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The U.S. government is insolvent. Who says so?
Timothy F. Geithner, the U.S. Secretary of the
Treasury.
Geithner sent a letter to Congress on Jan. 6, 2011 asking
for the debt limit to be raised. If it is not raised, he warned, the U.S.
will default on its debt. In his words:
Never in our history has Congress failed to
increase the debt limit when necessary. Failure to raise the limit would
precipitate a default by the United States."
He didn’t say that the government will
be inconvenienced. He didn’t say that the government would be forced to
muddle through by delaying payments, raising taxes, and cutting
non-obligatory programs and services. He said the government will default.
This means that the government doesn’t have enough cash to pay its
obligations to the many and sundry persons to whom it owes cash unless Congress
authorizes an issue of even more debt.
After the government issues the new debt, its
overall debt will be even higher than before. Unless its obligations that
require cash payments are reduced, or unless it finds new sources of revenue,
or unless the interest rates that it pays decline, the same situation will
surely occur again and occur even faster because its
overall debt will have risen. It will run short of cash to pay its
obligations.
Suppose that you had a debt of $10,000 that
required a payment of $500 in order to stave off your creditors’
seizing your assets. Suppose that you didn’t have the $500. One way out
would be to borrow $500 from a new lender and use that $500 to pay off the
old lenders. That buys you time. However, now you have debts of $10,500. You
have to find ways of lowering this or else you will again be faced with an
even worse situation.
You are approaching insolvency when you begin
to run out of new lenders who are willing to add to your debt. The willing
lenders dry up because they know that they have to get in line to get their
promised payments while you continually seek out new borrowers, all the while
making your situation worse and worse.
Knowing their precarious position, the new
lenders are likely to demand rising default risk premiums.
That means they demand higher interest rates.
That means your cash payment obligations go
up. That hastens your approach to insolvency.
Insolvency occurs when you cannot find enough
cash from any source, even new lenders, in order to make required payments.
The U.S. is approaching insolvency, according
to its Treasury Secretary. He didn’t put the matter in precisely that
way, but he put it in words that are as close as you can get to it. He said
that the U.S. would default, and its only way out at this moment is to issue
more debt.
The increases in the debt limit have necessarily accompanied the increase in the
government’s overall debt. Those increases have been especially
astonishing in the last 10 years. The ceiling is now $14.29 trillion. The
ceiling was $5.73 trillion in September of 2001. That’s a growth rate
of over 10 percent a year.
A few months back, Laurence Kotlikoff wrote that "The U.S. is bankrupt." Using
the government’s numbers properly labeled, he found that the U.S.
fiscal gap, which is the difference between the present value of projected
spending and revenues, is $202 trillion. An IMF study of the U.S. finances
found that it would have to double taxes to close its fiscal gap. This is an impossibility. It would destroy the struggling economy.
Geithner’s statement confirms those of
other analysts outside of the U.S. government.
According to Kotlikoff, the government’s
sixty-year "massive Ponzi scheme" will end when there are not
enough revenues to pay for Social Security, Medicare, and Medicaid. He sees
large benefit cuts, large tax increases, and high inflation ahead when the
government seeks to survive.
How will the U.S. extricate itself from this
situation? That’s a matter of speculation because there are many
interacting variables involved. There are lots of ifs, ands, and buts.
When a state cannot meet its promised
obligations, there is no bankruptcy code to guide a
reorganization, as there is with a company. There is no court to
oversee a restructuring. There is no judge or panel that decides on the
priority of claims. Instead, the government itself decides how to handle its
inability to pay cash to fulfill its promises.
In the immediate future, the U.S. government
will not default on its bonds. They will have priority of payment. The reason
the government will do that is to maintain its capacity to borrow at
reasonable rates of interest so that it can maintain its size and programs.
If the government defaulted on its bonds as a way of solving its financial
problem, it would have immediately to cut back its spending severely. The
government would shrink radically all at once. The government would take a
big bath. Congress doesn’t want to do that. It would rather stretch out
the default process and inflict the pain over time and among more groups than
bondholders. Congressmen prefer to maintain themselves in power while
managing a large government. Other branches and bureaucracies also prefer to
keep their pet programs and activities afloat.
Therefore, as usual, Congress will raise the
debt limit again. That doesn’t end the financial problem. It adds to it
even as it postpones and enhances possible insolvency.
The new lenders that the government seeks out
to lend it new cash are likely to demand higher interest rates, except for
one major lender, which is the Federal Reserve System.
Bond yields are subject to numerous worldwide
influences. They include the default risk premiums demanded by foreign lenders,
including Asian central banks. Those risk premiums are likely to rise.
In contrast, the Federal Reserve has committed
itself to buying $600 billion of new government debt in the next few months.
Its purchases tend to support bond prices and keep interest rates down, other
things equal.
As the Federal Reserve keeps buying more and
more government debt, with no prospect of reducing its holdings unless and
until the government gets its house in order, bond yields are likely to rise,
despite Fed buying, because yields also reflect inflation premiums. The
prospect of inflation will rise as the Fed monetizes the debt. We would then
see yields rising accompanied by firm prices of commodities and metals.
The inflationary participation by the Fed,
which postpones the inevitable fiscal decisions of the government, harms all
holders of fixed-dollar assets and all those whose receipts of dollars are
fixed and lag behind the Fed’s production of new dollars. In addition
and more importantly, the inflation sets in motion another boom-bust cycle.
