P. J. O'Rourke
Famous satirist and author P.J. O'Rourke wrote one of his books about why some countries do well economically, and others do not. He called his book: "Eat the Rich: A Treatise on Economics,"(1998; Atlantic Monthly Press, New York, 241p). In one of his chapters, O'Rourke wittily discussed the amazing example of Sweden, whose "good socialism" permits massive redistribution without apparent rancor between the classes. However, experience would now cause us to qualify that a bit by saying that there is no rancor among the native-born classes - the immigrant classes are a different story (cf. Margaret Wente, 2015). Thus there are two flies in the Swedish ointment: first, it turns out that, as Swedish researcher Dr. Carl-Johan Westholm puts it, "Sweden is borrowing its prosperity;" and second, Sweden has accepted huge numbers of immigrants, but 50% of these immigrants (who are now 16% of the population) don't work, and even after 15 years, only about 60% of immigrants have jobs. All those unemployed are supported by transfer payments from the government.
Chart 1 below would suggest that so far government borrowing to support the socialist dream isn't too bad relative to other rich countries. How do they pull that off? By having really stupendous and non-progressive taxes with top marginal rates of around 56% (and climbing; Chart 2); this top rate kicks in at an income level of only $88,180, according to Jared Dillian, who writes "The 10 th Man" blog at Mauldin Economics. In comparison, the American Federal marginal tax rate for married, filing jointly at that level of income is only 25%, although we pay many other taxes (e.g., payroll taxes) on top of that. The modern Swedish welfare state began in about 1965, and since then average GDP growth has dropped by a full percentage point annually (Chart 3). However, for now life is good there in general, except for the immigration-related unemployment and its accompanying massive crime wave, and the rapidly burgeoning costs of supporting Sweden's open-door immigration policy (Chart 4). It may be that the Swedish form of "good socialism" is in peril from their national generosity to strangers; there is room for debate about this, but time will tell.
Chart 1: Swedish Government Debt/GDP Rising
Chart 2: Swedish Top Marginal Personal Income Tax Rate Rising
Chart 3: Swedish GDP Growth Has Fallen
Chart 4: Swedish Refugee Spending Soars
Jared Dillian argues that when we add in payroll taxes, state and city taxes, property taxes, the investment income surtax, and unincorporated business taxes in some cities, our US marginal tax rate in some places is actually about 63.6% for higher income families, compared to a maximum rate of about 59.7% in Sweden. So maybe the American version of the socialist paradise is a bit pricey too. The difference is the progressivity of our tax code, which puts a much higher tax burden on those who make the most, and allows millions to avoid paying any income taxes at all (Chart 5).
Chart 5: US Tax Code Is More Progressive Than Swedish Code
Our problem in the US is that we are deeply in debt as a country (Chart 6), and this is projected to get much worse over the next few years. There are multiple factors driving this: 1) massive government spending increases (in general; cf. Chart 7) over time, which will not be fully funded by taxes, so the deficit will soar; 2) demographic impacts on payroll taxes; 3) Social Security cost increases (Chart 8); 4) soaring Medicare, Medicaid, ACA subsidies, and CHIP costs, plus interest payments, or service on the debt (Chart 9). It would appear that our Federal budget process is out of control, to put it mildly. Given the appalling nature of the Presidential Election process, there just hasn't been time (!?) for the candidates to discuss this enormous budget problem.
Chart 6: US Federal Debt Burden is $19.5 Trillion and Will Climb Steeply in the Years Ahead
Chart 7: US Federal Deficits to Triple by 2026
Chart 8: US Social Security Unfunded Liabilities to Soar
Chart 9: Soaring Costs for Transfer Payments and Interest
Although there has been no recent discussion of our budget problems, that will change after the election. Then the usual tug-of-war will take place, with the threat of government shut-downs again rearing its head until Congress sees reason, kicks the can, and permits the problem to get even worse. A natural part of this process will be for politicians and the media to question the efficacy of certain parts of the budget. For example, as Chart 10 shows, mandatory spending on Social Security, Medicare, and Medicaid totals about $1.872 trillion in the FY2016 budget. Another $670 billion will be spent on unspecified "other mandatory" programs. Subtracting all of this from the total, we apparently only have discretion over $1.458 trillion or 36% of the budget. Defense comprises about $605 billion of this, or 41.5%, so it is the likeliest target for Congress to "evaluate" for future budget cuts. However, in spite of defense spending being so "high" in a relative sense (Chart 11), it has actually declined a great deal over the last 50 years as a percentage of GDP (Chart 12).
