U.S Debt – how much is too much?

By Mitch Gurney

May 22, 2011

As policy makers bicker over the budget and increasing the debt ceiling let’s take a look at our nation’s financial condition. In recent years I have begun questioning how much debt is simply too much even for the U.S government.

Former chief economist for the IMF Simon Johnson raises this very question in; Will the U.S have a Debt Crisis?

There is also the vexing question of how much debt is too much for the modern US. In a world where international investors (from both the private and official sectors) routinely wring their hands about US fiscal deficits – and then go out and buy more US government debt – who knows the answer?

Mr Johnson explains nations never default because they can’t pay on their debts since it is feasible for them to cut expenditures and raise taxes. The only reason they might default is if those in power make a political decision to do so.

A country such as the U.S using fiat currency and with a monopoly over it never defaults on its debts in its own currency, which is exactly what the debt is, in that they simply print more dollars to meet its obligations. Fiat currency has value by government degree but lacks intrinsic value backed by something tangible such as gold. Extreme monetary crises often lead to a transition in the monetary system. Leading up to such a transition those with wealth will often invest in perceived tangible assets to preserve and shuttle that wealth to the new system. Fiat currencies have historically been replaced once debased beyond any reasonable purchasing power. Think Zimbabwe which abandoned its currency after hyperinflation yield it worthless to the point where 3 eggs cost $Z100 billion. A new currency has yet to be introduced but in the meantime Zimbabwean’s are currently using a basket of currencies; the U.S dollar and British pound among others. Additionally, the local currency is still being printed but all prices are set in U.S. dollars.

“The entire credit system in the U.S, and much of the rest of the world,” Mr Johnson writes, “is based on the notion that government backed securities are “risk free-assets.” This conviction is predicated on the implied guarantee the U.S government will pay its obligations.

He points out:

There is no provision in the US Constitution to guarantee that the US will always pay its debts, but the American Republic has proven itself for 200-plus years to be about as good a credit risk as has ever existed.

Of course past performance is no guarantee of future performance. And a government is only as trustworthy as its leaders.

Speaker of the House Rep. John Boehner is leading the Republicans position that before approving raising the debt ceiling they will need to see trillions of dollars cut in government spend. This position, observed Mr Johnson, will “completely and quickly antagonize the Republicans most important constituencies, the U.S corporate sector.” Republicans haven’t always been against raising the debt ceiling and it’s likely they will support increasing it this time. A brief recap of the voting history for the House and Senate illustrates they vote in support of it when as the majority party a Republican also occupies the White House.

We often hear pundits say deficits don’t matter. And in turn the world’s credit system seems to operate on the notion that government debt doesn’t matter either. But this triggers a multi-trillion dollar question; if ‘wealth’ can be so easily created by merely printing currency (or makes up money electronically as is more accurate) and used by the government to spend in the real-life economic world of human toil, then why is there a need for industry, for tax collection, for education, for creativity and innovation? If this were true would the hyperinflationary conditions as seen in Zimbabwe have occurred or would Weimar Germany have needed to elect Hitler to solve their problems? If true then no nation or empire would fail as a consequence of fiscal and currency mismanagement.

I recently read an article titled Deflation or Hyperinflation in which the blogger contributes his views in the ongoing debate among some economists whether we’re in a deflationary or inflationary or hyperinflationary phase. He argues that we’re in the early stages of hyperinflation and contrasts his views with those taking the deflationary position such as Rick Ackerman, and Mish.  It’s an excellent informative read.

Hyperinflation is generally associated with the expansion of paper money, fiat currency. The expansion of credit via fractional-reserve banking ultimately leads to the expansion of paper money. The root causes leading to hyperinflation is widely debated but in terms of both classical economics and monetarism it is always the result of the monetary authority irresponsibly borrowing money to pay all its expenses. U.S government policy authorizes the expansion of paper money and credit when needed, hence the current debate over raising the debt ceiling.

