Rate Watch #721 The Impending Fiscal Disaster.
The Impending Fiscal Disaster
Few people are paying attention to the fact that the U.S. is facing an impending fiscal disaster. The problem is that public debt has grown so large that there is no discernible solution. The crisis which started in mid-2008 has increased gigantically the amount of public debt. In 2007 general government debt was 62% of GDP. It is projected to be 100% of GDP in 2011. A table and graph of this data is here. The fact that public debt exceeds 100% of GDP does not guarantee disaster. What is of serious concern is the constant increase in debt/GDP. The economy could theoretically sustain any level of public debt as long as the debt/GDP ratio is constant. Japan's debt/GDP ratio is almost 200%, yet the 10-year yield there was 1.35% this week. The proliferation of public debt in both Japan and the U.S. was rooted in housing sector asset bubbles. Japan had an utter lack of transparency and covered the problem up. Though Japan's real estate bubble was harmful almost exclusively to Japan, the harm from the U.S mortgage mess has been felt worldwide. The fact that this asset bubble was in housing is not the issue. Accommodative monetary policy causes asset bubbles. Where those bubbles appear is a matter determined by the market players. The Fed does not engineer monetary supply with the intention of creating bubbles. It carries our monetary policy in order to achieve its set of sometimes conflicting goals of : GDP growth, low inflation, and strong dollar. Much like a fire company creating water damage by putting out a fire with lots of water, aggressive monetary policy creates asset bubbles as unintended consequences.
While concern lately has been about the debt of EU nations, which started with Greece, the same problem they are facing is the one which the U.S. will also have to eventually deal with. In fact EU pain may make the pain here worse in the long run. Interest rates are so low for U.S. Treasury debt simply because of concern about EU debt, mortgage debt, and corporate debt. The U.S. is building up debt without feeling the pain only because the interest rates Treasury currently pays are so low. Like a homeowner with a negative amortization loan we just keep piling up debt.
So what is going to happen? Some time within the next 6-24 months investors are going to ask themselves "How the heck is the U.S. going to pay this money back?"
Let's sidetrack for a moment and define a couple of terms. There are really two deficits: one is the fiscal deficit which is the difference between Congressional spending and Treasury receipts, which come mainly from income (personal and corporate) and excise taxes. This is what is commonly referred to as "the deficit." As the budget deficits add up they increase the total national debt which must be serviced from taxes. On top of that we have structural deficit. Structural deficit is what you have no matter how well the economy is running. Structural debt is created by promising payments which no one has bothered to provide enough revenue for. Structural debt results from legislators placing reelection above fiscal sustainability. To keep it simple, this is Social Security, Medicaid and Medicare. There are two problems with the Social Security and Medicare Trust funds: 1) these have been underfunded to meet the future and 2) they don't really exist because almost all of the money has already been loaned to Treasury and spent. What is left is a bunch of IOUs. All of this will have to either be paid from future tax revenue or from borrowing or by having the Fed create money to retire it. Keep this point in mind: The IOUs which the Trust funds has are non-marketable. The only way to produce the cash once the Medicare Trust Fund is empty on the balance sheet is to convert these non-marketable Treasuries to marketable Treasury debt, thereby expanding the supply of debt, and causing treasury prices to fall and yields to rise.
The present value of the shortfalls alone in Medicare and Social Security is enormous. The 2009 report on the trust funds said that the Medicare "A" Trust Fund would be zero in 2017. It is difficult to believe that with 10% unemployment this has not moved to 2015 already. Interestingly, the administration directed the trustees not to produce a report by this year's due date because they wanted the effects of the health care bill accounted for. While that may be justified, we do not have an updated assessment of the health of these trust funds. In a speech here in San Francisco in 2008 Dallas Fed Chairman Richard Fisher stated that it would require a 68% increase in Federal income tax revenue to cover just the unfunded part of Medicare.
Part of the problem is demographic. The percentage of the population who will be collecting social security and Medicare is increasing. This is a consequence of a) the Baby Boom, followed by b) an extended period of restrained birth rate.
The problem appears to have no short-term solution. Deficit reduction through higher taxes, less spending, or both will dampen the economic recovery and reduce revenues. Not reducing the deficit will mean that when Treasury yields spike up there will be much more debt to service and either taxes will have to be raised to service the debt, or the debt has to be monetized. The issue with mounting deficits and higher Treasury yields is that it is a positive feedback system. When Treasury has to pay higher rates, that will generate more deficits due to higher interest expense, which creates higher rates which... you get the idea.
Monetization of the debt (the Federal Reserve creating money to pay part of the debt) will inevitably result in inflation. The only other possibility is significant expansion of GDP resulting from technological breakthrough which pumps up domestic industries. The thing with technology is that it happens on its own time frame and not when it is convenient to us. While that might be a solution, it would be irresponsible to rely on it.
In general, fixed income securities (which guide mortgage rates as well as Treasury debt) are pegged to inflation. More accurately they are pegged to fear of inflation even before it happens. Buyers of public debt are going to demand higher yields as long as they see no effort to maintain fiscal policy in a responsible manner. The risk of monetization of U.S. Treasury debt is a priori inflationary, causing a demand for higher yields. The major change here is that the debt of governments now has two risks: 1) default or 2) inflation induced to monetary expansion.
Folks who have been around for many years and seen economic cycles play out may conclude that this is just another cycle. I disagree. This one is different from all previous cycles because we have the massive increase in public debt occurring just before the shortfalls in the structural deficits need to be made up. This has never happened before.
I grant that is somewhere between difficult to impossible to fix a number here but I believe that within the next 24 months we will see 10 and 30 year Treasury yields and mortgage rates move up at much as 3%. It is worth noting that at the end of the last extended recession we saw 30-year Treasury yields over 10%.
I want to offer some practical advice to folks who are waiting for their property value to go up before they refinance: for the most part, values will stay flat at best before the fiscal disaster (and higher mortgage rates, and the indices for some adjustables) occurs. Waiting is a bad choice. As long as EU debt remains a concern there will be buying of U.S. Treasuries and little pressure on rates. The same monster created by deficits in Europe will then be faced by the U.S. The sooner we all recognize the magnitude and seriousness of the problem the sooner we can start seeking solutions.
If you have something to add to this discussion please post a comment on the blog.
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