U.S. Debt Burden: Negotiate, Inflate or Repudiate?

While equity markets are legitimately catching a reflation bid as the economic freefall reflected in incoming trade and industrial production statistics begins to level out, it's crucial to take a realistic view of the sort of recovery that is likely in 2010 and beyond. A key constraint will be the enormous and historically unprecedented leverage the US economy has accumulated over the past 15 years. In recent years, it has taken over $5 of new debt to generate an incremental dollar of US national income, a ratio up 70% in a decade.

Debt, like any economic factor, suffers from diminishing marginal returns. US gross national debt/GDP will rise to 82.5% in 2010 (up from 55% in 2000) according to OECD projections, after running at least a 12% fiscal deficit this year. Globally, only two other major economies, Japan at 177% and Italy at 115% will have higher debt burdens, but both have enormous private sector savings and little personal debt. Household mortgage and financial sector debt both doubled from 2000 to 2007 from a base that was itself an all-time high.

US consumers have had no choice but to pull back from spending to try to service that debt in the context of huge personal balance sheet destruction. Hence the fast rising personal savings rate, already at 5% and headed to at least 8-10% over the next year as the private sector begins to pay down its debt load. I think the national debt, corporate debt and personal debt are all ultimately claims on the same thing: the future productive work of taxpaying US citizens. On that basis, we should look at the total debt load imposed by all three, because the ratio of that total debt to the reasonable capacity for future work is what makes credit, in the aggregate, believable or not.

The US is now adding public debt faster than it is shedding personal/corporate debt and it's simply not sustainable as looming demographic decline reduces trend growth rates. Those 4% medium-term growth forecasts in the Obama budget look hopelessly optimistic faced with a deleveraging financial environment and shrinking workforce; the US struggled to reach even 3% in 2003-7 as it binged on cheap credit. The US average household debt to income ratio was above 1.6x at end 2008; the Eurozone is half that level. That average flatters the situation; the distribution of debt versus income and net household wealth is particularly extreme in the US, and that 'two paychecks from bankruptcy' cliche rings true for many. Aggregate public, corporate (including financial sector) and consumer US debt is currently about $57trn or 4 times national income, and likely to rise further by end 2009, as a function of falling GDP and rising government spending. The question now is: will this crushing debt burden be repaid, eroded by inflation or simply repudiated?

Of course, there are netting effects in those gross debt figures, as some Federal debt is held by other government agencies etc. Nonetheless, no society in human history has accululated anything close to this level of debt relative to income and none of the figures above include the unfunded liabilities for Medicare and Social Security. They also take the Administration's latest deficit projections at face value, which the CBO certainly doesn't. The chart below shows their independent deficit forecasts through 2020, and are truly sobering (the CBO runs a separate analysis of the budget to determine the projected deficit using the President’s proposals). Assuming that the changes proposed by the White House are, in fact, enacted, on CBO estimates the 2009 budget deficit will total over $1.8 trillion.

click to enlarge images

While a high debt ratio is rational early in an individual's or indeed a country's economic life-cycle ie when they're in a high income growth phase, it is reckless for a mature economy like the US facing a declining number of labor force entrants over the next decade, a rising dependency ratio and trillions in unfunded retirement liabilities and healthcare costs. The chart below should give any prospective buyer of a 30 year Treasury bond serious pause for thought.

Near term, a combination of growing private sector savings and Fed manufactured inflation will erode the consumer debt mountain, but probably not fast enough to avert a public debt funding medium-term in the long period of relative economic stagnation that seems the most likely outlook. The fact is that aggregate debt to income is a mean-reverting series, and that mean for the US takes us back below 200% gearing or about half current leverage levels, even assuming the dollar retains its current status. The question is how to get there; current (declining) tax revenues of $2.6trn don't support an additional $1.8trn of debt this year alone. US public debt held by non-resident foreigners is about 115% of US GDP.

