Boeckh Letter: US Government Debt Sep 21 2010

VOLUME 2.
14
SEPTEMBER 21, 2010
U.S. Government Debt:
The Upward Spiral Continues
The great reflation—a combination of various stimulus packages, bank bailouts
and built-in fiscal stabilizers—worked its magic in preventing the economic downturn of
2008-2009 from morphing into another great depression. Calculations by Alan Blinder
1
and Mark Zandi indicate that, without those actions the economic downturn would have
been three times deeper and unemployment would have almost doubled from its 10%
peak. Our sense is that the economic and financial crisis would have been even more
devastating than that because those calculations ignore the psychology of panic.
Failure to “put out the fire” would have risked burning the whole forest down.
The reflation, however, was only Act I. Now we are into Act II which is all about
dealing with the long-run consequences of massive and escalating government debt. In
addition, governments will soon have to face age-related effects on their expenditures
for health and social security and on economic growth.
Total gross U.S. government debt was approximately 90% of GDP in 2010, of
which over 80% is Federal. Chart 1 provides comparisons of the U.S. with some other
1
Alan S. Blinder and Mark Zandi, “How the Great Recession was Brought to an End”, Blinder-Zandi Report, July 27, 2010.
© BOECKH INVESTMENTS INC., 1750‐1002 SHERBROOKE STREET WEST, MONTREAL, QUEBEC. H3A 3L6 TEL. 514‐904‐0551, INFO@BCCL.CA
big debtors. The U.S. is well behind Japan, Italy and Greece but ahead of the UK and
the Euro area.
CHART 1
That the U.S. is in a dangerous debt situation is hardly a secret. Yet nothing will
be done about it any time soon. Politicians, now back from their holidays, are focused
on securing re-election. Republicans are moving further to the populist right. Cutting
deficits has once again taken a back seat to spending and minimizing taxation. It is
often said that the electorate get what they deserve and one of those things is huge
government debt, which is going to get much bigger. There is a rapidly escalating
Greek-style debt:GDP scenario unfolding and all the consequences that go with it.
Below we discuss how fast and how far the debt trajectory will track. But first, let’s look
at some of those consequences.
©THE BOECKH INVESTMENT LETTER WWW.BOECKHINVESTMENTLETTER.COM 2
The Consequences of Excessive Government Debt
The long-term structural consequences of growing U.S. government deficits must
be seen in the context of declining U.S. private savings. Chart 2 shows that U.S. private
savings have fallen progressively since the era of the bubble began in 1982, reaching a
post-war low around 1.2% of income just prior to the crash. Savings have since
rebounded as households and businesses are trying to reduce debt, but it remains to be
seen how long this will last. Federal budget deficits have absorbed an increasing share
of those dwindling savings ultimately taking almost 100% prior to the crash (Chart 3).
The consequence has been that non-residential net investment has fallen from 6% of
GDP to near zero before the crash. That dwindling amount of investment has
increasingly been financed by the Chinese and other surplus countries which now hold
about $3-4 trillion in highly liquid U.S. dollar balances and short-term Treasury bonds.
This is a reflection of the steady and dramatic deterioration of the U.S. net international
investment position over the 25 bubble years (Chart 5).
As we point out in our calculations below, the total debt of the Federal, state and
local governments is likely to be over 110% of GDP by 2020 if nothing happens to
reverse current trends. To put this in perspective, Iceland, Spain and Ireland, three of
the most over-extended debtor countries went into the crisis period with debt between
25% and 36% of GDP. Greece, the poster country for sovereign debt catastrophe, went
into the crisis with debt at close to 100% of GDP, where the U.S. is likely to be in five
years according to the IMF.
CHART 2 CHART 3
CHART 4 CHART 5
The dynamic in which government deficits absorb a high proportion of private
savings leads to crowding out of private investment. In the absence of an inflow of
foreign savings, for example from China, domestic investment would decline even
faster. A country’s growth rate diminishes as investment in plant and equipment gets
crowded out, eliminating the only painless exit from a debt trap. In the U.S. the deficits
will continue to be financed in good part by foreigners for the time being, adding to an
already massive amount of foreign liabilities. Italy and Japan, two highly indebted
countries have financed most of their deficits internally. This makes them much less
vulnerable and helps to explain why they have not yet experienced a fiscal or currency
crisis.
Similar to Greece, the U.S. has a high proportion of its liabilities due to foreigners
and those liabilities are highly liquid. Much of them are owned by central banks as part
of their dollar reserves. On the other hand, central banks are already in the category of
owning so many dollars they don’t want the dollar to collapse. Moreover, in a deflation
all countries want a cheap currency. Recently Japan has panicked over an excessive
