Faking Our Way to Sovereign Bankruptcy (American Thinker)

 

By Monty Pelerin

As political events in Egypt play out, including likely contagion to other parts of Africa and the Middle East, attention is diverted from the real threat to our country -- government insolvency. From Jeff T. Allen, writing in American Thinker:

There will soon be a crisis affecting US citizens beyond any experienced since the Great Depression. And it may happen within the year.

Unlike the Great Depression, however, we will enter such a shock in a weakened state, with few producers among us and record mountains of debt. More cataclysmic is the specter of inadequate food, as less than 4% of us farm ...

Fantasy Land

Political lip service will not solve this problem, only spending cuts will. Yet lip service is all we get. President Obama's State of the Union address spoke of the problem but not to the problem. Obama offered no spending cuts, while proposing a host of new spending programs. The release of his budget reflects more of the same - phony promises but no real action

President Obama continues to revel in his world of fantasy and duplicity while the economy and world crumbles. Mr. Obama appears delusional and more interested in political posturing than constructive effort.

Newly elected Republicans seek $100 billion in immediate cuts but struggle to get to this level. Smaller numbers elicit calumny from Democrats and the media. Democrat Majority Leader Harry Reid reacted this way to the potential cuts:

"In many cases, these proposals may mean taking workers off the assembly line or taking teachers out of the classroom or police off our streets," Senator Harry Reid, the Nevada Democrat and majority leader, said.

Characteristically, Reid touches the political hot buttons in an attempt to scare people. While Reid is correct that low-level cuts will be harmful, it is for an entirely different reason than he suggests. Small cuts ensure a government default, civil unrest and economic collapse.

Head-in-the-sand politics must end. Feigned ignorance and cowardice will not serve politicians well. Reality is on the way and they are apt to be run over by it. For politicians like Majority Leader Reid, the remainder of this article may be detrimental to your health. Do not proceed without a cardiac care unit on standby.

Fiscal Conditions

John Mauldin, in his recent newsletter, argues that public spending in welfare states has reached a turning point:

Clearly, we are looking at a watershed event in public spending in the United States, United Kingdom, and Europe. Because of the Great Financial Crisis, the usual benefit of a sharp rebound in cyclical tax receipts will not happen. It will take much longer to achieve any economic growth that could fill the public coffers.

Welfare states are faced with life-or-death problems that may not be soluble. To understand the gravity of the situation, two studies are useful.

The BIS Study

The Bank of International Settlements (BIS), is known as the Central Banker for central banks. In addition to other duties, BIS produces respected research pertaining to the world economy. They warned of the inevitable debt crisis long before it was apparent.

They are less political than central banks. As a result, their analysis can be more objective. Below is an excerpt from a BIS Working Paper which presented the necessary surpluses by country necessary to regain sounder fiscal condition.

[Table 6.1] presents the average primary surplus target required to bring debt ratios down to their 2007 levels over horizons of 5, 10 and 20 years. An aggressive adjustment path to achieve this objective within five years would mean generating an average annual primary surplus of 8-12% of GDP in the United States, Japan, the United Kingdom and Ireland, and 5-7% in a number of other countries. A preference for smoothing the adjustment over a longer horizon (say, 20 years) reduces the annual surplus target at the cost of leaving governments exposed to high debt ratios in the short to medium term.

These numbers have deteriorated since the table was constructed. For example, the US budget deficit is now expected to be in excess of 10% of GDP in 2011, not the 7.1% shown. The implications of the table are discussed below, but first a look at the problem from a different perspective.

The Jagadeesh Gokhale Study

Almost a year ago, an article entitled Welfare States - R. I. P. showed debt levels from around the world. This analysis included funded and unfunded (Social Security, Medicare, etc.) liabilities while the BIS study dealt only with funded debt.

The US government then had debt and unfunded liabilities equal to 8.4 times GDP. Today the number is almost 9 times. In 2005 the EU averaged 4.3 times GDP. The ratios for the PIGS, those troubled EU countries, were as follows: Portugal 4.9, Italy 3.6, Greece 8.8 and Spain 2.4. A methodological difference understated these ratios versus the US. It was crudely estimated that using the same methodologies, the EU and the US would be comparable.

