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Putting Deficits into Perspective (2)

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