, a desired confidence interval and some historical data, we can compute VAR for almost any variable. VAR allows us to make statements such as “At 95% confidence, our losses will not exceed $10 million in the next six months”. The problem with this is that it can give organizations a false sense of security, and a feeling that “We’ve done our homework. We have very bright Risk Managers top of this.” VAR offers no instructions on what to do if the 5% event occurs. Usually organizations (the government included) have risk tolerance rules set that can be explained with VAR. Commonly, when these rules are satisfied, everyone is happy, and there is inadequate disaster planning because nobody thinks there will be a disaster. Further, in the VAR example above, we use a 6 month time horizon. This means that given a 95% confidence interval, every 10 years we would expect a tail event to occur.
What is perhaps most troubling about the unprecedented amount of risk the government is taking is how Congress and the President do not appear to have learned from the financial crisis. Congress and the President have mercilessly lambasted the private sector for excessive risk taking. The risks taken by the federal government eclipses those taken by the private sector by a gargantuan proportion. When Chris Dodd and Barney Frank presided over the witch trials of bank executives, it wasn’t just the fox guarding the hen house. It was the fox acting as judge and jury for some fall guy, after perpetrating the biggest hen house raid in history. To butcher the metaphor even further, taxpayers were the hens and are on the hook for $200-300 billion to the GSEs.
REGULATION
According to a Bloomberg poll, 80% of people don’t feel that the Frank-Dodd financial reform bill will prevent future financial crises. Maybe it’s that the bill does nothing to reform Fannie Mae and Freddie Mac, the agencies at the center of the financial crisis. Maybe it’s because it is called the Frank-Dodd act, after the two legislators who designed the bill, and who also presided over the financial crisis as leaders of the House Finance Committee and Senate Banking Committee. Maybe it’s because the bill is like a form that still needs to be filled out. It reminds me of Mad Libs. If you’re not familiar with Mad Libs, it’s a kid’s game where a friend asks you to fill in blanks in a story, but you don’t know the story so you wind up with something that’s absurd and entertaining. For example: “Bill decided to ride his (kind of animal) to (place)” might wind up as “Bill decided to ride his turtle to Egypt”. After constructing a whole story like this with a friend, you can read the story to each other and laugh your heads off. The main difference between the bill and Mad Libs is that instead of having a friend fill in the blanks, the blanks will be filled in by special interests, lobbyists and attorneys, and probably no one will laugh about it.
The bill is not a complete disaster, although it does have the potential to become one due to the uncertainty that it creates and due to the incentives that exist for special interests to shape the bill’s ultimate form to their advantage. The consumer protections provisions in the bill are laudable, although it makes it more difficult for card issuers to effectively price risk. Increasing capital adequacy requirements for banks is a step in the right direction. Implementing the Volcker rule, even if it is a highly compromised and watered down version of the rule, should help to improve stability of “banking entities”.
Any serious financial reform regulation needs to acknowledge the public and private sector’s role. If we are talking about systemic risk, we need to address the system, not just the part of the system that’s easy to demonize.
SOUND MONEY AND QUANTITATIVE EASING
Long term interest rates are rising, US trading partners are incensed, commodity prices are soaring, Fed credibility is crumbling and QE2 is still not over. What's worse is that we have sacrificed all of this and even the economists in favor of qe2 feel that it is too small to be effective.
The next time an IMF economist breaks out his X-Y axis and begins to explain the minutiae supporting the wisdom of a currency debasement, take a long pause before responding. An invariable quality of sound economic policy is that it makes intuitive sense. Spending our way to prosperity does not seem intuitive, neither does destroying the value of our currency to restore our economic vitality. There are some rational and well respected arguments that can be made for both of these practices, although in moderation. The problem is that moderation is in the rearview mirror. We are on the equivalent of our 12th drink with respect to fiscal and monetary stimulus.
A great economist said "There is no subtler, or surer means of overturning the existing basis of society than to debase the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which only one man in a million is able to diagnose." I might have guessed that Milton Freidman or Friedrich Hayek said this. I would have been wrong. It was Maynard Keyenes. Today, the remaining economists on the quantitative easing bandwagon are the same ones that have invoked Keyenes as justification for every failed and irresponsible policy decision of the past two years. No single economist holds a monopoly on Keyenesean credibility, although there is no shortage of those who sully his legacy by behaving as if they do.
Recognizing the importance of expectations seems to be making a comeback however. The Rational Expectations Theory (4) of economics tells us that on average, the expectations of economic agents will be correct. Economic "agents" are consumers and business people making buying, selling and investing decisions. While each agent might individually make errors in judgment, in the aggregate they will be correct. Aggregate expectations among economic agents are currently grim and this is why business spending, investment and employment all remain low.
Economic decision makers realize that US creditors will tire of seeing the value of their dollar denominated loans to the US shrink along with the value of the dollar. Our creditors have been very patient so far, but it is folly to think that this patience is limitless. The patience of our creditors is a function of the US economy's size and importance. As US importance diminishes, so will the patience of our creditors. Pontificating about the duration of this patience is little more than gambling. When their patience does run out, the ensuing crisis could make the last one look like a picnic.
