Note: I am Long TECS, RSW
US Debt Crisis
Adam Hamilton December 7, 2012 3347 Words
With the rancorous fiscal-cliff negotiations dominating news feeds, the markets are rightfully on edge. Will a deal be reached as time relentlessly dwindles, or not? How the fiscal cliff is resolved has massive implications for the US economy and markets in 2013 and beyond. But provocatively, the fiscal cliff is a minor sideshow in the real crisis. The United States of America is drowning under federal debt.
The media, commentators, and politicians always talk about deficits. This whole fiscal-cliff debate centers around how to reduce the federal deficit. Should we cut government spending, raise taxes, or do both? But a deficit is merely the current shortfall, the government spending more in any given year than it takes in. The true problem lies in the past's accumulated deficits, which collectively add up to the national debt.
Unfortunately deficits and debt are often confused in public discourse. If you spend $1000 a month more than you make, that is your deficit. The cash for this excess spending can only come from borrowing. A year of $1k monthly deficits adds up to $12k in new debt, not including interest. Merely reducing your monthly deficit does absolutely nothing for your already-existing debt, which continues right on growing.
And naturally as your debt expands, so does your interest burden. And since you are already operating at a deficit, you have to borrow even more money just to pay the interest on your existing debt. This leads to a vicious circle that spirals downwards into bankruptcy. This ironclad law of finance applies to nation states as surely as it does to families and businesses. Deficit spending ultimately leads to financial ruin.
The so-called fiscal cliff the United States now faces is an early milestone in this disastrous process. And sadly, every single major proposal on the table from both sides is a total joke. Using that $1000-a-month analogy for a family, the current ideas would only cut that by $60 to $150 at best. They leave 85%+ of the government's deficit spending intact, doing absolutely nothing to pay down its mind-boggling debt.
This first chart shows the sorry state of US government finances with data from the Federal Reserve. The blue bars show how much Washington is spending annually in billions of dollars. Meanwhile the yellow bars reveal how much the federal government is receiving in taxes. The differences result in the red bars, the federal deficits. And since Obama won the presidency, they have exploded to record levels.
The US government living beyond its means has been common since the Great Depression. But the degree of deficit spending we've seen in recent years is far beyond anything except the second World War. And regardless of your politics, the Obama years stick out like a sore thumb. The great majority of today's debt problems, of which the fiscal cliff is merely the tip of the iceberg, originated under Obama.
And these gargantuan deficits of the past four years were driven by record government spending. Notice above how fast the blue spending line has outpaced the yellow receipts line. Per this Federal Reserve dataset, on average the US government has taken in $2398b annually during the Obama years. This compares to $2219b during Bush the Younger's reign, and $1608b while Clinton commanded office.
So the government's average take from taxation under Obama grew by 8% from Bush and 49% from Clinton. Absolute tax receipts have proved remarkably stable in the last four years despite the struggling US economy. The yellow line above, which provocatively saw big growth after the Bush tax cuts, hasn't shrunk dramatically during Obama's term. His deficits are almost exclusively the result of overspending.
On average the Obama Administration has been spending a mind-blowing $3614b per year! This is 44% higher than Bush's average of $2508b annually and 115% higher than Clinton's $1683b. The result of such unprecedented government largesse is crystal-clear above, the largest deficits by far in the history of our Union. If you are a Democrat, you have to own the indisputable fact that these are Obama's doing.
During the last four years, the Obama Administration ran average annual deficits of $1274b per the Federal Reserve! The size of this overspending defies belief. This week Apple, widely considered one of the most successful companies in world history, was worth about $500b. Washington is spending the equivalent of over two Apples per year more than it is taking in! We are talking $3.5b per day in deficits!
Despite Bush's tax cuts that are widely reviled by Democrats, during his entire 8-year presidency his Administration's deficits only averaged $251b. Obama's were 408% higher! And Clinton, which is the Democrats' greatest and most-loved hero, merely averaged deficit spending of $40b per year. Obama's deficits were 3081% higher than Clinton's! Clearly Obama has an unprecedented spending problem.
