The Top 5 Looming Financial Issues

Includes: DIA, QQQ, SPY
by: John Lounsbury

With all the turmoil in investment markets, I have found it useful to try to estimate major financial issues that will influence the American economy over the next few years and several decades. This will summarize my current findings ranked in order of total dollar value. All of these problems need to be resolved for the future viability of our way of life. I think it is obvious that if the biggest problem is not solved, what we do with the other four will be of little consequence.

Issue #5: The estimated asset write-downs resulting from the 2007-2008 credit crisis. The International Monetary Fund has estimated this to be $1.1 trillion. Less than half of this has been realized to date. The time frame for this to be totally realized is one to three years. The potential for this estimate to be too high is limited to a couple hundred billion at the most. The potential for this estimate to be too low depends on whether or not we see an extended downward spiral in home prices and the associated worsening of credit markets. Worst case scenario is probably another $1 to $1.5 trillion, corresponding to defaults on 20% to 30% of home mortgages.

Issue #4: U.S. national debt of $4.4 Trillion. This figure is obtained from the “Long-tern Financial Outlook”, U.S. Government Accountability Office, Jan. 2008. Government estimates envision a balanced budget by 2013. If you believe this, I would like to sell you a well known bridge over the East River. However, I will use that to project the national debt to grow to $5.9 Trillion in the next five years. The probability that this is too high an estimate is extremely low. The probability that the national debt will be larger than $5.9 Trillion in 2013 is very high. Furthermore, I am skeptical that a balanced budget will be achieved, not only in five years, but even in 10 years. The risk is high that the national debt will continue to grow through deficit spending for many years to come. I do not have a rational way to estimate an upper limit for the national debt in five years or beyond.

Issue #3: The unfunded liabilty of the Social Security System is estimated to be $6.7 Trillion (Government Accountability Office, Jan. 2008). This number could be higher with inflation above the report estimate - approximately 3%. The time frame for this figure is several decades.

Issue #2: The unfunded liability of Medicare is estimated by the Government Accountability Office to be $34.1 Trillion. Again, higher inflation could raise this estimate. The time frame is several decades.

Issue #1: The cost of imported oil. Many sources have estimated the 2008 cost for imported oil to be approximately $800 Billion at an average price of $120 to $130 per barrel. The estimate for the hidden cost of oil - added military expense, environmental expense, health care expense, infrastructure degradation, etc - was approximately $825 Billion per year in 2006. See here for details on the hidden cost (.pdf). 

If we assume the 2006 hidden costs and the estimated 2008 purchase cost to be applicable for the next 30 years, the cost of importing oil over that time frame is approximately $48.7 Trillion. The likelihood that this too high an estimate is extremely small. To lower the cost not only does the price of oil have to stay at or below current levels, the amount of oil we import must stay at or below current levels and there must be no inflation for 30 years. With that scenario, the present value of a cash flow of $1.6 Trillion per year is $45 Trillion at a discount rate of 5%.

It is much more likely that the annual cost for imported oil will rise from the $1.6 Trillion per year. If the cost rises by 10% per year (probably too small a figure), the present value of the cash flows over 30 years is approximately $58 Trillion. The cost of continuing current energy policy is somewhere between $45 Trillion (an unrealistic lower bound) and something larger than $58 Trillion. Half of this money is paid to entities outside of our economy and can only return to us by purchase of our assets. A lot of the hidden cost remains within our economy, but none contributes to higher productivity. The hidden costs are basically maintenance expenses.

I have been trying to find some economist who would assess how the investment in getting the energy problem addressed would positively effect the federal debt, Social Security and Medicare problems. If we were to develop domestic energy sources that would remove the need for imported oil within ten years (Al Gore has called for such an effort), $40 Trillion (or more) of Issue #1 would not go overseas and to maintenance of the oil import system, but would be spent domestically on new production and distribution systems. If I (arbitrarily) assign 60% to labor and 20% to domestic corporate profit, potential federal income tax revenue increases by $7 Trillion or so, Social Security revenues are increased by about $4 Trillion, and Medicare revenues are increased by about $1 Trillion. This is all back of the envelope, and does not incorporate the time value of money considerations.

The problem is that there must be political will to deal with a level of economic austerity usually found only in times of major war, such as WW II. Can America face the music or has our country become prisoner to living in the moment?

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