Subscribe to BrookesNews’ Bulletin `

U.S. government, on its way to bankruptcy, Part 3

Michael Pollaro

Monday 5 April 2010

Michael PollaroIn part 1 of this series, I made the case for a U.S. government that is quite literally out of control, a government that has committed to obligations so big, that unless policies change, it's a government that's on its way to bankruptcy. Starting with the simple fact that the U.S. government has NO money, that it must tax Peter to spend it on Paul, I posited that in addition to the ever constant cry for more government spending in support of Paul, it's the way the government taxes Peter that allows the government to spend so much on Paul.  Lay the bill bare and its likely Peter throws a fit.  But mask Paul's true cost and it empowers the government to commit to obligations far beyond the ability of Peter to ever pay the bill.

I then introduced the 3 kinds of government tax forms — Tax Peter now, Tax Peter later and Tax Peter don't tell him — and further posited that it is the latter two, Tax Peter later, better known as borrowing, and Tax Peter don't tell him, namely the inflation tax, which have been instrumental in masking the true cost of Paul and putting the U.S. government and therefore Peter in a deep financial hole.

In Part 2 of this series, I demonstrated that the tab being run by the U.S. government is years in the making and it's going from bad to worse.  I further demonstrated that the policy of deferring the costs of all this spending largesse, by Taxing Peter later via borrowing instead of Taxing Peter now, has helped create obligations so huge, a bill so big, that it can never be paid. 

I concluded that unless millions of Pauls are about to be told that they are not getting what they were promised, because it simply costs too much, or that millions of U.S. government debt holders are not getting their money back, because Peter can't afford it, there will come a time when the only way out for our politician friends, to make good on their promises, will be via the wholesale use of the Tax Peter don't tell him policy of inflation.  In other words, by devaluing those obligations by printing money.

National bankruptcy through the Federal Reserve's printing press.

So, is wholesale inflation right around the corner?  As I suggested in part 2, it's coming, but we are not there, quite yet. The reason, the U.S. government and by extension Peter and Paul, have some friends, friends that allow the U.S. government to fund its spending programs without resort to the wholesale use of the inflation tax.

And those friends are the U.S. government's creditors.

Armed with their hard earned savings, they buy all those treasury bills, notes and bonds issued by the U.S. government, funding the excess of spending over tax receipts, so that the Federal Reserve doesn't have too.  At 3.5 percent interest on 10-year treasury notes and 4.5 percent interest on 30-year treasury bonds, and inflation of no current concern, they part with their savings and invest, because, at least for now, they get a real rate of return, a return of their investment, at a purchasing power equal to their original investment, plus interest.

The problem is, this funding policy is unsustainable, because it sows the seed of its own demise.

You see, a creditor's greatest fear is inflation, to be repaid in increasingly worthless dollars.  And when it becomes clear that the U.S. government can not possibly make good on its mounting debt obligations by taxing Peter, that the only way out of those obligations is via inflation, the U.S. government's creditors, fearing the debasement of the dollar and therefore the value of their investments, will go from friends to foes, from eager buyers of those treasury bills, notes and bonds to eager sellers.  And as they do, indeed because of it, the Federal Reserve will be forced into action like never before, to become THE buyer of these bills, notes and bonds en masse, a vicious circle which could eventually lead to the destruction of the dollar.

To repeat, national bankruptcy through the printing press.

In part 3 of this series, we will have a look at these U.S. government creditors, how much longer we can expect them to remain friends of Peter and Paul, and with it, the prospects for the wholesale entrance of the Federal Reserve and the inflation tax as the politician's last resort.

Part 3. Peter and Paul have some friends, for now

Let's begin with a recap of the U.S. government's financial state.

As we saw in Part 2 of this series, The U.S. government has $12 trillion in debt.  It has unfunded liabilities, that is, committed spending in the pipeline, of between $52 and $107 trillion.  That's total obligations of between $65 and $119 trillion, and as I suggested in Part 2, likely a lot closer to $119 trillion.  And to top it all off, the U.S. government is not only spending almost $4 trillion per year, but adding to its obligation footings at a rate of between $5 trillion and $8 trillion per year.

A financial mess and clearly unsustainable.  So what's next? Well, our politician friends could renege on their promises to Paul.  Political suicide, I submit, and highly unlikely, certainly without the cover of an all out government funding crisis. With that aside, let's review the financing roadmap for all this government largesse.