Illustrated in the chart here, Uncle Sam Maxed Out, the government has since the 1940’s raised the debt ceiling 78 times and since the 1990’s the debt ceiling has raised an average of 8% annually – an increase of almost $10 trillion. Basically when the government has treasuries and bonds that come due they just roll them over. The national debt ceiling, set by Congress each year, is how this is done plus how government prints the money it needs to fund itself. The government doesn’t have to print millions of dollars in bills; it’ll pump billions into the economy electronically. Despite how unpopular rising the debt ceiling is and despite the political rhetoric both parties vote for it with a fair amount of regularity. It becomes the burden of the majority party that finds it necessary to call for it in order to fund the government, as the voting history exhibits here and here. It allows the government to continue investing in the nation’s infrastructure, its economy and funding the services it provides. It seems nearly impossible for anyone, especially governments to operate without some debt and a manageable national debt is good. Manageability is determined by the debts relation to the nations GDP. As of 2010 figures the U.S debt ($14.3 trillion) was 98% of its GDP ($14.66 trillion) ranking 12th highest against other nations.

But how reliable are these measurements when they are all set using the same fiat dollars?

In Deflation or Hyperinflation the author provides the following definition of hyperinflation:

“…hyperinflation is the process of saving debt at all costs, even buying it outright for cash… because policy will allow the printing of cash, if necessary, to cover every last bit of debt and dumping it on your front lawn!”

FOFOA argues that the conditions leading to hyperinflation already exists in the form of various promissory debt instruments; bonds, government issued securities and treasuries, government backed pensions, mortgages, CDO’s and other derivatives, etc. He asserts that the government bailouts, especially in the last few years, and the Federal Reserve’s Quantitative easing (QE1&2) monetary policies are acts to “cover and save every last bit of debt, even buying it outright for cash” and the “dumping of it on your front lawn” is the transferring of this privately held debt to the taxpayer, thereby socializing the debts. QE is when the Fed purchases large quantities of U.S issued securities or other assets held as collateral by boosting bank reserves that enable more leveraged lending of 20 to 1 or more. These policies are in essence the U.S fulfilling its implied promise to its creditors, serving as the lender of last resort.

The Fed finds it necessary to step in with QE in place of investors who are not stepping up as they had in the past as reported in a Daily Reckoning article Why Bernanke’s “QE” isn’t fooling anyone. China, a major hold of U.S debt, has been a net seller of U.S treasuries in recent months as observed recently in another Daily Reckoning article When China Loses Confidence in US Treasuries.

Inflationist and deflationist generally agree that “ultimately every penny of every debt must be paid, if not by the borrower, then by the lender,” that ultimately one or the other takes the hit. As a hyper-inflationist FOFOA agrees that ultimately someone pays, he differs though as to who, borrower or lender takes the hit by proposing a third option that is often overlooked – when debt is socialized:

“Human nature has followed this path for thousands of years…these lenders will influence our financial policy [and change the rule to suit their needs]…they will try to get their debt securities liquefied first, spend the fiat and in this process outrun you and I…leaving anyone they can beat to the mercy of…hyperinflation…eating their remaining fiat assets”

The extreme conditions of hyperinflation as seen in Zimbabwe or Weimar Germany for example occur once people lose faith in the government’s ability to make good on its obligations. The loss of faith is generally triggered by some political event sparking the fear that ignites it. Herein FOFOA explains where his view again differs with the deflationist:

They ignore the political (collective will) that backs it all up; the same political will that always changes the rules to suit its needs as surely as the sun rises. They underestimate the will of the politicians and bureaucrats who are playing God [and will go to any length to save debt at all cost, even buying it outright with cash]. They underestimate the power of fear and monetary velocity.  Velocity can have the same exact effect as printing. Fear is the spark that ignites it. And then the government will need to fund itself in this hyperinflationary environment. This will entail the massive printing that always follows immediately after hyperinflation starts. This is the political event that I am talking about – not the priming beforehand. That’s already done. We are already in the summer of 1922; because we have [fiat currency printable on demand] a dollar-denominated deflation is impossible. It is this mandatory function of the political will that backs the entire system [resulting in bailouts and QE, etc.]… [here is how this mandate] comes into play; the Fed is helpless against the debtor’s balloon but it is not helpless against the saver’s [investors] balloon. It will not let the savors balloon deflate. [They] have the power to keep the savers balloon 100% full and the political will to fully back that action. And it is this political will that makes dollar hyperinflation a certainty this time around.

