America's Debt - No Big Deal?

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Includes: CNY, CYB, UDN, UUP
by: Ray

I just read a Time Magazine article Sunday about the U.S. debt and how it is no big deal that the U.S. has so much debt. In fact, Zachary Karabell actually believes that our debt is a good thing. I actually met Mr. Karabell last year at a conference we both spoke at, although he was paid and I was merely on a panel, but it is unlikely he would remember me. Regardless, I have to humbly disagree with the conclusions he came up with in his article.

Debt can be a good thing, but only in small amounts and for productive reasons. For example, a business that takes out a loan to hire a new employee to expand their business would be productive debt as it contributes to society, hopefully. However, taking out a loan to buy a 50” high definition TV is, in my opinion, a terrible reason to add debt to one's balance sheet. The U.S. government has recently borrowed money to hire people and encourage spending, but the government is not creating productive jobs because it creates nothing and it must tax the people in order to pay off the debt for the job it created. The government actually destroys wealth through taxation and wasteful spending. Basically, the government is borrowing money to buy big screen TVs. Bad debt.

The U.S. government does need to carry debt because we are the reserve currency and carry trade deficits. Debt for a government could be a good thing if that country is the reserve currency, but there is a point where too much debt is the ultimate problem. The impact of too much debt during strong economic times may not be a major problem because a growing GDP means more tax revenue is being collected and should increase over time as long as conditions are good. However, any economy has cycles where there are good and bad times. We are currently experiencing bad times, and when times get bad that large debt load becomes a problem and is no longer good. Greece is a good example of this. Kind of.

Excess debt during poor economic times means tax revenues decline and the government will have to run deficits to pay for its spending. I am over simplifying this, but generally, a government will spend much more during these bad times to spur the economy. This is known as the Keynesian Theory. But this spending, in my opinion, is not the way to spur the economy. As the debt builds and the central bank cuts interest rates, the debt during these bad times might not seem so bad because the country has artificially lowered the cost of borrowing, again to spur growth. The key word is “artificially”; lowered interest rates and the current interest rate may not actually reflect the current economic conditions or the risk of holding said country's government debt. The reason people ignore deficits more during lower interest rate periods is because the cost to carry the debt is so low, like now.

The U.S. currently has over $12T in debt, heading much higher rapidly, but the carrying costs of that debt is about $500B a year. Keep in mind this is because the Fed Funds Rate is at .25%, which means yields on the U.S. government debt is very low, artificially low. The government can currently borrow money for 30 years, (for those crazy enough to buy it) for less than 5% - not a bad deal, right? However, what happens if the bulls are right and the economy is recovering and rates have to increase? A 1% increase in Fed Funds would mean the aggregate increase on our debt would be roughly .70%. Most of our debt matures in less than 10 years, not good, I might add. That means our debt servicing costs, the interest we pay, would increase to about $600B a year - still not bad.

The problems start to get real bad when the Fed increases rates to say 3% or so. The cost to borrow on the 30 year treasury would go up dramatically to about 6%, on the conservative side, and even our short-term interest rates on our bills and notes would go substantially (everything is relative) higher. Before I go further, you have to remember that debt is a deadly circular beast because the more you borrow the more you have to pay back. And during rising interest rates, in order to make all of your payments, you either have to tax the people or have more deficit spending. Guess which will win in the U.S.? If rates go to 3% because of a hot economy the interest on our debt servicing costs will quickly rise to about $800-$900B. It will take no time at all for the interest payments to reach $1T and considering our debt mostly matures in 10 years or less, you cannot forget the refunding that must take place. The CBO just did an estimate on a lot of this in the past few days. I did not read the report, but I know the final numbers will end up close to what I just said.

Karabell makes the argument that the U.S. would use the borrowed money to retrain our workforce and rebuild our infrastructure. That may be the case, but to fully upgrade our infrastructure (not including pie in the sky green energy items) would cost about $2T. I believe the last stimulus only applied to a small portion of what is needed, so the infrastructure idea Karabell had does not pan out in my book. Plus, there is no return on infrastructure immediately. Over time yes because it makes commerce easier, but that takes time. He also made the case that China and India are flush with cash and building their infrastructure now. He also indicated that since the U.S. is so stable excess cash will end up here, which is reasonable to assume, for now.

What he failed to address is the fact that the money they are flush with is ours from them exporting goods to us. Because they have such huge exports to the U.S. we have a trade deficit with them and they need to buy our debt to balance it out. It is a case of vendor financing and all vendor financing ends up with someone getting hurt. Guess who in our case? The point I am making is that the Chinese and Indians will buy our debt now because treasuries are going up in value (thank you, deflation), but how long will that continue for? Not only that, but if China un-pegs their currency from ours it will appreciate and their treasury holding, in RMB terms, will decline. Why would one invest in treasuries if your currency is rising and the country you are loaning money to has a declining currency. You wouldn’t do that.

Essentially, all gravy trains end and there is a limit to how much a country can borrow. Consider that the U.S. has implicit guarantees on not only our debt, but also on banks, insurance companies and the mother of all bad investments, the GSEs. Oh, and if you ever expect to see GM pay back the money they got, well, I wouldn’t hold my breath on that one. All of those guarantees are about $23T, not including the national debt and the entitlement guarantees we have. Again, my point is the limit to what the market will allow a country to borrow cannot be far off. At the very least we will need to pay a greater risk premium on our debt which means the interest rates on our government bonds will detach from where the Fed sets them at and go through the roof.

I get what Karabell is saying, but he is speaking in the here and now which is suicide when talking about so much money. You must look forward in order to see the real problems and it is kind of crazy to think that all this borrowing will go towards retraining the people and vastly improving our infrastructure. The government is the worst at spending money efficiently and much of that money goes to wasteful projects like DNA research on bears in Montana. No offense to bears, but I just do not care about their DNA. On top of all that, who knows if we will actually emerge from this downturn. Sorry, I do not buy an inventory rebuild as a real economic recovery. If we do not exit this thing in the next 10 months our problems will be bigger than we think.

On top of all of this there is the whole impact to our currency, which is not good. The more debt we issue the more we dilute our currency and at some point the world will demand some type of other reserve currency. It is even being talked about now. If we lose our reserve currency status we are in a heap of trouble though I know that could ‘never happen.’ All of these problems, or these potential problems, lead me to a couple of conclusions (aside from the fact that bulls will spin even really dangerous debt problems positively). 1) Precious metals are cheap and 2) The Fed will never raise the Funds rate to a reasonable level again.