Creditors realize that as US debt continues to reach new stratospheric levels it becomes increasingly unlikely that they will be paid back in full. At some point, US creditors are going to demand higher yields for the risk they are taking and the US will be forced to pay more to attract buyers. Because the average duration of US debt is less than 5 years, this means that a rapidly increasing portion of US income will be used to service debt. When short term debt is rolled over, it will be rolled over at much higher rates and debt service payments will increasingly crowd out other forms of spending and investment. Furthermore, the value of existing US debt will plummet as interest rates increase. Harvard Economist Niall Ferguson said recently "US debt is a safe haven just like Pearl Harbor was a safe haven in 1941".
US inflation remains low, but the reliability of US inflation measures is highly suspect. Economic decision makers are not oblivious to the fact that gold, corn, coffee, rice, copper, sugar, cotton and silver prices are all up over 50% in the past two years. Oil prices, which were a contributing factor to the great recession, just hit a 25 month high. Inflation transfers wealth from savers like China, Japan, and anyone with a 401k, to borrowers like the Federal government. Keyenes said it more eloquently, but currency debasement is legalized theft.
Although QE2 is often rationalized in terms of benefits to the US export sector, a weak dollar increases input costs for manufacturing processes, which in turn makes our goods less competitive and US firms less profitable. Considering the extent to which the US is a net importer, the magnitude of this tradeoff should not be underestimated.
Keynesian and Monetarist approaches to economic recovery have both been pursued with reckless abandon. By comparison, the expectations of economic decision makers have been completely ignored. Economic decision makers understand the potential for crisis and these expectations are reflected in their conservative decision making. When they see massive government debt, a plummeting dollar, agitated creditors and trading partners they hunker down and prepare for the worst. Only when they see the government behaving like responsible grown-ups will they invest and hire.
CONCLUSION
The debt problem will not be solved in days or months. It will take years. Although it is important to get federal debt under control in order to reduce interest rate risk, and to minimize the amount of federal tax revenue that is spent on interest, having a plan to solve the problem may be just as important as actually solving the problem. Creditors, businesses and investors will all behave more cautiously and conservatively if there is not a viable plan in place to reduce the deficit. Given the current deficit projections, all that these stakeholders know for sure is that there will be some combination of (1) increasing taxes (2) currency devaluation (3) higher interest rates (4) debt default or restructuring (5) reduced spending. This is a very uncertain future and some outcomes are obviously more favorable to business and investment than others. What is needed most is a clear and reasonable plan to get the deficit under control. This will eliminate the uncertainty among the 5 options listed above and enable businesses to make long term investments with confidence. Such a plan would also help to keep interest rates low as foreign investors would have more reason to remain confident that they will recover their full investment in US debt.
From a risk management perspective the US needs more debt headroom. Given current debt levels, a natural disaster or financial crisis could turn to catastrophe if global markets lost confidence in US currency and/or the ability of the US to repay its debt. There is a growing risk that a debt auction will fail at some point and the fear generated by some sort of crisis would make this scenario much more likely. Once again, this risk could be diminished perhaps as much with a viable plan to reduce the debt than by actually having reduced the debt.
Massive pieces of regulation result in massive compliance costs, not to mention the direct costs associated with whatever mandates the law imposes. When regulations and laws are so massive that they need to be rolled out over several years, compliance costs are uncertain, which inhibits long term planning, hiring and investment. When the specifics of the bill are left to experts or committees to determine in the future, the uncertainty is even greater, and so is the negative effect on growth and investment. Regulation can also create perverse economic incentives that cause capital to be allocated inefficiently, which also stifles growth, hiring and useful innovation. Regulation needs to be clear, fair and simple in order to not disrupt economic growth. Ultimately, it is economic growth more than anything else that will reduce the deficit most quickly.
Finally, the United States needs to return to sound money policy. Printing money, or quantitative easing, is a slap in the face to savers, wage earners, trading partners and foreign lenders. Printing money does not create wealth. It creates bubbles and diminishes US credibility. Gambling on how patient foreign lenders and trading partners will be is a risk that carries potentially grave consequences. Quantitative easing also prevents economic restructuring by reducing incentives to save and deleverage.
The United States has a deep hole to climb out of. The longer a deficit fix is delayed, the more the ultimate solution will hurt. The more interest and debt that accumulate, the greater the ultimate tax burden and spending cuts that will be required, as well as the attendant economic slowdown that would likely result.
REFERENCES
(1) All data about US debt, tax revenue and spending are from http://www.usgovernmentspending.com/
(2) “In China's Orbit”, by Nail Ferguson, Wall Street Journal, November 18 2010
(3) Value at Risk: The New Benchmark for Managing Financial Risk,
Philippe Jorion, August 2000
(4) Learning and Expectations in Macroeconomics (Frontiers of Economic Research) by George W. Evans and Seppo Honkapohja (Feb 1, 2001)
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