First, our politician friends could raise taxes.  As the Obama administration has recently proclaimed, the U.S. government is certainly on track to impose all kinds of new Tax Peter now venues, to try to pay for all this spending.  But as we saw in Part 2 of the series, compared to the spending load the government now faces, to the extent tax rates can be hiked without eventually cratering the economy, any funding raised in this manner is likely transient and clearly a drop in the bucket.

Next, we have a politician favorite, Tax Peter later; namely, borrow the excess of spending over tax receipts by tapping the savings of U.S. government creditors.  For sure, where the action has been and will continue to be.  But as we have seen, to take a bill already too big to pay and make it an even bigger bill is financial suicide.

That brings us to every politician's favorite tax venue, the inflation tax.  Yes, say the politicians and Federal Reserve officials too, must sprinkle in a bit of these stealth taxes.  Not too much though, so as not to destroy the value of the dollar and scare the government's creditors.  Just enough to lend a bit of assistance to the government's Tax Peter later policy, so that the government is not too big a burden on the economy.

Problem is, as the IOU the U.S. government is running with its creditors grows ever larger, it will become more and more apparent to those creditors that the only way out for the government is via the Federal Reserve's inflation engine.  A sprinkle here and two sprinkles there, they will surmise, ain't going to get it done.  The IOU will have become just too big.  And then D-Day, time for them to pull their savings, before the U.S. government ushers in the wholesale use of the Federal Reserve's inflation engine.

OK you say, I got it.  The clock is ticking, but when can we expect Peter and Paul's creditor friends to turn from friends to foes? The first question to ask, how deep are the pockets of these creditors? Let's start with U.S. based creditors and ask this question, is the U.S. savings pool big enough to fund all this government borrowing and spending, and if so, for how long? Here's the 50 year record of government borrowing against U.S. private savings through fiscal year 2009:

And the 50 year record of government debt against those same savings aggregates:

Can you say parabolic?  The charts speak for themselves.  The government is simply overwhelming the capacity of U.S. based creditors to fund all this government spending. Now, let's add in the impact of unfunded liabilities, as they mature into spending, and then into yet more government debt.  For this, we need some scenario analysis.  The resulting debt-to-savings ratios are breathtaking.  Take a look:

Assuming just 50 percent of the government's unfunded liabilities are turned into U.S. government debt, under the best case scenario, we are looking at debt-to-savings ratios of 16 times gross and 47 times net private savings (net of capital consumption on fixed assets), and under the worst case scenario, ratios of 28 times gross and 80 times net private savings. 

Assuming 100 percent of those unfunded liabilities are turned into government debt, under the worst case scenario, and I do believe that is where the U.S. government is heading, those ratios balloon to a whopping 50 times gross and 145 times net private savings. Add in the fact that the government's obligations are currently growing at $5 to $8 trillion per year and it's impossible not to conclude that the U.S. government's borrowing needs will be swamping the capacity of U.S. based creditors to fund those needs for years to come.

With all this, you ask, what's keeping the government's inflation engine in the yard?  Clearly U.S. based creditors do not have near enough savings to buy all the government's debt.  Why is the Federal Reserve not in their hook, line and sinker, printing money, buying up government debt, right here, right now? And the simple answer, not all of Peter and Paul's friends are U.S. based creditors.  In fact, of late, not many at all.

Enter Peter and Paul's best friends, foreign private and central bank creditors.  They are filling the gaps left by U.S. based creditors, and doing so in size. Here's the long term trend of foreign held U.S. government debt against total government debt sold to and held by the public, through fiscal year 2009:

And the long term trend of annual foreign investment flows:

Again, the charts speak for themselves.  Foreign based creditors hold about half of the U.S. government's publicly offered debt, about twice as much as they did in the 1990s, 3 times what they did in the 1980s and 10 times what they did in the 1960s.  In the decade just passed, foreign based investors absorbed about three fourths of the government's public debt offerings, interestingly about the same time U.S. government spending really took flight. Indeed, to say that foreign based creditors are Peter and Paul's best friends is an epic understatement.

Let's pause for some Austrian economics 101.

As discussed in Part 1 and Part 2 of this series, and in contrast to mainstream Keynesian thinking, Austrian economists teach that the government can not take from Peter, the producer, to spend on Paul, the consumer, and expect the economy to grow.  Indeed, it's just the opposite.  One must produce before one can consume, lest before long there is nothing left to consume.  Continue down a spend-now-ask-questions-later path and you eventually run out of Peters.  You eventually end up with a basket economy, with no one left to pay ANY bills.