Chart 10: US FY 2016 Budget Is Only 36% Discretionary
Chart 11: US FY 2015 Defense Spending Relative to the World
Chart 12: US Defense Spending Declining
I am fascinated by certain other spending items that may be worthy of Congressional review: the Dept. of Agriculture budget, which is an astounding $137.7 billion (must be the food stamp program driving this), the Dept. of Education budget ($70.9 billion for perpetual and comprehensive failure, based on surveys), the Dept. of the Treasury budget ($484.0 billion for something or other, no doubt related to the aftermath of the Financial Crisis, with likely dubious results), and the budget for "other departments and agencies," which amounts to another $184.8 billion. There is no way that either party would have the courage to take on the problem of unfunded mandates for various transfer payment programs, which are the main problem.
So what will we do? If transfer payments to support the socialist mandate are untouchable, but tax revenues fall far short of what's needed, two things will occur: 1) taxes will go up even higher; and 2) debt financing of US government deficit spending will increase dramatically. This is where it gets pretty interesting, because if the government is going to issue $600 billion of new debt next year, and more than double that amount annually by 2025, then the higher interest rates that the FOMC keep talking about will bankrupt us in fairly short order. In 2016 we have paid an estimated $432.6 billion in interest, up from $402.4 billion in 2015. The average interest rate is on the order of 2.20%, based on Treasury data. A mere 1% increase in rates would therefore cost (nominally) about $195 billion extra in 2017. So at normalized interest rates of around 5% (Chart 13), future interest payments would eventually exceed all other budget items combined.
Chart 13: Long Term Interest Rates Are Around 5%
But as we project spending and interest on the debt forward, all of the unfunded liabilities of the government will come into play. For example, the Federal off-balance-sheet obligations of Fannie Mae and Freddie Mac totaled about $5 trillion when they went into conservatorship in 2008, and these have apparently grown a bit since then. All of the unfunded obligations under Social Security, Medicare, etc. have been estimated to total at least another $62 trillion by the year 2100. However, others (Vance Ginn, 2014) have calculated a figure more like $114-127 trillion or so (Chart 14); this latter figure is double the global GDP in 2012; in any case it's a lot of money that we don't have. Former US Chairman of the Joint Chiefs of Staff, Admiral Mike Mullen has warned, "I've said many times that I believe the single, biggest threat to our national security is our debt."
Chart 14: US Debt and Unfunded Liabilities
The main problem is demographic, in that there are far too few workers to support the huge (77 million strong) and aging baby boomer generation's projected benefit costs. Laurence Kotlikoff and Scott Burns wrote a book about the demographic challenge (2005; The Coming Generational Storm: What You Need to Know about America's Economic Future, MIT Press, Boston, Massachusetts, 302p) in which they estimated that it would require raising taxes by 17%, raising payroll taxes by 24%, cutting Federal purchases by 26%, and cutting Social Security and Medicare benefits by 11%, in combination, to solve the budget shortfall. And the longer we wait, the more it will cost. Since we can pretty much rely on Congress and the next President to continue doing nothing about this, and there is a strong consensus that fiscal policy must become expansionary to fund infrastructure projects on a large scale, we don't need to worry about this drastic solution. What we need to worry about is all of the debt that will be issued going forward. We are clearly going to emulate Japan. But as the folks at the Zero Hedge blog have pointed out, foreign central banks have cut their US Treasury purchases dramatically (Chart 15). Either the baby boomers will have to massively increase their bond purchases in the next few years, or the US government is going to be forced to monetize part or all of the future deficits. This already happened during the Financial Crisis and its aftermath on a "temporary" basis, and is still ongoing in Japan, where much of the deficit is currently being monetized by the BOJ.
Chart 15: Foreign Purchases of US Treasuries Have Plummeted
Putting this all together, it would appear that the sell-off in US Treasuries will find a floor, with yield increases eventually stabilized by FOMC interventions designed to keep the service on the debt manageable. Therefore, in spite of the market's current angst over interest rates, the only way the FOMC could fully normalize rates is if they actually don't care whether the government can service its debt. I don't believe that is the case. Instead, I think that the Fed will raise rates only slightly in the next few years, if at all. The implications of this contrarian outcome would be significant for markets.
I would remain a long-term holder of Treasuries and High Grade corporate bonds, with appropriate hedging in place until the market realizes that the contrarian outcome will be the dominant trend. It may therefore make sense to hold some intermediate to long Treasuries: the iShares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), the Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV), and the DoubleLine SPDR Total Return Tactical Bond Fund (NYSEARCA:TOTL); also some corporate bonds: the iShares IBOXX I.G. Corporate Bond ETF (NYSEARCA:LQD); also some hedges like bank loans (e.g., iShares Floating Rate Bond ETF (NYSEARCA:FLOT)) or Lord Abbot Floating Rate Fund (MUTF:LFRIX); and high yield bonds (e.g., SPDR Barclays Short-Term High Yield ETF (NYSEARCA:SJNK)); and convertible bonds (e.g., SPDR Barclays Convertible Securities ETF (NYSEARCA:CWB)).
Disclosure: I am/we are long TLT, TOTL, LQD, FLOT, LFRIX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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