Ned Williams'  Instablog

Under President (W) Bush, debt was approximately 40% of GDP.  For purposes of discussion, let’s assume that interest rates were 4%.  That means that annual interest payments were 1.6% [40% of 4%] of GDP.

Under President Obama, debt is forecast to rise to 80% of GDP.   To induce people to buy all this debt, for our purposes, let’s assume that interest rates will be pushed up from the previous 4% to 6%, resulting in annual interest payments equal to 4.8% [80% of 6%] of GDP.

Looking forward, we clearly have no indication that spending patterns will be reduced and with the economy limping along it is unlikely that revenues will increase enough to compensate; therefore, the increase in interest payments of 3.2% of GDP will of necessity be added to the deficit on an annual basis, over and above deficits from normal overspending behavior.

Increasing interest rates combined with interest payment acceleration will continue to build momentum, until they spiral out of control, unless we can limit government spending as a percent of GDP.

This example ignores the overhang of entitlements (more on that in my next piece), which will only add to the deficit problem.  Inflation fighting, financing difficulties, and inflation fears should push interest rates through 6% and beyond.

Debt at 80% of GDP shows very bad past management, but can be accommodated by the markets, only if a viable plan is presented [Fixing Everything, by yours truly] that will maintain or begin to reduce that 80%.

Our only hope for the immediate future is that bond vigilantes will force up interest rates so fast that interest payment acceleration starts now.  It will be easier to stop the bleeding if debt is at 50% of GDP, with interest rates at 12%, than it will if debt is 100% and interest rates are 6%.  While annual interest payments in both cases would be the same, interest rates can be reduced; whereas, accumulated debt will probably be with us forever.

Disclosure: Long TBT, HL, and APL

Current discussions regarding changes in the capital gains rate drive me nuts. 

Obviously, we won’t even consider “fairness”, but mentioning the “Laffer Curve” [big fan, but it doesn't fit here] or “supply-side effects” is also missing the point.

The critical factor is: destruction of the accumulated-gains tax base.  There are several other factors, but this is the most important.

For purposes of this discussion, we will assume the stated capital gains rate applies to all, and there are no control benefits gained from majority ownership.

At a 15% capital gains tax rate, stock is valued at 85% of the potential value it would have at a 0% capital gains rate, based on after-tax yield.  An increase to 20% would decrease yield to 80%.  Such a rate increase would have an immediate adverse effect on the price of stock, and the stock market should fall to 94.1% (80/85) of its prior value [more, if state capital gains taxes are factored in].

The accumulated-gains tax base, which is the basis for calculating the actual tax, is a small subset of total stock value, but it is negatively effected dollar-for-dollar with a fall in the price of the stock.

For example:  If stock was purchased for $75,000 and is now $85,000; the capital gain is $10,000 [if sold, tax would be $1,500].  If the capital gains rate is increased to 20%, as above, the value of the stock should fall to $80,000 and the capital gain to $5,000, with both stock and tax base losing $5,000 in value [at the new rate, if sold, tax would only be $1,000].  While the capital gains rate went up by 33.3%, the accumulated-gain tax base lost 50% of its taxable value.

One might argue that a significantly larger accumulated capital gain, as a percentage of total stock value, would result in higher taxes, but they would be wrong.  Stocks with large capital gains tend to be long term holdings, and since this is a voluntary tax (you must sell in order to incur the tax) fewer long term holdings would be sold at the higher tax rate.

The ultimate hypothetical test would be at a capital gains tax rate of 100%:  The stock market would be destroyed, the ex-rich would have the 100% loss of their purchase price to apply against other income taxes, and the economy would be in shambles.

Luckily, discussions are centered on raising the capital gains tax rate to 20%, which will only destroy the economy a little bit.

 Disclosures:  Will short everything, if legislative discussions begin.

Government numbers are worthless, when analyzing relative improvement or deterioration, since they do not reflect the present value of commitments made during the year and the increased liability caused by inflation or cost of living adjustments, on commitments made in prior years.  To get an accurate picture, some form of “generational accounting” will be required. 

Future Deficits – Future Entitlement driven deficits will play havoc with credit markets and with the economy, because they represent excessive transfers from the productive to the non-productive.  Missing in these discussions is the other side of the ledger.  Entitlement transfers will not be lost to the economy, but will become revenues for bloated medical and support services for the aged.

·   &nbs... Don’t expect the productive economy to absorb these excess costs through taxes.  As workers become a scarce resource, they will demand that after-tax compensation rise in real terms, and they will get it through free-market competition for their services.  The political power of retirees will be outweighed by the economic power of workers.  To avoid salary induced hyper-inflation or skyrocketing inflation-fighting interest rates, eventually benefits must be cut deeply enough to match nominal debt growth with nominal GDP growth.

As long as relative deficits do not grow, credit markets should continue to absorb debt. HOWEVER, our current grossly excessive deficits will soon result in increased interest rates, resulting in increased interest cost that will compound the relative deficit problem.  As interest rates move up, a premium will be added to compensate for increased interest rate and market risk.  Since much of our outstanding debt is short term, interest rate increases will not only affect debt from on-going deficits but existing debt being rolled over. 

Monetization of debt may be theoretically justified to fight current deflation, but it significantly increases future interest rate and/or inflation risk, since the only way to keep future inflation in check will be to issue enough additional debt to reabsorb excess capital, at a time when credit markets will already be clogged.  Such inflation fighting action will be politically unacceptable, since high interest rates will choke off any 2010 recovery, just prior to 2010 elections. 

A detailed plan to get back to relative debt balance must be announced soon, before the lid blows off credit markets.  Because growth rates are so important to relative debt, any realistic plans must include actions that promote business development and reduce government interference.

Disclosure: Long APL and HL