A different take on the economy (???)

An acquaintance of mine, Doug Tengdin, a CFA (Chartered Financial Analyst), writes an engaging five-days-per-week financial commentary on his employer's website.

His perspective about the state of America's finances has seemed so far out-of-step with what I've been thinking that last week I "couldn't take it anymore." So I wrote him:

Doug:

Your Global Market Update for last Friday (i.e., 2/12) suggested Greece’s economic difficulties should be “a cautionary tale for all countries with budget problems.”

I'm curious, then, why you seem rather sanguine about the United States’ situation. . . . I can't put my finger on specific posts, but that has been my general feeling.

I “just” wish I could get a stronger sense of WHY I should look with favor on the U.S.’ position . . . or acquire some kind of confirmation that I'm not quite crazy to be writing posts like these on my blog:

• The long-term demise of the U.S. dollar
   
• The financial future of the United States
   
• Need a Churchill for our age?

Yesterday morning’s post:

• The Greenspan-Guidotti Rule (or Guidotti-Greenspan)

. . . I'm hoping perhaps some of this might inspire a post or two. . . .

Thanks!

He wrote back pretty much what he posted on Tuesday in Why Not Here? Major reason people in the U.S. ought not to worry: "The US isn’t Greece."

• "We don’t have a culture of permanent employment and tax evasion as a national sport."
   
• "We have a culture that includes a modest safety net along with entrepreneurial innovation."
   
• "We have an incrementalist political culture that is . . . hostile to revolutionary change. . . . That’s a good thing for investment and wealth accumulation."
   
• "The US debt level isn’t as high as many people fear. Much of our 'debt' is held internally by Social Security."
   
• "For the past 30 years, real economic growth has averaged 3%. Deficits have averaged 2.5%. So the debt, as a percentage of the economy, has been getting smaller."
   
• "Greece [ran 10% deficits] for years. And played with the accounting rules to mask this. We didn’t do that." (On the other hand, "if we run 10% deficits in the long run, that’s another story.")
   
• "[T]he government is a much smaller part of the economy here than most people realize. Government spending makes up about 28% of GDP. By contrast, the Greek public sector is 40% of their economy. So it’s harder to cut spending there without pushing Greece into another recession."

There was one last comment he made in his personal response that particularly struck my eye.

It appears he read my Banking, lending . . . and government bond auctions post in which I reference Bob Prechter of Elliott Wave fame.

Doug wrote:

I’m skeptical of the Elliot Wave. . . . History is not destiny—it’s a guide as to human character and behavior. Prechter misses the fundamentals for the charts.

Here’s a fundamentalist I respect:

http://www.ft.com/cms/s/0/7467f85e-1b30-11df-953f-00144feab49a.html


In this post Martin Wolf quotes Brad DeLong. I’m not so keen on DeLong, but he makes a good point: short-term deficits are a bet that borrowing is worth it in the long run. If the present value of the future cash streams of the borrowing are less than the present value of the income stream that you create by avoiding the wealth destruction of a financial panic (or revolution or war), then the borrowing was an economic plus.

Many of the gloom-crew ignore Stein’s Law: If something cannot continue it will stop. And Coolidge’s dictum: if ten problems are coming toward you down the road, chances are that nine of them will go off into the ditch before they reach you.

There's a lot in these three paragraphs. But even more in the referenced article. And at far too many points, in what Doug wrote and in what I read in the referenced article, I found (and find) myself highly skeptical or critical of what the authors are saying.

Let me begin with Doug's comments:

• "We don’t have a culture of permanent employment and tax evasion as a national sport." --Okay. That's good. I'll buy that. For now. (Though it appears our country is heading downhill on this score.)
   
• "We have a culture that includes a modest safety net along with entrepreneurial innovation." --Again a good point. Indeed, a very good point. May it continue!
   
• "We have an incrementalist political culture that is . . . hostile to revolutionary change. . . . That’s a good thing for investment and wealth accumulation." --Amen.

But now I begin balking:

• "The US debt level isn’t as high as many people fear. Much of our 'debt' is held internally by Social Security." --???? I'm afraid our debt is far higher than our government acknowledges. What about all the unfunded future obligations? And what about the debt Doug tries to minimize by means of the quotation marks? He says it is "held internally by Social Security." --And we are supposed to take comfort in that? The fact that the government uses debt to pay debt? That it has already spent all the funds Americans have "invested" in their Social Security accounts? The fact that all of the federal government's future obligations for Social Security and Medicaid and Medicare are going to have to be funded through future taxes . . . because it has saved absolutely no money in any of the "fund" accounts that have supposedly been "set aside" for those purposes?
   