rise in the yen and is actively trying to devalue it. So the “balance of financial terror” (a
term coined by Larry Summers) could well prevail for some time. Excess dollar supplies
are bought by foreigners in order to preserve or boost their exports. This mitigates
pressure on the U.S. government to cut spending. Foreign support of the dollar buys
time and allows the U.S. to procrastinate in fixing its fiscal problems. This encourages
the “house of cards” to become bigger and increasingly unstable. Ultimately a
combination of declining growth, dwindling investment and rising debt to foreigners is
unsustainable, with serious implications for interest rates and inflation.
The Government Debt Trajectory
There are a number of assumptions needed to calculate the growth in
government debt relative to GDP, some more plausible than others. The key
ingredients are the starting primary balance (the deficit net of interest payments),
estimates of how it will change and the difference between the growth rate of the
economy and the rate of interest. We use the Congressional Budget Office (CBO)
calculations as a starting point as it is generally recognized as the authority. The CBO
baseline projection assumes no change in basic laws (e.g., all of Bush’s tax cuts expire)
or discretionary spending and is totally unrealistic.
The most plausible projection is the CBO’s “alternative fiscal scenario”2 which is
based on several fairly conservative assumptions regarding increased spending, for
example in Medicaid payments to physicians as well as the reinstatement of Bush’s tax
cuts for all but the wealthy. This scenario forecasts Federal debt to GDP rising 25
percentage points by 2020. Assuming state and local government debt to GDP remains
around 16%, the total U.S. government debt level would be over 110% of GDP by 2020.
This is not too far from Greece’s current level and well above its pre-crisis ratio. The
calculation is pretty close to the IMF’s more elaborately constructed outcome. Chart 6
shows the CBO’s Federal debt baseline and alternative scenario projections. As can be
seen, the alternative scenario, which we think is the best one to use, rises sharply in the
next ten years and thereafter explodes upwards.
2
For definitions of baseline and alternative scenario please see CBO website:
http://www.cbo.gov/ftpdocs/115xx/doc11579/SummaryforWeb_LTBO.pdf
CHART 6
However, even the CBO’s alternative projection for the U.S. is naively optimistic
because it assumes GDP growth averaging 2.9% for the next ten years and no
recession. The U.S. has never experienced a ten-year period with no recession, and
the growth rate they assume is the same as that during the debt-fuelled bubble years of
1980-2007. If we assume that the 2010-2020 period will be one of deleveraging and
crowding out of private investment, growth is likely to be significantly less than in that
earlier period.
Interest rate and inflation assumptions are much more vulnerable to error. The
key here is the gap between real growth and the interest rate the government has to
pay on its debt. When the gap is unfavorable (rates above growth), debt explodes
upward. In the U.S. currently the two are fairly close. The 10-year inflation adjusted
(TIPS) bond yield is currently 1%, about the same as the economy’s current growth
rate. However, as we recently saw in Greece, when the market smells trouble, capital
will flee, causing growth to head south and interest rates north with little or no warning
(Chart 7).
CHART 7
The bottom line is that a total U.S. government debt (including state and local)
above 110% of GDP by 2020 will turn out to be a significant under-estimate, if no
serious action aimed at fiscal consolidation occurs. It should also be noted that age and
health related spending are not the key factors pushing up debt by 2020. Those
pressures come to bear after 2020 and will eventually play total havoc with the U.S.
fiscal position, as shown in Chart 6, if swift, decisive action is not taken now.
Assuming no congressional miracle occurs by 2020, the government debt:GDP
ratio would move into the stratosphere, far beyond where Greece is now. By 2035, U.S.
government debt would rise to over twice GDP according to the CBO’s conservative
assumptions. Such an outcome is so untenable that it won’t happen. The issue is the
circumstances under which fiscal retrenchment occurs. Will the U.S. follow the Greek
model and wait for a crisis to drive change? Or will enlightened politicians figure out
how to sell fiscal austerity to a complacent public? Given the permanent state of
electioneering and partisan gridlock in the U.S., it would not be wise to assume a timely
and sufficient cut in the deficit.
Fiscal Adjustment
There are two ways to approach the issues of when and how much to cut the
deficit. The IMF has done considerable work on this question both for the U.S. and
other heavily indebted governments for comparison.
In the soft approach, the IMF calculates that the U.S. would have to cut the
cyclically adjusted primary deficit3 by a total of 12%, spread over ten years to bring the
federal net debt back to 40% of GDP by 2030. This would be 60% gross debt, which is
the Maastricht Treaty requirement. The calculation assumes no recession over this
