There was an interesting and thought-provoking article in January 3rd Barron's by long-time trader Victor Sperando. Mr. Sprerando's core thesis is that there is a level of current government borrowing to spending (e.g. borrowing to fund a deficit) that is associated with hyper-inflation. And, more specifically, the U.S. is now running at that level.
Let's suspend that discussion for a moment and focus on the accumulated debt, which is approximately $14 trillion. If those notes and bills were to carry an interest rate of 5%, which is certainly not outlandish, the annual carry would be a whopping $700 billion. That, of course, wouldn't be amortizing the loan (paying any principal), but rather would be analogous to paying the minimum on one's credit card bill.
How could this debt ever be repaid? There are four ways:
1. The method that Republicans seem to be placing their hopes on: that the economy grows so fast while spending remains so constrained that our current $1.2 trillion deficit melts away, replaced by annual surpluses, which gradually pay off the debt. That is certainly mathematically possible, as is winning Powerball or getting struck by lightning while in an underground bunker.
2. Our leaders develop gumption, discipline and commitment, raise taxes and slash spending, eliminating entire cabinet departments and agencies. Social Security eligibility age is hiked dramatically to 70 and quickly to 72 for younger contributors, and the option to take benefits at 62 eliminated. Sacred cows like Medicare and defense get seriously cut. Tax rates go up not just on the rich, but everyone to make everyone part of the solution. This puts the country through a painful adjustment period, but a path to fiscal rectitude is established.
3. The currency is debased, not a little, but a lot, e.g. 25% or more, so that tax revenues explode (tax rates are assessed against salaries, wages, and interest-income that has been jacked-up 20% or more, moving masses into higher wage brackets). Since the vast majority of U.S. Government debt is not indexed for inflation, debt holders get paid with dollars of much lower value than the amount the holder originally loaned.
4. A default. The U.S. government announces that it simply cannot repay its debts as they come due, and is going to cut the rates, extend the maturities, and reduce the principal balance it will pay.
Let's comment further on each. Number one is the path chosen by Portugal and Greece. That is, lying to the government employees about its ability to pay pensions, lying to contributors to Medicare and Social Security that there will be money for them when they retire, etc. in effect shifting current obligations to future generations.
The second seems abundantly logical to me, but conservatives are unwilling to cut defense or raise taxes (fellow countrymen: we are broke; you must accept that and act accordingly) and liberals aren't prepared to surrender low ROI functions (Departments of Energy, and Education as Exhibits I & II). (Repeat after me: we are broke. We owe 14 trillion dollars). And every elected official is prepared to give Homeland Security anything they ask for, no matter how ridiculous).
Therefore, while I think the tough medicine of number two is the logical choice, I despair over the likelihood that anyone will volunteer to take the pain.
The third will lead to a variety of mischief and unintended consequences (who will buy a treasury bill, even at a 10% coupon, if they think it will lose 15% per year in purchasing power). Mr. Bernanke recently opined about the Federal Reserve's power to stop inflation. I don't know if he actually believes that, or felt that he must preserve the myth. In either case, if unemployment is high, opposition to the kind of choking reductions in the money supply and increases in interest rates required to subdue a strong wave of inflation will be bi-partisan and massive.
Lastly, a default/restructuring of U.S. Government debt probably triggers a global depression. Unless the government is running a balanced budget or surplus at the time it defaults, it almost certainly precipitates a U.S. depression, because no individual or foreign government would be willing to purchase new issues of debt to a government in default. All holders of government paper: individuals, pension plans, university endowments, charities, foreign governments, mutual funds, etc would suffer crushing losses, destroying purchasing power, retirement income streams and the like. This was done by both Argentina and Chile in the last 25 years or so. Chile followed with very strong free-market initiatives (including successfully privatizing their version of Social Security) and has largely recovered. Argentina, once a first-world country, devolved into a shadow of its former economic self.
Let's come back to Mr. Sperando's Cassandra warning. Being a trader, Mr. Sperando understands sentiment. Negative sentiment caused stocks in 1973 and 2008 to trade at valuations, in some cases, down almost to amounts that were fully backed by corporate balance sheet cash. Conversely, positive sentiment caused Internet stocks in the fall of 1999 and January of 2000 to trade at dozens of times revenue. While Mr. Sperando views the collapse signal to be very high double digit monthly inflation, I would look for something entirely different. Currently, treasury auctions are selling out at low interest rates (albeit that a lot of it is being bought with chimerical dollars by another government agency: the Federal Reserve). If one suddenly observes a sharp rise in the rates required by investors to purchase t-bills, that seems to me to be the red blinking light on the dashboard, signaling that the Chinese and others foresee getting repaid with 80 cent, 60 cent or even 40 cent dollars, and they are no longer prepared to assume that risk. At that point, hyperinflation may occur, or America gets its visit from the IMF like Malaysia 15 years ago, and ordered to enact the second program, except, by then, the hole is even deeper.
The doomsday scenario is the "busted" auction: the government offers $100 billion for sale and only gets buyers for, say, $50 billion. We are back to the fall of 2008 on the brink of economic collapse. The TARP remains widely criticized by seemingly smart and educated people. There is clear data that the U.S. was on the brink of a credit collapse at that point. This would bring us right back to that point or worse.
Since I don't believe our elected officials are prepared to tax and slash, and the cure via super-high-growth seems so unlikely to me, the path of least resistance is runaway inflation.
In the same Barron's, there was a interesting interview with a large hedge fund manager who is buying timberland. He went out of his way to say that buying the stock in a timber company or REIT was insufficient; one needed to own the actual trees. Similarly, over the last few years the price of farmland has risen throughout the country, as the smart money moved from financial to real assets.