• "For the past 30 years, real economic growth has averaged 3%. Deficits have averaged 2.5%. So the debt, as a percentage of the economy, has been getting smaller." --There is some truth and, I'm afraid, quite a bit of falsehood in that statement. Yes, the debt as a percentage of the economy declined quite steadily from 1948 till 1974; but then it began increasing--in fact, it more than doubled--from 1974 through the early 1990s. At that point, it officially began to hold steady and even decline till about 2001. But then it has taken off again.
  
  Part of the problem, however: We are talking about acknowledged public debt. We are not talking about the government's massive unacknowledged "off-book" and unfunded obligations. As Michael Hodges explains in answer to the question, "Since debt increased each year, how could [federal government] officials claim they had a budget surplus in the late 1990s and 2000?"
  

  Answer: the general federal government did not have a surplus. In fact, they ran a huge deficit each and every year. . . . The Deficit-Trust Report shows the general government spent more than its general revenues, but they covered up the over-spending deficit by siphoning-off all surpluses from all trust funds, including spending every penny remaining in the social security trust fund on non-pension items - - while creating even more debt IOUs to 'paper-over' their actions. . . . See the 1999-2000 data report.

• "Greece [ran 10% deficits] for years. And played with the accounting rules to mask this. We didn’t do that." --Really? You wouldn't call the use of all the Social Security funds for current government expenses, and the massive increases in unfunded mandates and unfunded future obligations and massive "off-book" accounts (for example, the trillions of dollars of Fannie Mae and Freddie Mac obligations now being guaranteed by our government--off the books--a kind of "playing with the accounting rules"?
   
• "[T]he government is a much smaller part of the economy here than most people realize. Government spending makes up about 28% of GDP. By contrast, the Greek public sector is 40% of their economy. So it’s harder to cut spending there without pushing Greece into another recession." --How wonderful! But should we rejoice simply because they are worse off than we?

But where I really got bogged down was here, in the material Doug had me consider from the "fundamentalist" he said he respects:

First, Doug's comment about Brad DeLong's "good point" . . . that "short-term deficits are a bet that borrowing is worth it in the long run."

And I wonder: Are they really? Always? Or do some people--and some governments--borrow not with any real intention of paying the debt back, but with the (vain) hope that somehow, somewhere, someone will get it paid back . . . "just so long as it's not us (or me) right now." --The whole "Let's palm our problems off on someone else" methodology; the kind of behavior that Porter Stansberry noted that GM managers were engaging in for years before the company was finally forced to declare bankruptcy: "GM had no conceivable way to repay its debts. It was even borrowing money to pay for the interest expense on its existing debts." Moreover, "GM used byzantine accounting to hide the truth of its deteriorating fiscal condition." --And isn't that what the United States government is doing at this point?

"Many of the gloom-crew ignore Stein’s Law," Doug says: "If something cannot continue it will stop."

Oh, yes! That is correct. It will stop. The question is, will it stop of its own accord, with a positive outcome? Or will it stop in pain by the force of outside agencies?

"And [the gloom-crew ignore] Coolidge’s dictum: if ten problems are coming toward you down the road, chances are that nine of them will go off into the ditch before they reach you."

Very nice.

But/and/then, what are we to make of Martin Wolf's concluding remarks?

[A]s the BIS [Bank of International Settlements] paper . . . noted, long-run fiscal prospects, largely driven by ageing, are dire. Projecting forward from the dreadful starting points [i.e., where these nations' balance sheets are today], the BIS authors argue that ratios of public debt to GDP could reach 250 per cent of GDP in Italy by 2050, 300 per cent in Germany, 400 per cent in France, 450 per cent in the US, 500 per cent in the UK and 600 per cent in Japan. If the sovereign debts of high-income countries are not to be reduced to junk, these countries do indeed need credible plans for retrenchment. On this there is no disagreement.

????!!!!

Did you catch what Wolf is saying? That the United States, Great Britain and/or Japan might wind up with public debt equivalent to 4.5, 5, or even 6 times their Gross Domestic Products?

Can you imagine anyone being foolish enough to lend a government money so it can go that far into debt?

Suppose we take the "conservative" 450% of GDP number that the authors of this study--and the "conservative" fundamentalist Martin Wolf!--suggest for the United States.

