Gyroscopic Investing

With all this talk about the national debt being unsustainable, I decide to take another look at the issue.  For instance, go back to year 2000 and the debt was only(!) $5.6T.  Just 10 years later it stood at $13.5T.  People have been worried about a default for decades, but it hasn't happened yet.  So.....how much is too much?  $20T? $50T? 

I think people get too wrapped up in "how much" without looking at the ability to service the debt.  It's like saying to your free spending buddy, "How could you rack up $500,000 in debt?  You only make $50,000 a year!"  Then your buddy says, "true, but my lenders only charge me 1.2%, so all I need to do is pay $6,000/yr and I'm fine.  I don't actually have to pay it back."

Look to Japan for a case study in this type of approach.  The debt itself almost doesn't matter.  What really matters is the ability to service the debt.  So, what does the U.S. look like?  In FY2010, interest payments on the national debt were a paltry $164B, which represents an interest rate of 1.2%.  Let's say the national debt doubles to $28T and the interest rate stays the same.  Does anyone think $328B in interest payments are too much for the U.S. to cover?  I don't think so.  How about 2x that?  What if the U.S. national debt quadruples to $56T?  Anyone think the U.S. can't cover $756B in interest payments?  I don't, but if you ask most people if $56T is too much debt, I'd bet 9 out of 10 would say yes.

Let's look at the inflation issue.  Say inflation picks up and the average interest rate on the current debt doubles to 2.4%.  We're still looking at $328B in interest payments.  Same scenario if interest payments quadruple to 4.8%: $756B, still doable.

As I see it, the end game is found in the African Monkey Trap.  If you're not familiar(no need to speak French, just watch):

http://www.youtube.com/watch?v=IHdJVzYB ... re=related

From a financial standpoint, we've got a long way to go until we run into trouble.  But at some point the cumulative total of the debt gets high enough at a low enough interest payment that it becomes impossible to get the figurative "closed hand" back out of the trap.  When interest payments on the debt get high enough and/or inflation accelerates, the debt burden quickly spirals out of control.  A cascading affect will occur as investors realize there's no way out for the country and default is imminent.  Rates continue to climb and the country is either forced to continue printing money or default outright.

So what's the moral of the story?  Relax, the U.S. isn't going to default any time soon and in reality has plenty of time to get the financial house in order.  The U.S. could deficit spend $1T/yr for 40 years and still be able to service the debt.  Just watch the monkey to the east called Japan.  Whatever happens to them will most likely happen to us in due time.

Some would say that with our ability to print money the idea that we'd default unless we literally tried to is asinine... so I agree, servicing and inflation are the things that matter most.

Wonk,

Its always great to re-evaluate my views on things like this...so thank you for your post.

However, if I look @ the price of gold, silver, oil, or commodities...I'm not sure those back up your argument, but rather are signaling just the opposite?

regards "So what's the moral of the story?  Relax, the U.S. isn't going to default any time soon"

how soon is soon? is your view that we have months, years, decades, or centuries?

Also, I know you speak of interest rates, but you don't consider a "reversion to mean" of interest rates, considering that rates are SO low.

It seems other countries are waking up to the fact that you can't create real prosperity simply buy suppressing rates, running up debt, and debasing the currency.

Overall, I think you are right, if it concerns an outright default. However, I think the stealth default is happening as I type this (currency debasement as evidenced by gold & silver).

my 2c

p

i will briefly add that this discussion fails to address the *fundamental* immorality of saddling future generations with an inheritance of debt...even Jefferson warned of this.

murphy_p_t wrote: Also, I know you speak of interest rates, but you don't consider a "reversion to mean" of interest rates, considering that rates are SO low.

Interest rates have been reverting to the 100 year mean for the past 30 years.

Prior to the 1970s, 4.5% was high.

I think what you are feeling is called "recency bias."

Looking back on the history of US debt, I see that the last time only other time it approached 100% of GDP was because of WWII.  Considering the huge economic dislocations that war caused, we may find it impossible to adjust to future crises of that magnitude because our peace time debt is already so huge.

Another concern is that our prior debt was held largely by Americans, who could on occasion be cajoled to buy bonds for patriotic reasons. Now, with foreigners holding the largest chunk, the matter is largely an investment decision.  LT interest rates are now hostage to the willingness of foreigners to continue to buy that debt.  Their decision can be greatly affected by any perceived weakness in America's ability to repay principal.  It may also be affected by geo-political decisions taken to marginalize the economic influence of the United States.  (BRICS??)