Well, there is no surer way for the government to usher in a basket economy then to attack the fuel which powers Peter's production, the economy's savings pool.  It's what Austrian economists call crowding out and it's an economic disaster, worse then outright taxes.  One of my favorite economists, Henry Hazlitt, explains:

The crowding-out argument can be stated in a few elementary propositions: (1) Government borrowing competes with private borrowing. (2) Government borrowing finances government deficits. (3) What the government borrows is spent chiefly on consumption, but what private industry borrows chiefly finances capital investment. (4) It is the amount of new capital investment that is chiefly responsible for the improvement of economic conditions.

Nothing like shooting yourself in the foot, don't you think?

So, not only is there not enough savings in America to fund the government's ballooning borrowing needs, but because all this government borrowing "crowds out" private capital investment, and so retards economic growth, the income producing capability of the American economy is being systematically destroyed.  No economic growth, no income growth.  No income growth, no way to pay for all this government borrowing and spending, except of course through the printing press.

Now, do you think that at least some of Peter and Paul's foreign creditor friends might agree with the Austrians?  That a country with a massive debt burden, that's growing that debt by leaps and bounds every year, all the while gutting its ability to service that debt by consuming it away, may not be such a good long term investment.  Especially, a country with the world's largest printing press as its back-up plan.

I think so.

Indeed, just listen to one foreign government leader after another as they express their concern over the U.S. government's ever mounting debt obligations, and what that might do to the value of their U.S. treasury holdings.  Do you think they are starting to get it?  James Grant, editor of Grant's Interest Rate Observer, calls this concern foreign creditor "restiveness."  I love the term, and that "restiveness" is growing. The evidence isn't all anecdotal, either, for one could make the case that you can see this "restiveness" in the foreign investment flow numbers too.

First, have another look at the previous two foreign investment flow charts.  Note the topping action in both the foreign investment flow dollars and the amount of government debt held by foreign creditors.

Now, let's zoom in on that topping action.  Have a look at the chart below, showing the foreign investment flow into U.S. treasuries as a percent of U.S. government borrowing, and ask yourself these questions.  Are foreign based creditors getting a bit apprehensive?  Are they perhaps pulling back?

Note the blue line.  Quite a drop in the amount of U.S. government debt offerings foreign creditors have been willing to take of late, don't you think? Foreign based creditors may still be buying U.S. government debt, but at nothing like the pace experienced in recent years.

None of this necessarily says that foreign creditors are about to abandon the U.S. government, right here and now, en masse.  Certainly, many think Bernanke's unprecedented zero interest rate policy and Obama's massive fiscal stimulus will cleanse America's financial system and restore American growth.  For many, their Keynesian economic training tells them so.  But as an Austrian economist, I know their policies will fail.  And maybe, some foreign creditors are beginning to think so too.  Maybe they are beginning to think their investments may not be so safe.

The interesting thing about the foreign creditor is that there is no investor more sensitive to the purchasing power of the U.S. dollar than he.  Think of him as a leading indicator.  At the first sign that the U.S. government can not make good on its obligations other then via the Federal Reserve's printing press the foreign creditor will want out.

And when that time comes, expect these foreign creditors to sell their U.S. treasury holdings in increasing amounts, to get out before it's too late.  And as they do, don't bet on U.S. based creditors to stand idly by, not for a minute.  They will be right behind them.

You know, what's going on in Europe, with the fiscal plights in Greece, Portugal, Spain and Ireland, it's a bit of a prelude to what might eventually happen to America.  America is not Greece, Portugal, Spain or Ireland, at least not yet, but the fiscal state of these nations are not all that different from that of America, with one glaring exception —America can print money at a moments notice with which to pay its debts.  But as we have seen, that only means that when the U.S. government's funding crisis does come to America, it could make what's happening to these countries look like child's play.

So, back to the original question, what's keeping the U.S. government's inflation engine in the yard?  The answer, foreign creditors.  And when they say it's time to exit, it won't be long before our politician friends will have no other choice but to either come clean with Paul, and cut spending, or, and pardon the vernacular, tax the crap out of Peter via the Federal Reserve's printing press.

In my opinion, bet on a lot, and I mean a whole lot of the latter first.

In fact, as the recent investment flows of these foreign based creditors suggest, the Federal Reserve's printing press is already beginning to grind its engines.  I'll show how in the next and final part of this series.

U.S. government, on its way to bankruptcy, part 1

U.S. government, on its way to bankruptcy, part 2

Michael Pollaro writes a column called The Contrarian Take, its mission to present thoughts and ideas on important financial market and economic trends from the perspective of a free-market, Austrian economist. He is also is a retired Investment Banking professional, most recently Chief Operating Officer for the Bank's Cash Equity Trading Division. He is a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor.

Subscribe to BrookesNews Bulletin