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The Fed's lucky streak of luring bond investors with low
interest rates may be drawing to a close. Nevertheless, the extended period
of low borrowing costs has bred a new breed of investor. To the bulls and
bears, we can now add the ostriches - those who bury their heads in the sand
of declining debt service ratios while refusing to face up to intractable
levels of total US government debt. If these ostriches were to actually look
at the numbers, they would realize that it is their investments which are
made of sand.
As the issuer of the world's reserve currency, the US
government has enjoyed the benefits of low interest rates despite its
inflationary practices. When we run a trade deficit with a country like
China, they have a strong incentive to 'recycle' the deficit back into our
dollars and Treasuries. This practice has hidden what would otherwise be much
higher borrowing costs and much lower purchasing power for the dollar. This
artificial price signal allows people like Paul Krugman to claim that the
Obama Administration's stimulus programs should be much larger. Because our yawning
fiscal deficits have not driven bond yields significantly higher, he sees no
reason to curtail spending. Krugman wants to spend like its World War III,
and then has the nerve to call those worried about the budget mindless
zombies!
Krugman is just one partisan Democrat shouting at mirrors,
but the misunderstanding has struck the right-wing as well. Last week, in a
debate with me on CNBC's The Kudlow Report, Brian Wesbury,
Chief Economist of First Trust Advisors and writer for The American
Spectator, claimed that our $9.3 trillion national debt is of little
consequence because our GDP is a far greater. However, he failed to note that
our $14.7 trillion of GDP only yields about $2.2 trillion in revenue for the
Treasury. To fully access that entire GDP, the government would have to raise
all tax brackets to 100% without producing any reduction in output or
decrease in revenue. This is, of course, preposterous. As was demonstrated in
the 1970s, even small increases in marginal tax rates have a substantial
negative impact on output. A healthier appraisal would center on the fact
that our publicly traded debt is now 422% of our annual tax revenue.
Wesbury did mention that if the government could not raise
revenue to pay off the bonds, it could simply monetize the debt with few
significant consequences. Apparently, paying back one's creditors in
worthless paper is not technically "default" to an economist.
So neither Krugman nor Wesbury, both intelligent, highly
educated economists, see our current course leading to imminent crisis.
Unfortunately, both have been led astray by the low debt service ratio which
has masked our economy's underlying insolvency. To see through the haze, you
have to look at the numbers behind this so-called "deleveraging
consumer" and then look at the debt of the nation.
The data point most utilized by those who espouse the idea
of a healthy consumer is the household debt service ratio (DSR), a metric
that relates debt payments to disposable personal income. This figure peaked
at 13.96% in the third quarter of 2007; it has since dropped by 15%, to
11.89%. It is hard to see this as a significant amount of deleveraging, especially
when looking at longer term trends. But it gets worse! Most of that modest
decline is simply a function of lower interest rates, which have made debt
easier to bear. Total household debt has gone down much less. This figure
peaked at $13.92 trillion in Q1 2008, and has since declined only 3.5% to
$13.42 trillion. How's that for deleveraging?!
It's also worth noting that back in the first quarter of
2008, most homeowners were sitting on a pile of home equity to offset that
debt. Today, most of the equity has vanished, yet the debt still remains.
When looking at the national debt, the situation is even
more depressing. At the end of 2006, total debt held by the public was $4.9
trillion. According to the Treasury Department, the average interest rate paid
on that debt was 4.9%. Therefore, the annualized interest payment at that
time was $240 billion. At the end of 2010, our publicly traded debt has
increased to $9.3 trillion, but the average interest rate on that debt has
plummeted to just 2.3%. So, despite an 87% increase in debt in just a 4-year
time span, the annualized debt service payment actually fell 11% to $213
billion. Krugman and Wesbury look at this and see progress.
Meanwhile, the average maturity on our debt has declined
to 5.5 years. Compare that with the UK's gilts, which average about 14 years,
or even to Greece's bonds, which average about 8 years. Falling interest
rates and reduced durations have merely given the illusion of solvency to the
US as compared to these other ailing sovereigns.
By 2015, our publicly traded debt is projected to be at
least $15 trillion. Even if interest rates simply revert to their average
level - not a stretch, given surging commodity prices and endless Fed money
printing - the debt service expense could easily reach over $1 trillion, or
about 50% of all federal revenue collected today. Just imagine what would
happen if rates were to rise to the level of Greece, nearly 12% on a 10-year
note, as opposed to our current 10-year yield of just 3.5%. I bet Athens, Georgia
wouldn't look much better than its namesake. Don't forget: as interest rates
rise, GDP growth slows, sending the debt-to-GDP ratio even higher.
Earlier this year, it wasn't the nominal level of debt
that suddenly sent euroland into insolvency, but rather a spike in debt
service payments. Right now, the US national debt is the biggest subprime ARM
of all time. Much like homeowners who thought they could afford a mortgage
that was 10 times their annual incomes, Messrs. Krugman and Wesbury are
blinded by deceptively low current rates of interest. These ostriches won't
poke their heads up to see the writing on the wall: low rates and
quantitative easing cannot coexist for long. As rates continue to rise, the
reality of US insolvency will be revealed.
Michael Pento
Senior Market Strategist
Delta Global
Advisors, Inc.
Delta Global Advisors
: 19051 Goldenwest, #106-116 Huntington Beach, CA 92648 Phone: 800-485-1220
Fax: 800-485-1225
A
15-year industry veteran whose career began as a trader on the floor of the
New York Stock Exchange, Michael Pento recently served as a Vice President of
Investments for GunnAllen Financial. Previously, he managed individual
portfolios as a Vice President for First Montauk Securities, where he
focused on options management and advanced yield-enhancing strategies to
increase portfolio returns. He is also a published economic theorist in
the Austrian school of economic theory.
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