Now inarguably it is in the best interests of Democrats to get this record overspending under control. If Obama continues along this path, history will remember him as the president who bankrupted the United States of America! And as the dire real-world financial consequences of such deficits come home to roost, the Democratic Party will increasingly shoulder the blame with American voters. They have to act.
The proposal the Obama Administration has on the table today to address his gargantuan deficits is a $1600b tax hike on high-earning Americans and $400b in murky future spending cuts. But in the crazy way Washington has come to operate, these numbers are over the entire next decade. So for 2013 alone, Obama is asking the Congress to agree to $160b of tax hikes and no spending cuts to avert the fiscal cliff.
But $160b is nothing compared to the size of the problem! With average annual deficits of $1274b, a $160b tax hike on the top 2% of American earners will merely close one-eighth of the shortfall. The Republicans offered Obama an $800b tax hike over 10 years, or $80b per year. That is only a sixteenth of the Obama Administration's average deficit spending. The current fiscal-cliff talks are truly a total farce.
Excessive government spending is always a big problem, whether it happens under the Democrats or Republicans in power. But the upcoming deficit in 2013 pales in comparison to the collective accumulation of all past deficits, the national debt. This next chart looks at US federal debt and average annual interest rates as measured by the yields on 1-year and 10-year US Treasuries. The picture it paints is utterly terrifying.
Thanks to Obama's record federal overspending, the United States has suffered record national-debt growth in the last four years. Before Obama took office, the federal debt was $9986b. Today it is running near $16,345b, a 64% increase! The Democrats want to run this country, and half of the Americans who recently voted awarded them that privilege. So they have no choice but to deal with this huge problem.
It is interesting that today's entire fiscal-cliff mess is the direct result of Obama's record deficits. Back in the spring of 2011, the incredible federal spending of the Obama Administration threatened to slam the national debt into its statutory ceiling. Remember that every dollar that the government spends beyond what it takes in must be borrowed, the exact way deficit spending works for families and businesses.
While the Democrats wanted to give Obama a blank check to continue exploding the national debt, the Republicans in Congress balked. They understood the data behind the first chart in this essay, and knew that those levels of government spending were unsustainable. So Congress wanted spending cuts before it gave Obama the authority to borrow even more, but Obama recoiled at such constraints.
Because the US government is so deep in debt, it has to borrow money to pay interest on its existing debt. So the first default in modern United States history threatened, and a deal narrowly avoided it in early August 2011. That was the Budget Control Act of 2011, which raised the debt ceiling immediately but foolishly delayed any real spending cuts until 2013. This earlier showdown created today's fiscal cliff.
But again the national debt is the real problem, and merely reducing deficits does nothing to address it. I suspect most Republicans and Democrats love our country deeply, although we certainly differ on the appropriate levels of government spending. But if this debt problem isn't tackled head on, if deficits don't become surpluses to actually pay down existing debt, all government spending is greatly threatened.
The national debt that Obama foolishly grew by two-thirds is a ticking time bomb due to current interest-rate levels. Washington borrows to get the cash for its deficit spending by selling Treasury bonds, and the yields these Treasuries pay are the national interest expense. Catastrophically as national debt skyrocketed in the last four years, the Federal Reserve manipulated interest rates to record lows.
Two benchmark interest rates are shown in this chart, the yields of short-term 1-year Treasuries and long-term 10y Treasuries. During Obama's reign so far when his $1274b average annual deficits added up to $6358b in new national-debt growth, 1y Treasuries averaged just 0.3% and 10y Treasuries averaged just 2.8%. These record-low interest rates drove average annual interest expenses of just $209b per year.
But interest rates can't and won't remain near these record lows forever. Either the Fed will eventually raise them as the economy improves or inflation heats up, or the global bond markets will sell Treasuries so aggressively they will force yields higher. Rising interest rates are as utterly inevitable as the sun rising tomorrow. There is no force on the planet, including the Fed's printing presses, that can stop them.