lengthy period of 20 years. It should also be noted that net debt of 40% is not a
conservative target. It was just slightly higher than that in 2007 and thus provided no
protection against a debt spiral once the crisis hit. Given the precarious shape
advanced economies are in, we must expect further economic crises and hence, it is
imperative to build a sound buffer into government finances so as to deal with future
economic crises without inducing fiscal crises.
3
The cyclical adjusted primary deficit is what the deficit is estimated to be if the economy was at full
employment and interest payments are excluded.
The faster the deficit is cut, the smaller the adjustment needs to be, but at the
risk of hitting the economy with another shock. Calculations by the IMF and CBO
suggest that a one-time cut of around 5% of the cyclically adjusted primary deficit might
get the U.S. Federal net debt back to 40% before the end of the decade. However,
policy is moving in the opposite direction and too rapid an adjustment risks creating a
double-dip recession which would actually widen the deficit sharply. Clearly it is a
delicate balancing act between avoiding a fiscal crisis on the one hand, and nurturing a
sick, deleveraging private economy back to health on the other. At present, policy
makers are leaning heavily towards the latter. Therefore, bet on a continuation of a
sharply rising U.S. government debt:GDP ratio.
Would Severe Fiscal Adjustment in the U.S. Work?
There are clearly huge risks of cutting either too fast or too slowly. Even if the
U.S. imposed the “right” degree of fiscal austerity the result might be disappointing.
The IMF has studied many cases of countries trying to cut deficits in order to see what
works and why.4 There were several important conclusions. First, many countries fail
at first and are forced to take a second and third crack at it. Second, it was clear from
their research that cutting spending worked much better than raising taxes. While the
Democrats tend to be more averse to spending cuts than Republicans, the U.S. is
hardly an example of government overspending compared to most developed countries.
4
Fiscal Adjustment: Determinants and Macroeconomic Consequences, Kumar, Leigh and Plekhanor, IMF
Working Paper, WP/07/178, July 2007.
The fact is there isn’t much to cut, compared to say, 1945 when debt was very high but
massive wartime military expenditures were set to collapse.5 Third, successful fiscal
consolidation programs usually involved steep currency devaluations and sharp interest
rate declines. The U.S. cannot easily generate a significant dollar depreciation given its
reserve currency status and need for massive foreign financing of its budget deficit.
Neither would other countries welcome a large drop in the dollar while global
deflationary pressures are acute. Lowering interest rates is also not an option. Short
rates are close to zero and long rates are about two standard deviations on the side of
being too low. Growth is the key but there is no magic bullet there. The U.S. is in a
long wave decline, it is deleveraging, its population is aging and the deficit is crowding
out private investment.
Cutting the deficit will not be easy or painless, which explains why no one really
wants to do it. As we have often said, watch what the politicians do and ignore what
they say. On the other hand, we have to look at the consequences of not cutting the
deficit. With post-war record lows in interest rates and an easily financed deficit, where
is the pressure? With the cost of debt service at a low 1% of GDP and painless, we
assume that the government debt:GDP ratio will continue to escalate. That is, until
something bad happens to interest rates, equities, inflation, the dollar and living
standards—a subject for another letter.
5
While raising taxes is a poor second best to cutting spending, the continuing success of the Tea Party is
pushing the Republican agenda further to the right. That means tax increases are not going to happen any time
soon.
The Current Scene & Investment Conclusions
In our last letter we suggested that stock market investors shift towards a little
more caution as it seemed that investor expectations had not yet adjusted to the fizzling
economic recovery. Revisions to second quarter GDP growth with adjustments for
temporary effects from government stimulus and inventory investment indicate that
underlying growth is around 1% per annum. This is consistent with average growth in
final demand (i.e., excluding inventory investment) of slightly less than 1% p.a. since the
recovery began. This is a record for poor performance following a serious recession. It
is particularly disappointing given near zero short-term interest rates, 2.7% 10-year
bond yields and a budget deficit of 10% of GDP.
Some economic data looks slightly better in recent weeks but the basic situation
hasn’t changed. Growth is far below normal and the economy and financial system are
very distorted and unbalanced. For example, the key housing sector could easily face
another 10% drop or more in prices. Weak growth will sustain high unemployment
keeping the authorities focused on adding more stimuli. The upward debt spiral is