At an interest rate of only 5%--which is extremely low, considering the risks involved!--the interest payments alone on such a debt would amount to 21.25% of Gross Domestic Product. That is interest only. No current expenses. No services. No employees.

I don't believe that day will ever get here. Impossible. Doug is correct: Stein’s Law will come into play long before that occurs: "If something cannot continue it will stop."

But what really gets me is how Wolf "argues" his "case."

Look at his conclusion:

The best approach [to the future crisis] would be sharp reductions in long-term growth of entitlement spending. Furthermore, as economies recover, short-term fiscal action will be needed. Actions will have to include spending cuts and increases in tax, to restore revenue lost forever in the crisis. . . .

So, yes, high-income countries face huge fiscal challenges. And yes, the crisis-hit countries start from grossly unsustainable fiscal positions. But the US is not Greece. Moreover, a massive fiscal tightening today would be a grave error. There is a huge risk – in my view, a certainty – that this would tip much of the world back into recession. The private sector must heal. That, not fiscal retrenchment, is the priority.

In other words: Yes, we're in trouble, and yes, we need to take care of the dire future we can see coming at us. And, yes, we need to sharply reduce our entitlement spending. But . . . not now. Not now. This is a bad time.

Put another way: "I don't really have any good solutions. But tightening our belts right now is a very bad idea."

And I reply: Based on the federal government's behavior throughout the last 40 years, when is a good time to tighten our belts?

My hypothesis?

Never. Never "now." Tightening our belts is always a good idea "sometime in the future."

From the politicians' perspective, it is never a good time to pay back debts we have accrued. It is always a fine time to borrow on the future.

. . . Which brings us back to the issues I've been raising in so many of my posts over the last few weeks: My friend Doug's attempts to dissuade me notwithstanding, I don't see a bright future for our country . . . primarily because there is no one who has the guts to address the fundamental fiscal problems that confront us.

Financial storms on the horizon?

Image by Voetmann via Flickr
I receive Gary North's Reality Check every weekday but read it only once every extreme once-in-a-while. And today was one of those once-in-a-whiles. Or, I should say, today I read Friday's "Reality Check." North said Storms on the Horizon by Richard W. Fisher, president and CEO of the Federal Reserve Bank of Dallas, is the scariest speech he has ever read, and "I have been reading speeches for a living for over 40 years."

Things are worse than I had imagined, and my scenario has been bad. This dwarfs my scenario. Coming from the person who delivered it, you had better take it seriously.

I have no further comments. Click. Print. Read.

Coming from Gary North--a guy known as "Scary Gary" for his rampant pessimism and doomsday scenarios--his comments are probably a bit of hyperbole. But maybe not.

Mr. Fisher's comments, certainly, merit attention. I think North is correct: "Coming from the person who delivered [them], you had better take [them] seriously."

Fisher, speaking on May 28th this year, said,

Eight years ago, our federal budget, crafted by a Democratic president and enacted by a Republican Congress, produced a fiscal surplus of $236 billion, the first surplus in almost 40 years and the highest nominal-dollar surplus in American history. While the Fed is scrupulously nonpartisan and nonpolitical, I mention this to emphasize that the deficit/debt issue knows no party and can be solved only by both parties working together. For a brief time, with surpluses projected into the future as far as the eye could see, economists and policymakers alike began to contemplate a bucolic future in which interest payments would form an ever-declining share of federal outlays, a future where Treasury bonds and debt-ceiling legislation would become dusty relics of a long-forgotten past. The Fed even had concerns about how open market operations would be conducted in a marketplace short of Treasury debt.

That utopian scenario did not last for long. Over the next seven years, federal spending grew at a 6.2 percent nominal annual rate while receipts grew at only 3.5 percent. Of course, certain areas of government, like national defense, had to spend more in the wake of 9/11. But nondefense discretionary spending actually rose 6.4 percent annually during this timeframe, outpacing the growth in total expenditures. Deficits soon returned, reaching an expected $410 billion for 2008—a $600 billion swing from where we were just eight years ago. This $410 billion estimate, by the way, was made before the recently passed farm bill and supplemental defense appropriation and without considering a proposed patch for the Alternative Minimum Tax—all measures that will lead to a further ballooning of government deficits.