Unfortunately I believe we must take Mr. Sperando's cautionary article very seriously.
Let's suspend that discussion for a moment and focus on the accumulated debt, which is approximately $14 trillion. If those notes and bills were to carry an interest rate of 5%, which is certainly not outlandish, the annual carry would be a whopping $700 billion. That, of course, wouldn't be amortizing the loan (paying any principal), but rather would be analogous to paying the minimum on one's credit card bill.
How could this debt ever be repaid? There are four ways:
1. The method that Republicans seem to be placing their hopes on: that the economy grows so fast while spending remains so constrained that our current $1.2 trillion deficit melts away, replaced by annual surpluses, which gradually pay off the debt. That is certainly mathematically possible, as is winning Powerball or getting struck by lightning while in an underground bunker.
2. Our leaders develop gumption, discipline and commitment, raise taxes and slash spending, eliminating entire cabinet departments and agencies. Social Security eligibility age is hiked dramatically to 70 and quickly to 72 for younger contributors, and the option to take benefits at 62 eliminated. Sacred cows like Medicare and defense get seriously cut. Tax rates go up not just on the rich, but everyone to make everyone part of the solution. This puts the country through a painful adjustment period, but a path to fiscal rectitude is established.
3. The currency is debased, not a little, but a lot, e.g. 25% or more, so that tax revenues explode (tax rates are assessed against salaries, wages, and interest-income that has been jacked-up 20% or more, moving masses into higher wage brackets). Since the vast majority of U.S. Government debt is not indexed for inflation, debt holders get paid with dollars of much lower value than the amount the holder originally loaned.
4. A default. The U.S. government announces that it simply cannot repay its debts as they come due, and is going to cut the rates, extend the maturities, and reduce the principal balance it will pay.
Let's comment further on each. Number one is the path chosen by Portugal and Greece. That is, lying to the government employees about its ability to pay pensions, lying to contributors to Medicare and Social Security that there will be money for them when they retire, etc. in effect shifting current obligations to future generations.
The second seems abundantly logical to me, but conservatives are unwilling to cut defense or raise taxes (fellow countrymen: we are broke; you must accept that and act accordingly) and liberals aren't prepared to surrender low ROI functions (Departments of Energy, and Education as Exhibits I & II). (Repeat after me: we are broke. We owe 14 trillion dollars). And every elected official is prepared to give Homeland Security anything they ask for, no matter how ridiculous).
Therefore, while I think the tough medicine of number two is the logical choice, I despair over the likelihood that anyone will volunteer to take the pain.
The third will lead to a variety of mischief and unintended consequences (who will buy a treasury bill, even at a 10% coupon, if they think it will lose 15% per year in purchasing power). Mr. Bernanke recently opined about the Federal Reserve's power to stop inflation. I don't know if he actually believes that, or felt that he must preserve the myth. In either case, if unemployment is high, opposition to the kind of choking reductions in the money supply and increases in interest rates required to subdue a strong wave of inflation will be bi-partisan and massive.
Lastly, a default/restructuring of U.S. Government debt probably triggers a global depression. Unless the government is running a balanced budget or surplus at the time it defaults, it almost certainly precipitates a U.S. depression, because no individual or foreign government would be willing to purchase new issues of debt to a government in default. All holders of government paper: individuals, pension plans, university endowments, charities, foreign governments, mutual funds, etc would suffer crushing losses, destroying purchasing power, retirement income streams and the like. This was done by both Argentina and Chile in the last 25 years or so. Chile followed with very strong free-market initiatives (including successfully privatizing their version of Social Security) and has largely recovered. Argentina, once a first-world country, devolved into a shadow of its former economic self.
Let's come back to Mr. Sperando's Cassandra warning. Being a trader, Mr. Sperando understands sentiment. Negative sentiment caused stocks in 1973 and 2008 to trade at valuations, in some cases, down almost to amounts that were fully backed by corporate balance sheet cash. Conversely, positive sentiment caused Internet stocks in the fall of 1999 and January of 2000 to trade at dozens of times revenue. While Mr. Sperando views the collapse signal to be very high double digit monthly inflation, I would look for something entirely different. Currently, treasury auctions are selling out at low interest rates (albeit that a lot of it is being bought with chimerical dollars by another government agency: the Federal Reserve). If one suddenly observes a sharp rise in the rates required by investors to purchase t-bills, that seems to me to be the red blinking light on the dashboard, signaling that the Chinese and others foresee getting repaid with 80 cent, 60 cent or even 40 cent dollars, and they are no longer prepared to assume that risk. At that point, hyperinflation may occur, or America gets its visit from the IMF like Malaysia 15 years ago, and ordered to enact the second program, except, by then, the hole is even deeper.
The doomsday scenario is the "busted" auction: the government offers $100 billion for sale and only gets buyers for, say, $50 billion. We are back to the fall of 2008 on the brink of economic collapse. The TARP remains widely criticized by seemingly smart and educated people. There is clear data that the U.S. was on the brink of a credit collapse at that point. This would bring us right back to that point or worse.
Since I don't believe our elected officials are prepared to tax and slash, and the cure via super-high-growth seems so unlikely to me, the path of least resistance is runaway inflation.
In the same Barron's, there was a interesting interview with a large hedge fund manager who is buying timberland. He went out of his way to say that buying the stock in a timber company or REIT was insufficient; one needed to own the actual trees. Similarly, over the last few years the price of farmland has risen throughout the country, as the smart money moved from financial to real assets.
Unfortunately I believe we must take Mr. Sperando's cautionary article very seriously.
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