intact.
We believe that the market will most likely remain in a trading range of +/- 10%
around 1,100 on the S&P 500. The rally in recent weeks has been driven by Federal
Reserve assurances of unlimited liquidity, if needed, and the reporting of slightly better
economic data. This has provided investors, wishing to achieve a more conservative
posture, with an opportunity to rebalance their portfolios in a rising market.
Bonds and gold have recently attracted a flood of investment money. It would be
extreme to call the Treasury bond market a bubble in the sense that huge permanent
losses could be incurred by long-term holders. Worst case, you hold the bonds to
maturity, get your cash back and a return that might be less than the alternatives.
Nonetheless, the move in bond prices seems wildly over-done. According to Ned
Davis, close to $600 billion has moved into bonds in the past three years ($325 billion in
the last 12 months) about the same amount that flowed into stock funds in the three
years prior to the 2000 stock market top. Short-term risk is obvious. Our discussion of
the government’s debt trajectory also suggests long-term risks are probably high.
Gold is a somewhat different story. The flow of hot money has been huge, but
unlike bonds, no one knows where the downside limit is. When the previous bubble
broke, the price fell 75% and remained in the doldrums for 20 years. We do not dispute
gold’s useful role as insurance and as an inflation hedge. However it is expensive
insurance and we believe that deflation and rising real interest rates are a greater threat
than inflation. Having said that, gold is in a bull market, has a huge and growing
following and momentum investors love it. It could possibly go a lot higher, but it is not
a safe place for conservative long-term investors who can’t live with extreme volatility.
The big dilemma for stock market investors revolves around the extent to which
the huge drop in real and nominal bond yields has supported stock prices in the face of
deteriorating economic fundamentals and whether it has led to a switching of
investment funds from stocks to bonds. If the latter, it could reverse should the bond
bull market falter and drive stock prices up. In other words, if bonds get re-priced to
remove their overvaluation, would that hurt or help the stock market? Our guess is that
in the short run only, stocks will do okay in that scenario because bonds would probably
be selling off due to expectations of a stronger economy and profits. In addition, stocks
do not look expensive on a P/E basis (slightly below their long-run average) and on a
free cash flow yield basis.
Since relative value does matter, it is likely that a downward re-pricing of bonds
would ultimately trigger a downward re-pricing of stocks. Of course there are many
other factors which affect stock prices. Corporate liquidity has been extraordinarily
strong as has corporate profitability. The prospect of sustained economic weakness
virtually guarantees low short-term interest rates and huge liquidity in the banking
system, an important offset to the risk of a softer profit outlook.
When we add up the pros and cons for stocks, we come back to our relatively
neutral view of a trading range. Number precision is not very useful but it is likely that
+/- 10% around the 1100 level in the S&P 500 will contain most of the action for the time
being.
As one investment manager wisely and rhetorically asked recently, “Where is the
growth? Where is the edge?” 6 Investors should always allocate their assets with the
“where is the edge?” concept in mind. At present there does not appear to be any
compelling thesis which would offer such an edge, given our overall view. Therefore,
we would advocate above average cash positions and general caution until better
6
East Coast Asset Management, Second Quarter Update, July 7, 2010
opportunities arise. Capital preservation is crucial and, as Warren Buffet has often said,
“You don’t have to swing at every pitch.”
Others have very different views. Some believe the bull market in gold has just
begun. Others believe we are headed for a deflationary depression in which high
quality bonds would continue to thrive. Another view is that we are heading into high
inflation and a dollar collapse. Yet others believe there will be a return to the good old
days of stability and growth. In the time frame of most investors, we are in none of
those camps. With bonds significantly overvalued, investors hardly have an edge in
that area, except perhaps to go short. High yield bonds are fair value but the weak
economic picture suggests growing risk for those companies with poor balance sheets
and poor cash flow prospects. Gold as insurance at 5-10% of the portfolio makes sense
but only for the long run and only if volatility can be ignored.
With such a wide range of plausible opinions out there, and very high levels of
uncertainty, it doesn’t make sense to bet big in any one sector. Investors should
maintain a defensive, highly diversified allocation and continue to focus on wealth
preservation.
Tony Boeckh / Rob Boeckh
Date: September 21, 2010
www.BoeckhInvestmentLetter.com
info@bccl.ca
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VOLUME 2.