And sadly, the Obama Administration has chosen to do most of its borrowing on the short end of the yield curve. When interest rates are abnormally low, most families choose to lock them in for the long term. But the Obama Treasury has instead concentrated new Treasury issuances in shorter-term bonds since their yields are near zero. That means national interest payments will skyrocket rapidly with interest rates.
The US government runs on fiscal years, starting October. In fiscal 2012 which ended a few months ago, the federal interest expense divided by the national debt yields a rate under 1.4%. Yet between 1965 and 2008, the pre-Obama years in other words, yields on 1y Treasuries averaged 6.3% and 10y Treasuries averaged 7.2%. So if interest rates merely revert to long-term averages, federal interest expenses soar.
And we are talking on the order of 5 times or so! So at average modern interest rates and current national-debt levels, the federal interest expense alone would soar to an unimaginable $1113b per year! This ought to terrify Democrats as much as Republicans, because such skyrocketing costs would cut all government spending to the bone if not eliminating much of it entirely. Social programs would vanish!
Even more frightening, historical average interest rates are conservative. After extremes, markets tend to mean revert and overshoot to the opposite extreme. And since interest rates have been held abnormally low by Fed manipulation in recent years, odds are they are heading much higher than normal once they start reversing. The Reagan years were the last time such a mean-reversion overshoot occurred.
During those 8 years, 1y and 10y Treasury yields averaged 9.6% and 10.8%! This is on the order of 7 times current interest costs on the federal debt. This would force interest payments up to $1558b a year, compared to tax receipts of roughly $2400b. And in addition to rising rates, continuing large deficits will continue ballooning the debt. Even an optimistic scenario on Obama's second term bodes more trouble.
Remember that Obama's first-term deficits averaged $1274b per year. Even though all he is proposing now is a measly $160b-per-year tax hike on job creators, let's assume he somehow manages to cut his average deficits in half in his second term. This would still leave annual deficits of $637b, pushing the national debt to $18,893b. A best-case one-sixth growth in debt drives up interest expenses accordingly.
That would catapult the yearly debt burden to $1299b in an average-rate environment and $1818b in a mean-reversion-overshoot high-rate environment! Once again there would barely be anything left over for all the transfer payments, welfare handouts, and social programs the Democrats hold so dear. And our massive military budget many Republicans support would be starved of virtually all funding as well.
Record levels of national debt accrued while interest rates are near record lows is the most dangerous economic threat our nation has ever faced. If we love our country, we have to force our politicians to not only reduce deficits but to create surpluses that pay down this debt. And all the tax hikes in the world are not going to make this happen. Obama's mind-boggling excessive spending has to be slashed quickly.
This final chart looks at federal spending, federal receipts, and federal deficits as a percentage of US GDP. Gross domestic product of course is the flagship measure of the size of our country's total economy. This is the most-accurate-possible portrayal of the crisis facing America today because it effectively adjusts for inflation. And the history of government finances offers plenty of pain for both parties.
Even as a percentage of GDP, Obama's record deficits utterly dwarf everything seen since the second World War. Democrats ought to be totally embarrassed by this. The 60-year-average deficit before the Obama years was 1.7%. Yet Obama's gross overspending averaged annual deficits of a staggering 8.7% of GDP! To get an idea of how scary these are, all we have to do is look to the fiscal disasters in Europe.
The European Union was formed by the 1992 Maastricht Treaty. One of the core requirements that all signing countries bound themselves to was government spending as a percentage of GDP. Deficits were legally limited to 3% of GDP. So Obama's approaching 9% are so horrendous that it defies belief. This year, the deficit-to-GDP ratios of troubled Greece and Spain are only 6.6% and 7.3%. 9% is outrageous.