While there is no historical example of a country whose currency enjoys global reserve status (a key distinction between America and Argentina) lapsing into public debt insolvency, that crucial status is now under long-term pressure. The historical record shows that the repudiation of public debt had several precedents in American experience. The first wave of repudiation of state debt came during the 1840's, after the panics of 1837 and 1839. Those panics were the consequence of a massive inflationary boom fueled by the Second Bank of the United States. During the deflationary 1840's succeeding the panics, of the 28 American states, nine repudiated part or all of their liabilities. As in every debt repudiation, the result was to lift a great burden from the backs of the taxpayers in the defaulting states. The next great wave of state debt repudiation came in the South after the Northern occupation and Reconstruction had been lifted. Eight Southern states proceeded during the late 1870's and early 1880's under Democratic regimes, to repudiate the debt foisted upon their taxpayers under Reconstruction. In all these cases, popular revolt against economic hardship emboldened politicians to take radical action. Is it inconceivable that over the next decade, as taxes rise inexorably in a very weak and erratic Japanese style recovery pattern, that similar sentiments don't gain traction?

Another shameless precedent was set when the US repudiated Cuba’s external debt after conquering the island in the Spanish-American war in 1898; the American goverment claimed that Cuba’s debt had been incurred without the consent of the Cuban people, so foreign loans had helped to finance oppression and weren't legitimate. Maybe the Chinese have been studying 19th Century American history; that would certainly help explain their panic out of Agency debt last year, and now fast reducing appetite for more Treasuries. Whether the US public debt is inflated away, rescheduled by negotiation, repudiated, or probably a gradual combination of all three, only a sustained boom in US GDP growth could now avert this scenario. The last time US GDP grew sustainably in high single digits was over 50 years ago and then at a time of rapid demographic expansion, not contraction.

Disclosure: None

Comments

[Dave Wrixon:]

So basically the numbers don't stack up?

Or rather they stack up too much!

Apr 03 03:49 AM

[capitalisth...:]

Interesting article! I say inflation will be the primary tool that the US government will employ to service it's massive debt. I'm advising everyone I know to buy commodities!

Apr 03 07:12 AM

[DONE_SONZ:]

Debt defaults are highly likely.Hold your gold.

Apr 03 08:31 AM

[athena:]

All you have to know is that we have been BORROWING money to pay the INTEREST on our debt. The interest payment WILL be close to 1 trillion as our debt climbs to 20 trillion according to their budget.
Who will lend us 1 trillion per year then? Pack your bags...

Apr 03 09:16 AM

[Trane250:]

Printing money on our Swiss-made intaglio presses is the easiest way for the political class to unburden themselves of the mess that they created.

Apr 03 09:24 AM

[Bull Run:]

Printing US dollars is the only game in town. This causes inflation, and allows the US to repay debt will worthless paper. An Austrian economist once said that governemnts are the only entity that can take perfectly good paper and ruin it with ink.

Apr 03 10:22 AM

[Socialism c...:]

There's a 4th option being neglected: "Pay it Back". I suspect the reason we look to the other 3 -- which are "make a deal" or "use monetary policy" strategies, is that Option 4 means old-fashioned hard work. In the case where the federal government owes, instead of individuals having debt, this means the government would have to cut its own power -- downsize government pretty drastically -- in order to have sustainable, ongoing balanced budgets. Our government does not know how to do that -- it has become a self-sustaining black-hole for taxpayer money.

It will not end until we end it.

Apr 03 03:06 PM

[Socialism c...:]

Hard to tell whether you're advocating this, or merely indicating that is what "they" will find to be the only solution.


On Apr 03 10:22 AM Bull Run wrote:

> Printing US dollars is the only game in town. This causes inflation,
> and allows the US to repay debt will worthless paper. An Austrian
> economist once said that governemnts are the only entity that can
> take perfectly good paper and ruin it with ink.

Apr 03 03:07 PM

[Socialism c...:]

Key point to ponder -- in the past, national debt was largely owed to the people of the U.S. Now, it's largely owed to China, Japan, etc. Repudiation is less of an option now, given that. And as for:

"I think the national debt, corporate debt and personal debt are all ultimately claims on the same thing: the future productive work of taxpaying US citizens."

National debt is when government spends too much. Of COURSE it's a claim on taxpaying citizens. Is not the obvious issue the need to cut spending rather dramatically???

Apr 03 03:15 PM

[Darrell:]

Our government debt is dominated in dollars so all the Federal Reserve has to do is issue more dollars and use them to buy back the debt; for sure, if the dollar holders decide to spend their dollars holdings rather than save or invest it, then we will experience hyperinflation.

I think the FR calls this buyback procedure qualitative easing.