The great reflation—a combination of various stimulus packages, bank bailouts

for health and social security and on economic growth.

the Euro area.

at some of those consequences.

The long-term structural consequences of growing U.S. government deficits must

investment position over the 25 bubble years (Chart 5).

local governments is likely to be over 110% of GDP by 2020 if nothing happens to

years according to the IMF.

The dynamic in which government deficits absorb a high proportion of private

savings leads to crowding out of private investment. In the absence of an inflow of

the “house of cards” to become bigger and increasingly unstable. Ultimately a

combination of declining growth, dwindling investment and rising debt to foreigners is

unsustainable, with serious implications for interest rates and inflation.

There are a number of assumptions needed to calculate the growth in

calculations as a starting point as it is generally recognized as the authority. The CBO

or discretionary spending and is totally unrealistic.

based on several fairly conservative assumptions regarding increased spending, for

example in Medicaid payments to physicians as well as the reinstatement of Bush’s tax

next ten years and thereafter explodes upwards.

above 110% of GDP by 2020 will turn out to be a significant under-estimate, if no

Assuming no congressional miracle occurs by 2020, the government debt:GDP

and sufficient cut in the deficit.

other heavily indebted governments for comparison.

economic crises without inducing fiscal crises.

sharply rising U.S. government debt:GDP ratio.

hardly an example of government overspending compared to most developed countries.

out private investment.

standards—a subject for another letter.

bond yields and a budget deficit of 10% of GDP.

posture, with an opportunity to rebalance their portfolios in a rising market.

gold’s useful role as insurance and as an inflation hedge. However it is expensive

deteriorating economic fundamentals and whether it has led to a switching of

free cash flow yield basis.

strong as has corporate profitability. The prospect of sustained economic weakness

system, an important offset to the risk of a softer profit outlook.

“You don’t have to swing at every pitch.”

maintain a defensive, highly diversified allocation and continue to focus on wealth

Tony Boeckh / Rob Boeckh

Date: September 21, 2010

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