An Intractable Problem

According to BIS, the US must run higher than a 2.4% budget surplus (higher than the Table above to reflect worsened conditions). A surplus this size has not occurred since the inception of the modern welfare state. To achieve this surplus, the US would have to cut spending by $2.0 Trillion in one year! (Note that any combination of cuts and tax increases necessary to produce this figure would suffice. This discussion assumes cuts only and tax increases would drive economic activity down and likely not be effective.)

Obama claims his new budget produces $1 Trillion dollars of cuts over 10 years. (At first blush, it is seen to contain at least 15 different tax increases to achieve his claim.) Even if his numbers were real, that is half of what BIS says is required in the first year and every year thereafter for 20 years! Over Obama's 10-year horizon, the BIS say that $20 Trillion is required. To achieve it, requires spending cuts of more than 50% of total government spending immediately!

The BIS solution is daunting, but not satisfactory for two reasons:

• 1. It only returns governments to their 2007 fiscal conditions. After 20 years of extreme austerity the US would return to the condition that preceded the financial crisis. That assumes that markets would allow us this much time. Returning to the condition precedent to a financial collapse does not seem too assuring.
• 2. The BIS cuts do not address the unfunded liability problems which would have to be dealt with as well, although presumably with less urgency.

The Gokhale study, based on 2005 data, concluded that government finance was unsustainable. By 2007, financial conditions had worsened.

The simplest way for most to understand the implications of the Gokhale data is to put it in terms that they can relate to. Several examples of that were provided in Spiraling to Bankruptcy. One illustration had the government confiscate all private wealth and apply it to their liabilities:

If the Government confiscated everything, the social programs would still be $50 trillion short and the Government would still be bankrupt. Furthermore, no company or individual would be left with anything.

Another translated government debt into the equivalent amount owed by each individual:

Assuming a total population of 315 million people, the portion of Federal Government debt that is owed by every man, woman and child in this country is about $381,000! Or, a family of four owes $1,525,000 of which they are unaware. This amount is in addition to whatever mortgages, credit card debt, car loans or other loans a family might have.

Both the BIS and Gokhale studies convey the desperate situation we are in. The BIS provides a solution via massive cost-cutting. Gokhale does not provide a solution. Neither study accounts for the additional state and local liabilities. Neither takes into account the federal guarantees of Fannie and Freddie which amount to another $5 Trillion.

The Federal Government is in what is known as a Debt Death Spiral. They are unable to pay the actual and implied interest on their debt. Hence, the unpaid balance is added back to the amount owed, making the problem worse next year. This debt spiral is growing exponentially. Unless this spiral is reversed, there is no way to escape a certain mathematical end.

Faking It To Bankruptcy

The supposed budget-cutting Republicans are having trouble agreeing on $100 billion of cuts. That is considered too much by some. Obama, on the other hand, claims he is cutting even as he submits a record-shattering spending budget. Politicians, unless their last name is Paul, believe budget cuts of any reasonable size are not possible. In the fantasy world of politics, perhaps they are correct.

The real world, however, is ruled by higher laws, unconcerned with politics. Physics and mathematics are beyond political influence. These forces don't think or care; they just are. They unemotionally influence events, oblivious to human needs, wants or suffering. Pure forces of nature cannot be bargained with or overruled.

A clash between these two worlds is imminent. A year ago in Welfare States - R. I. P., I speculated that we would come to this point:

The inability of politicians to say no or not play Santa Claus appears to be universal. It has every welfare state headed for bankruptcy. It is unlikely that politicians will act to head off this problem, but markets will eventually put these states out of their misery.

Lack of action is not necessarily a sign of ignorance amongst the ruling class. We got here as a result of their cowardice and Santa Claus politics. That is not about to change. The brighter politicians surely understand the situation as well as I have tried to explain it and probably better. Refusal to act is dastardly but likely "good" politics.

Initiating cuts of the magnitude necessary to avoid Armageddon would precipitate our version of an Egyptian rebellion. In the political mind, even a benevolent dictator with virtually unlimited power could not solve the mathematics of this problem. Given this attitude, it is rational for politicians to pretend ‘til the end. In effect, they are faking their way to sovereign bankruptcy.

Even though it is useless, they will do anything to keep the economy afloat for as long as they can. Once the true condition is known, we will be indistinguishable from Egypt. Apparently that will be fine with President Obama who stated that what was happening in Egypt was democracy at work. Will he feel that way when the US population realizes what has been done and reacts?

Monty Pelerin at www.economicnoise.com