For the Corporation with too much debt, they simply declare bankruptcy, and the stockholders loses, while the debt holders wins; the debt holders has several options: they can exchange their debt for new shares in the company; they can liquidate the company and collect the proceeds. Or whatever other options they can think up.

The debt holders are making the decisions, and they will select the option that will make them whole. In any outcome they select, the debt holders comes first, the shareholder comes last.

For the individual with more debt that their income can support, they simply declare bankruptcy. Their first action, once they decide on bankruptcy, is to visit a bankruptcy lawyer and empower the lawyer to take control of their bankruptcy.

In any excess debt situation, our laws have evolve in a manner that resolves excess debt problems in a rational manner; I would not worry about excess debt burdens destroying the ability of our economy to function effectively.

Much of our current debt problems is the result of our brokerage firms being able to securitize debt, have rating agencies give it a high rating, and then sell it to unsuspecting buyers. Most of these buyers were retirees, institutions and others that wanted an ongoing income stream.

Did these buyers of securitized debt, understand that they would lose their income stream and their capital that created the income stream?

If any thing our bankruptcy laws should be expanded so that these debt holders have the right to sue the sellers of securitized debt and take what ever profits they gained.

Apr 03 03:48 PM

[jimboy:]

A quite excellent article - just lays out the cold hard facts without histrionics. I am investing with a 20 to 25 year timeframe (retirement) and simply take it as a given that this period will see the a large chunk of the government´s debts repudiated explicitly (5% probability) or via inflation (95%). Even before the recession bit, I discounted the probability of actually repaying any debt to 0%. I don´t think anyone in government has actually acted as if debt is repayable for decades. How much inflation and when? No idea. The private sector deleveraging forces are so strong at the moment that it makes an inflationary surge look improbable for a number of years. Good time to gradually build a real asset portfolio including all the usual suspects.

Apr 03 03:54 PM

[Market Sniper:]

The printing press or the digital printing press is another form of repudiation. Best thing that could happen and possibly save this country from a bloody revolution/civil war/major civil mayhem would be to declare all debt public and private to be void. Why not? The Chicoms did it in 1949, the Russians have done it twice and Argentina does it every few years whether they need to or not. There are CONSEQUENCES for what is being done. That consequence is currency collapse. EVERY instance of currency collapse has lead to horrible consequences. We have had it happen here in the past. The collapse of the Continental Dollar (hence "not worth a continental"). We were fortunate. It lead to the US Constitution. We shall not be so fortunate this time around. He who understands history controls the future.

Apr 03 09:22 PM

[Northstar10000:]

Printing money won't work. It is the velocity that makes inflation work.
By simply walking away from the debt governments get to start the game all over again but without the cost of borrowing. Of course they don't have the option of borrowing either.

Apr 03 09:30 PM

[nun:]

I can read this quote 2 different ways. Which is the author implying?

"...the American goverment claimed that Cuba’s debt had been incurred without the consent of the Cuban people, so foreign loans had helped to finance oppression and weren't legitimate. Maybe the Chinese have been studying 19th Century American history..."

Apr 05 12:19 PM

[ExOut:]

That reminds me of some comedian's joke from the 80s (back when Japan was the boogie-man):

"So we owe all this money to Japan. Some day they'll come by and say, 'Okay, you pay us now!'

And we'll say, 'Well we don't have the money, but we do have these nuclear weapons...'

And then they'll say, 'Oh, okay, well that's fine! Take your time, don't worry...'"

Lest we forget also, to paraphrase: "When you owe the bank $10,000, that's your problem; when you owe the bank $100 million, that's the bank's problem."

And finally, as Mel Brooks said, "It's good to be the king!"


On Apr 03 03:15 PM Socialism cannot compete! wrote:

> Key point to ponder -- in the past, national debt was largely owed
> to the people of the U.S. Now, it's largely owed to China, Japan,
> etc. Repudiation is less of an option now, given that. And as for:
>
>
> "I think the national debt, corporate debt and personal debt are
> all ultimately claims on the same thing: the future productive work
> of taxpaying US citizens."
>
> National debt is when government spends too much. Of COURSE it's
> a claim on taxpaying citizens. Is not the obvious issue the need
> to cut spending rather dramatically???

Apr 19 01:20 PM