As is obvious the mandatory functions to keep investors 100% full at taxpayer expense are already occurring fully backed on Bernanke’s promise in 2002 to cover and socialize every last penny of debt. Bernanke’s critics often refer to him as “Helicopter Ben” for comments he made in 2002 when in essence he explained how he would fulfill our obligations:

The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.”

What has been covered thus far since the financial meltdown began in 2007 is but a tip of the iceberg.  Numbers don’t lie, but governments and our corporate media do. It’s deceitful to claim that producing “as many U.S dollars as we wish come at no cost.”

While reading through FOFOA’s other postings I came across the following tale in the opening paragraph of The Debtors and the Savers:

Ever hear the one about the little old lady living in an old but paid-off house, with a shoe box full of gold coins in the basement? Across the street lived a big guy, in a big McMansion. It had a special garage for the RV, and another four-car garage for the other four cars. He had a boat at the side and a trailer with two jet skis in front of the boat. Then one day little old lady noticed big guy was gone. The bank had taken back his house.
Most people thought big guy was rich and little old lady was poor. How wrong most people were.

The second paragraph follows with an 8 minute video clip from a movie called “The Tigers Tail” – I strongly recommend watching the clip.

By combining the above tale with the nation’s fiscal status summarized in Deflation or Hyperinflation I think you might better understand my concerns and gain a glimpse at the size of the iceberg:

Total US mortgage debt is a little over $14 trillion. That number includes you and your neighbors. Of that $14 trillion, about $6 trillion sits on the balance sheets of banks and $9 trillion has been packaged and sold to savers like pension funds. Of that $9 trillion held by savers, about $5 trillion is guaranteed by the US government.
So [the perceived]…lynchpin [among deflationist] that’s going to keep all you indebted homeowners honest: $14 trillion – $5 trillion guaranteed = $9 trillion. That $9 trillion lynchpin is so powerful because it is held by politically connected and powerful banksters and pension funds, or so they say. Now in a minute I’ll tell you why these two groups would rather have all that debt printed and the cash handed to them than to watch even 20% of you default on your mortgages. But first, let’s step back and take a wider look at what might be exerting…stress on this supposed lynchpin.

Total… [dollar value]…debt in the US, both public and private, is around $55 trillion, four times as big as that backed by physical real estate. If we add in the government’s unfunded liabilities (which definitely apply…stress to the dollar’s lynchpin) that number comes in around $168 trillion. And that is simply the promises to deliver worthless, purely symbolic tokens [dollars], at some time in the foreseeable future, emanating from within the United States.

Meanwhile the US produces enough “goods and services” (loosely defined) every year to be purchased by $14 trillion of these purely symbolic tokens at their present level of purchasing power. And with a trade deficit of around $500 billion per year, it appears the US is consuming roughly 103.5% of what it produces every year, in real terms.
So in real terms, that is, in terms of the dollar’s purchasing power as it stands today, it would take, let’s see… $168T/ ($14T produced – $14.5T consumed) = x years… hmm… somehow it’s going to take us negative 336 years to deliver those promised dollars at today’s purchasing power….the deflationists want you to [believe] …we will be forced to reduce our consumption to below our production in order to pay it…off …and…they are correct, though not in the way they think.

336 negative years to make good on our promises – what more can be said? Obviously a fiscally balanced nation typically pays its debts through net production. We on the other hand are a net consuming nation. Even though the $168 trillion is total debt, and not net debt it still has to be wiped out sometime. All it requires is one ‘massive sneeze’ and the printing presses could be spewing trillions of dollars to salvage our creditors. If we were to net produce $500 billion per year it would require 336 positive years to pay off this debt. Obviously policy makers have tough choices to make. Even if they managed to miraculously cut spending and raise revenue enough to create a surplus of say $1 trillion a year it would take 168 years to wipe out the debt amassed thus far.

I have reported in numerous articles that a contributing factor to our trade imbalance is that we import most of our own American brands because of outsourcing by American manufacturers. I suggest that the image of America as a net consuming nation is in part distorted. During a recession our trade imbalance narrows, but this is no mystery in that while importing less overall we’re also importing less of our own brands. If a percentage of this manufacturing were to return the trade imbalance could be reduced, more jobs could be created with more tax revenue collected. We’ve been running a trade imbalance since 1976 and today with over 90 countries. This results in a negative balance of payment for the U.S with most of the rest of the world. Some economist tell us not to worry in that the foreigners can use these dollars to purchase U.S assets; stocks, bonds, bank deposits, government debt, real estate, businesses, etc. In this way the U.S is said to be “financing” its account deficits by selling assets.