In keeping with the tradition of rosy scenarios, official budget projections suggest this deficit will be relatively short-lived. They almost always do. According to the official calculus, following a second $400-billion-plus deficit in 2009, the red ink should fall to $160 billion in 2010 and $95 billion in 2011, and then the budget swings to a $48 billion surplus in 2012.

If you do the math, however, you might be forgiven for sensing that these felicitous projections look a tad dodgy. To reach the projected 2012 surplus, outlays are assumed to rise at a 2.4 percent nominal annual rate over the next four years—less than half as fast as they rose the previous seven years. Revenue is assumed to rise at a 6.7 percent nominal annual rate over the next four years—almost double the rate of the past seven years. Using spending and revenue growth rates that have actually prevailed in recent years, the 2012 surplus quickly evaporates and becomes a deficit, potentially of several hundred billion dollars.

He goes on to outline how pessimists have usually fingered the unfunded liabilities of the Social Security system as one of the key factors we need to beware of in the not-so-distant future. But "Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare," he says.

The amount of money the Social Security system would need today to cover all unfunded liabilities from now on—what fiscal economists call the “infinite horizon discounted value” of what has already been promised recipients but has no funding mechanism currently in place—is $13.6 trillion, an amount slightly less than the annual gross domestic product of the United States. . . .

The infinite-horizon present discounted value of the unfunded liability for Medicare A [what covers hospital stays] is $34.4 trillion. The unfunded liability of Medicare B [which covers visits to the doctor] is an additional $34 trillion. The shortfall for Medicare D [the drug benefit that went into effect not quite three years ago, under the pressure of our current president] adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Add Medicare to Social Security, and, between those items alone, you have a total unfunded liability of $99.2 trillion.

Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household’s income.

Obviously, that's not going to happen.

So what else can we do?

[A] permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Wouldn't that be great? Maybe!

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation’s entitlement programs would be to cut discretionary spending by 97 percent. But . . . discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut--almost eliminated, really--to tackle this problem through discretionary spending. . . .

[J]ust to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. . . .

No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered, . . . someone must pay $99.2 trillion. , , , This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight. . . .

[L]et me come back to monetary policy and the Fed.

It is only natural to cast about for a solution--any solution--to avoid the fiscal pain we know is necessary because we succumbed to complacency and put off dealing with this looming fiscal disaster. Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.

We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.

So what should we do?

I found it interesting that Fisher never mentioned a "solution" that I've been scared our government will choose: attempt to extort concessions--"forgiveness of debt"--from other nations through war. How awful would that be?

Fisher concludes,

Purging rampant inflation and a debased currency requires administering a harsh medicine. . . .

Failing to face up to our responsibility will produce the mother of all financial storms. The warning signals have been flashing for years, but we find it easier to ignore them than to take action. Will we take the painful fiscal steps necessary to prevent the storm by reducing and eventually eliminating our fiscal imbalances? That depends on you.

I mean “you” literally. . . . When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them. You are the ones who let them get away with burdening your children and grandchildren rather than yourselves with the bill for your entitlement programs. . . .

When George Shultz, one of San Francisco’s greatest Republican public servants, was director of President Nixon’s Office of Management and Budget, he became worried about the amount of money Congress was proposing to spend. After some nights of tossing and turning, he called legendary staffer Sam Cohen into his office. Cohen had a long memory of budget matters and knew every zig and zag of budget history. “Sam,” Shultz asked, “tell me something just between you and me. Is there any difference between Republicans and Democrats when it comes to spending money?” Cohen looked at him, furrowed his brow and, after thinking about it, replied, “Mr. Shultz, there is only one difference: Democrats enjoy it more.”

Yet no one, Democrat or Republican, . . . wants to see the frightful storm of unfunded long-term liabilities destroy our economy or threaten the independence and authority of our central bank or tear our currency asunder.

Of late, we have heard many complaints about the weakness of the dollar against the euro and other currencies. It was recently argued in the op-ed pages of the Financial Times that one reason for the demise of the British pound was the need to liquidate England’s international reserves to pay off the costs of the Great Wars. In the end, the pound, it was essentially argued, was sunk by the kaiser’s army and Hitler’s bombs. Right now, we--you and I--are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so.

Are you ready to do your civic duty and say no to any candidate who is unwilling to say no to further deficit spending and who is unwilling to say yes to massive cuts in federal entitlements?

If not, who do you expect to to bring the federal deficit under control and the debt back to a level that can actually be managed? And by what means do you think the deficit is to be cut and the debt to be retired?