And the blue and yellow lines above tell the crystal-clear story of why Obama's record deficits arose. Over the 60 years before Obama took office, federal spending averaged 19.5% of GDP. Yet Obama's wild overspending catapulted this critical ratio up to an average of 24.5% in his first four years! Outside of the extreme case of World War 2, this is unrivaled. The federal government is now spending a quarter of our nation's entire output!
This is utterly unsustainable. No matter how much Democrats like their pet social programs or some Republicans like a big military, we can't afford such excessive spending. If Obama wants to be seen as a great president instead of an economic disaster, he has to slash government spending dramatically. The entitlement programs have to be cut until federal spending falls back down near its historical average relative to GDP.
This is possible, as Clinton managed to run surpluses late in his presidency. Granted, he had the great fortune of enjoying the booming economy of the bubble-end of a 17-year secular bull market in stocks that created a big surge in tax receipts. Obama won't, as we are languishing in the subsequent 17-year secular bear. But surpluses can still be achieved if the Democrats finally get serious about cutting government spending.
On the tax side, Republicans aren't going to like to see that federal receipts as a percent of GDP indeed fell to their lowest level in over a half century under Obama's first term. The 60-year average before Obama was 18.2% of GDP, yet he had to deal with 16.2%. So the Democrats do have a strong point about tax levels being low in historical context, whether or not you agree with their soak-the-rich solution.
But again the lion's share of the cause of the Obama deficits occurred on the spending side. While tax receipts were indeed about a tenth lower as a percent of GDP than the long-term average, he still chose to spend a quarter more as a percent of GDP than the long-term average. Obama has to start leveling with the American people and explaining why all government spending needs to be cut dramatically, or his legacy is doomed.
And on the spending front, the targets for cuts should obviously be the biggest outflows. Medicare and Medicaid together account for about a quarter of government spending, and Social Security and national defense each account for about a fifth. Together these programs represent over three-fifths of federal-government spending, so they are where Obama and the Democrats need to target to make progress.
But because of the record national debt and abnormally low interest rates, merely reducing the deficits isn't enough. The debt has to be addressed, and there are only three ways to do it. The honorable way is to slash spending until the government runs surpluses long enough to pay it down. The chances of that under Obama are sadly zero. With a $223b interest expense even today, a surplus would have to be much larger than that to make any progress.
The second alternative is to default, for the United States of America to effectively declare bankruptcy. But as Greece has seen in spades, the economic consequences of telling one's international creditors to bugger off are catastrophic. Despite the bitter debt-ceiling debates as Obama burns through borrowing capacity like mad, a default isn't going to happen. Which leads to the third and likely debt outcome.
The US dollar is a fiat currency, merely paper that the Federal Reserve can and does create out of thin air at will. As it has done extensively already, it can print money to help Washington inflate its way out of this crushing debt burden. New dollars pay off old bonds, but the result is rising prices as our currency becomes worth less and less. The Fed's quantitative-easing campaigns have already inflated away about a quarter of Obama's total debt growth!
Inflation is really the only viable outcome, and investors should act accordingly. Obama's record deficits and debt growth guarantee big inflation is coming, which is wildly bullish for the precious metals and their miners' stocks in the coming years. No matter what happens in the fiscal cliff, the dollar supply is guaranteed to mushroom far faster than the global mined supplies of gold and silver. So their prices will surge as investors seek inflation protection.
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The bottom line is the fiscal cliff is a sideshow. The real problem is the staggering national debt Obama's gigantic deficits have ballooned. As this debt continues to mount and interest rates start mean reverting away from their record lows, the federal interest expense will eventually grow to consume everything else. Merely reducing deficits won't even make a dent in this problem, we need to see surpluses to pay down debt.
The class-warfare tax hikes the Democrats desperately want are only about an eighth the size of Obama's annual deficits at best. And the Republicans are right do demand gigantic immediate cuts in the record levels of government spending. But sadly the likely outcome is nothing gets done, and the national debt keeps growing. This guarantees serious inflation as the Fed continues to monetize this crazy overspending.
Disclosure: I am long TECS.