A percentage of the $14 trillion in mortgage debt is ‘secured’ with real estate that has lost value since the loans were initially made before the real estate bubble burst. Currently banks are not required to reflect the actual market value of the real estate they hold in their loan portfolios. It’s anyone guess how upside down they might be. Bloomberg recently reported that more than 28 percent of the nation’s homeowners with mortgages owned more than the homes are worth. In addition the government via QE monetary policies and GSE programs; Freddie Mac, Fannie Mae, and Ginnie Mae are holding vast mortgage securities.

As real world events unfold the definition for hyperinflation as given by FOFOA above is playing out scene by scene. The Daily Reckoning In an Under-collateralized World observes:

The world is under-collateralized. This is the single most important feature of the 2011 economy. Sixty years ago, if assets were worth less than loans, it was possible to work our way into the black. In 1950, 59% of US corporate profits were from manufacturing; 9% were from finance. The roles of manufacturing and finance have reversed. Thus, we witness the desperate attempts to forestall what cannot be prevented. Yet, the world must deleverage. Banks must write off loans. Loans to bankrupt developers and companies must be called. Living standards must fall.
The authorities are doing all they can to prevent the necessary deleveraging. [Attempting to “save debt at all costs – even buying it outright for cash”]

That is the context in which Michael A.J. Farrell, CEO of Annaly Capital Management (NYSE: NLY), spoke to investors during his company’s first quarter 2011 conference call:

“[T]he change that is happening in the financial markets is a chaotic mess. I believe the simultaneous execution of radical monetary policy, fiscal policy, and financial regulatory reform is introducing rather than reducing systemic risk in the global financial system by ignoring the simplest lesson of the scientific method. Rather than change one variable in a complex system and test the outcome, regulators and policymakers are changing virtually all of them at the same time: QRM [quantitative risk management], risk retention, the Volcker Rule, Basel III capital rules, derivatives clearing and related margin requirements. GSE reform. FAS 166 and 167. Zero-bound fed funds policy and QE2. Deficit financing, structural budgetary imbalances and debt limit debate.”

Mr Farrell as CEO of Annaly Capital Management is someone with an inside view:

Annaly…invests primarily in mortgage pass-through certificates, collateralized mortgage obligations, agency callable debentures, and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans. Annaly Capital also invests in Federal Home Loan Bank, Federal Home Loan Mortgage Corporation, and Federal National Mortgage Association debentures.

The Daily Reckoning In an Under-collateralized World continues:

Michael Lewitt, proprietor of Harch Capital Management in Boca Raton wrote in the May issue of his monthly letter, The Credit Strategist:
Federal Reserve Chairman Greenspan and Bernanke “convinced investors the Fed would bail them out if the economy or markets got into serious trouble. As a result, investors engaged in increasingly reckless behavior…” The result: “Rather than saving the markets, Mr. Greenspan’s philosophy and approach guaranteed their failure.” One of the consequences is “the build-up of unsustainable debt levels.”

We are overleveraged, under-collateralized, and accentuating these unsustainable imbalances. Lewitt notes, “the Federal Reserve has accounted for 101 percent of the net Treasury bond issuance during the first four months of 2011.” He goes on: “The US government has been the largest purchaser of Treasuries, promulgating a Ponzi scheme of unprecedented scale.”

Are you familiar with the term normalcy bias? It is a mental state we often “enter when facing a disaster.” It “causes people to underestimate both the possibility of a disaster occurring and its possible effects,” causing most of us to be inadequately prepared. I suspect to a degree normalcy bias with the economy is at play in clenching this ‘faith based notion’ in the U.S. credit system all together. To make good on our promises it could be argued that Bernanke – that is the Fed – is doing the only thing it can do, now.

This report should be a sobering wake up call. It seems clear we are overextended and that something radical must be done. Part of this radical change needs to be a change of policy makers in Washington. As hard as I try I can’t suppress the concern our political and business leaders have cooked our goose.

Mitch Gurney

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