Continued debt monetization by the Fed is
quite likely for many reasons. One is that the Fed can act even when Congress
is deadlocked. Another is the apparent necessity, in the Fed’s view, to
avoid the failure of government debt issues. A third is that the Fed
rationalizes what it’s doing by economic slack and low headline CPI
inflation. Fourth, the banking system is still insolvent and the Fed wishes
to raise asset prices. Fifth, the Fed doesn’t connect its debt
monetization to higher yields. When it starts to make that connection, either
directly or because headline CPI inflation rises, then it may be more likely
to alter its current policy.
If the U.S. does not decrease the fiscal gap,
rising yields will rapidly force it into taking action because rising yields
raise the likelihood of insolvency and raise the likelihood of its occurring
sooner rather than later.
The effects of the Fed’s inflation on
stocks vary by individual company. They depend on the net monetary positions of
the companies, the nature and location of its operations, its hedging, and
other factors. There is no simple prognosis for the whole stock market.
Since yields are likely to rise as lenders
demand higher default risk premiums and as they demand higher inflation
premiums (when the Fed monetizes debt), with the Fed’s ability to keep
rates down only a temporary and/or only a restraining phenomenon, and since
these yield increases hasten the prospect of insolvency, the government can
only avoid default by either slowing down its borrowing (and spending) or by
raising revenues. Doing nothing means it will default.
If government borrowing slows down, its
spending will have to slow down. Many Americans will find this very
unpleasant as benefits, now and prospective, are cut, and as various other
programs are cut. If government raises taxes, the impact of its gargantuan
borrowing will come home to Americans, again in a most unpleasant way. Their
disposable incomes will fall sharply.
Outright default on U.S. bonds is not in the
cards because that immobilizes the entire U.S. government. The government
won’t do that. It will look after itself and its own survival first.
The American public comes last. Default upon promises made to Americans is
the more likely course of action.
Thus, the government will slow budget
increases, or stop them altogether, or cut its spending in absolute terms.
Like any borrower, its borrowing capacity is not unlimited. Its borrowing
capacity depends on its taxing power which, in turn, depends on the
productivity of those whom it taxes. Causation runs in both directions. The
productivity also depends on the tax and regulatory structures. It’s
inconceivable that the government could double taxes. If it did, most of the
economy would attempt to go underground. Whatever remained above ground would
have vastly reduced incentives to produce.
Which groups and programs will be the object
of government cutbacks? That is again a matter of speculation. It depends on
which groups have the firmest control over the government’s purse,
which groups make the largest protests, and which groups have the greatest
influence on votes for key Congressmen and campaign contributions. I agree
with Kotlikoff and Gary North that the most likely targets are the largest ones,
and they are the social welfare programs.
Some groups are going to experience the brunt
of the actions taken to avoid default. Others are likely to go relatively
unscathed. Government bureaucrats will try to protect themselves. This is
going to create domestic conflict, protests, and dissension. Life is going to
be much harder for Americans in the future, unless increased productivity
from some unknown sources of invention or technology offsets the impact of
government promises that are going to be defaulted upon.
Congress has another option, which is to seize
the assets of Americans. This is a form of taxation. Congress can force
pension funds to take its bond issues. This would force down the prices of
corporate stocks and bonds. It would devastate the economy. A large-scale
program of bond cram-downs is almost tantamount to making the Fed absorb
bonds. It puts pressure on the Fed to create more money so as to keep asset
prices up. Such a program would be an act of desperation by the government
that simply beggared the population. It would certainly not resolve the
insolvency.
When, if ever, will Congress start to act in
size, that is, with cutbacks large enough to avoid defaulting on its bonds? My answer is this: Not yet.
The prospect of rising yields is not yet felt
in the minds of those in government. The prospect of a budget out of control
due to a huge and rising bond interest payment obligation hasn’t yet
hit home among government officials. They can’t see the tidal wave.
They don’t believe it’s coming. The
Fed’s purchase program is obscuring their vision. The slow economy is
helping to hold down bond yields for the moment. The foreign central banks,
as a group, are still supporting the U.S. bond market. People who are afraid
of going back into stocks are still supporting the U.S. debt market.
Furthermore, the two parties are both enamored
of big government. Nearly all politicians are sensitive to public demands for
free lunches. That is one reason why the fiscal gap is so huge in the first
place. America did not exactly fall all over itself in trying to stop a
prescription drug benefit. Consequently, the government is postponing actions
to close the fiscal gap.
One fine day, there will be a discontinuity.
There will be a many-sigma event. There will be a fiscal earthquake or a
market earthquake or some combination of both. This will not be a pleasant
experience for Americans, but those in government have little reason to fear
it. They can label it a crisis, as if we do not already have a crisis. They
can use such a "crisis" as the excuse for more radical government
action. The government can demand even more power or simply exercise it, even
if the results are to make matters worse for Americans.
For governments, crises are opportunities, a
fact well known among analysts of government. This fact is one reason why
governments postpone taking actions to remedy what appear to the rest of us
to be bad situations.
Unfortunately, the fact that governments
batten on crises and see them as opportunities is not well known among the
general population which still looks to government to handle crises.
Since the insolvency of the U.S. is a fact and
a fact that implies hard times ahead for anyone who depends on government, it
is prudent to take measures to make oneself as independent of government as
one possibly can.
Michael S. Rozeff
Michael S. Rozeff is a retired Professor of
Finance living in East Amherst, New York. He is the author of the free e-book Essays
on American Empire. He publishes
regularly his ideas and analysis on www.LewRockwell.com
. Copyright © 2009 by
LewRockwell.com.
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