America Is Broke Again

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by: Jim Mosquera

Summary

Is MAGA (Make America Great Again) possible with current debt situation?

An examination of debt and GDP.

Beware the Ides of March.

The Ides of March (March 15) will acquire a special significance this year in Washington, D.C. For all the turmoil of the first month of the Trump administration, a significant challenge will present on this date. On this date, the debt ceiling suspension, negotiated in October of 2015, will expire. This means that whatever the outstanding debt figure is on this date, it will represent the debt limit of the Treasury. That number is estimated to be around $20.1 trillion.

What will Congress do? Will they create a new ceiling? Will they let the ceiling float again? How eager will fiscally conservative Republicans, with their party in control of the White House, be to raising the ceiling? Will Democrats dig in to fight the president?

The date is fast approaching without any resolution to a repeal and replace of the Affordable Care Act (ACA), income tax cuts, wall building, and infrastructure spending.

The above points represent the backdrop to this article, which will shed some light on the nation's funded debt problems. Please note that I'm not considering the unfunded liabilities that are numbers that are multiples of the funded debt.

I think it was Dick Cheney who said that deficits didn't matter. This is somewhat true as long as income continues to rise. The nation's income consists of tax receipts, tariffs, and fees. Yearly expenditures above this income are financed through funded debt issued by the Treasury. You would have a much more difficult time funding debt in your own household compared to the federal government. The U.S. is also in a unique position given that it is the world's reserve currency - for now.

The country's problem is how much that debt has increased relative to its income. In this case, I'll define income as the country's gross domestic product (NYSEMKT:GDP). Higher GDP should result in higher income. I'll use the following graphic to chart the course of the nation's funded debt to GDP ratio since the Nixon administration. The shaded vertical bars represent recession periods.

US Debt to GDP Ratio 1971 - Present

[Chart courtesy of MacroTrends with my annotations]

Nixon closed the gold window in August of 1971, which provided the opportunity to create more debt. Despite this, the ratio declined. After the 1970 and 1980 recessionary periods, the ratio also held steady. This point is instructive for those in the Keynesian camp who suggest higher government spending during recessions.

In my books, I often refer to 1981/1982 as the start of the great credit bubble. Notice what happened to the debt to GDP ratio after this date and for roughly the next decade. This period coincided with the Reagan - Bush 41 presidencies that featured increased Cold War spending and tax cuts. Only after Bush 41 reneged on the "Read my lips: no new taxes" pledge, did the ratio begin to level off.

The ratio turned down in earnest during the Clinton administration, particularly his second term. Clinton's presidency featured the peace dividend from winning the Cold War, higher taxes, and an increasing Federal Funds rate. Clinton was also sensitive to the major bank bond dealers and institutional investors who were sensitive to large budget deficits and the potential inflation implied. Not coincidentally, the country ran a budget surplus towards the end of his term.

Bush 43 ramped up spending with the War on Terror and during the financial crisis. These two factors increased the ratio from about 54% to 73% while Bush 43 was in office.

During the Obama White House, the ratio climbed to 105%. Obama inherited the aftereffects of the financial crisis. His economic team, conventional neo-Keynesians, did what they were taught to do - stimulate the economy through government spending. His lead economist suggested that the economy would produce $1.50 of growth for every $1.00 of deficit spending. This is the famous Keynesian multiplier that states that government spending stimulates economic growth well in excess of the amount spent. The Democrats capitalized on their opportunity to fund the Progressive agenda unfulfilled by the fiscally conservative Jimmy Carter and the moderate Bill Clinton.

I will now direct the reader to examine the two horizontal lines on the chart. The first line rests at 60%. A few years ago, I read a book called " This Time Is Different" by economists Reinhart and Rogoff (not light reading). The book is exhaustive research on financial and sovereign debt crises. The authors take great pains to describe how these crises evolve in mature and developing economies. Economists like Reinhart and Rogoff consider an external debt ratio of 60% to be a critical threshold where annual growth declines above this level. External debt is often denominated in a foreign currency. I can only think of one time that the U.S. issued debt in foreign currency (Carter administration). Nevertheless, the 60% ratio is important.

In the European Union (NYSEARCA:EU), the 60% figure is recommended for their membership and this debt is not in a foreign currency. Clearly, not all EU members abide by this figure, though it's not hard to identify those in the crosshairs by their ratio. Consider the 60% line to be a demarcation of safety - sort of like when you go to the beach and a marker suggests not swimming beyond a certain point. When the U.S. ratio eclipsed 60%, it was brought below that level during the Clinton years for the reasons cited earlier.

The next horizontal line is at 90%. This is a level identified by Reinhart and Rogoff above which economic growth declines further. Irrespective of whether the economy is mature or emerging, the message is the same - more debt means less growth. Intuitively, more debt means more debt servicing. Debt servicing by itself cannot imply growth. The Obama administration expanded the nation's debt by $11 trillion, yet the economy did not grow by the expected $16.5 trillion. Instead, for $11 trillion spent, we got $4 trillion in growth.

You might suggest that there have been periods in history where the nation's debt was above the danger level. During times of war, this is justified since the country has to direct so many of its resources to vanquishing an enemy. The ratio eclipsed 120% during WWII, though it fell from 1945 through the Korean War. Likewise, during the Vietnam War, the ratio also fell. Suffice to say, that even though the government continued to fund these war campaigns (the numerator of the ratio), the nation's output (denominator) grew with it. Today, the nation encounters a wholly different dynamic - debt expansion that greatly outpaces growth.

That brings me to the headwinds faced by Donald John Trump. Trump's economic team are holdovers from the Reagan Revolution. The blueprint for MAGA (Make America Great Again) includes repealing and replacing the ACA, tax cuts, increased defense spending, wall building and more money for infrastructure. Before MAGA and swamp draining, the Congressional Budget Office (CBO) is estimating steadily increasing deficits for the next decade. A word of caution with the CBO's estimates - they make no allowances for a recession nor for higher interest rates.

Another challenge will be the demographic bomb. The last of the Boomer generation reached their spending peak around 2007. From this point forward, they will spend less. This generation will contribute less towards economic growth and place greater weight on the social safety net (Social Security, Medicare, and Disability). In other words, the Boomers will impact the numerator more than the denominator. Generation Y (Millennials) are facing their own economic pressures as well as a mind shift towards a sharing economy, which features less economic growth in certain key areas.

Something else to keep an eye on are foreign holdings of Treasury securities. It's much easier for the debt to GDP ratio to continue growing as long as someone is there to buy Treasury securities. According to figures published by the U.S. Treasury, foreign holdings fell about $280 billion during the 2016 year. By comparison, when the U.S. expanded the debt to GDP ratio from 2008 to 2012, foreigners gobbled up Treasuries to the tune of $2 trillion.

Absent an increase in the debt ceiling, the Treasury might have enough cash on hand to get it to the beginning of summer. The upcoming debt ceiling debate will once again expose just how broke America is. It's gonna be one hell of a fight in the Beltway. Beware the Ides of March!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.