Our ability to repay debt is a function of our economic vitality.  A sudden reduction in foreign debt holdings will require vastly higher taxes on American businesses and consumers to make up the difference.  That, in turn, would tend to slow down our economy.  I don't see how that would make it easier for us to service the debt we already have, or encourage foreigners to invest here in the future.  If there's a silver lining in all this, I don't see it.

One more thing: in trying to avoid some of the negative outcomes mentioned above, there's a political risk to American independence insofar as we may become averse to taking positions which would inconvenience foreign investors.  That situation didn't look pretty when it happened to China 100 years ago.  How sad if it returned with the shoe being on the other foot.

I think one of the biggest risk factors is another September the 11th type of event which sends the economy back into recession.  If this occurred while the Fed is out of bullets and Uncle Sam is tapped out, we might find ourselves in quite a pickle.  Such a scenario could cause a rapid deterioration in the belief that we could repay our debts. 

While this is unsettling as we all hold a bunch of short and long term Treasuries, at least the PP has a large chunk of gold which would, at least partially, offset such a devastating hit. 

Pkg Man,

I tend to wonder if our fed/treasury has a natural free market counter-balance when things like that happen.  People tend to rush to safe return when things like 9/11 happen.  The treasury is naturally the most safe borrower of the dollar that there is.  Think of what things would be like today without what most people think of as "artificially low" interest rates.  I'm willing to bet treasury bonds would be paying sigificantly lower interest due to deflation and business' doors closing and society's riskier borrowers would be paying much HIGHER rates.  In other words, yield spreads would be huge.

This is probably why Keynesians say that since government debt becomes extremely attractive (comparitively) during recessions and the public is in bad need of extra funds, that defecits are entirely appropriate during these periods.

The last time a Democrat-controlled Congress balanced the budget was 1969. Republicans balanced it in four of seven years they controlled Congress over that time span. Unless we've been in a near-perpetual state of recession, I don't think anyone is following Keynes' playbook.

TBV wrote: The last time a Democrat-controlled Congress balanced the budget was 1969. Republicans balanced it in four of seven years they controlled Congress over that time span. Unless we've been in a near-perpetual state of recession, I don't think anyone is following Keynes' playbook.

I think it will be a long time before we will see another balanced budget from either party.

I used to see differences between the two major parties, but over time they have both come to resemble different species of the same breed of semi-delusional statist.

Perhaps this will change at some point in the future.  It would be nice to have more competent leaders.

murphy_p_t wrote:
However, if I look @ the price of gold, silver, oil, or commodities...I'm not sure those back up your argument, but rather are signaling just the opposite?

I think gold and to a certain extent silver are reflecting ongoing mismanagement of monetary and fiscal issues.  I don't think they are signaling an imminent default though.  Most commodities are simply reflecting more money & credit sloshing around.

murphy_p_t wrote: how soon is soon? is your view that we have months, years, decades, or centuries?

I honestly don't know in the least.  All I know is everything depends on decisions in the future that have obviously not been made yet.  If the will is there, we could reverse course tomorrow and be on our way to prosperity.  What I do know is the longer this goes on, the more difficult it will be to make the right decisions.

History does not make for optimistic precedent, though.  It's littered with numerous examples of empires just like ours and their process of decay.  I was recently in Rome and took a look at what was left of Circus Maximus.  On the sign, there was a telling quote from a Caesar around the 2nd century, I believe.  I can't remember which ruler it was, but he was lamenting the decay of the citizen character and said "all Romans want anymore are bread and circuses." 

Great civilizations rise by hard work and thrift and fall by laziness and entitlement.  Eventually ours will be no different.  My main point was that sometimes what seems like an inevitability can take a very long time to play out.  We might think a crisis is coming next year, but ultimately it might take 40 years.

One thing to consider is that there is a difference between a nation's debt and an individual's debt.  When you talk about a nation's debt, you're really talking about more than simply numbers/dollars.  You're really talking about how resources are going to be distributed. 

So the real question is, will the rest of the world continue to allow the US to consume resources that are made abroad in the form of accepting our dollars in exchange for the things that they have that we need?

Wonk wrote: With all this talk about the national debt being unsustainable, I decide to take another look at the issue.  For instance, go back to year 2000 and the debt was only(!) $5.6T.  Just 10 years later it stood at $13.5T.  People have been worried about a default for decades, but it hasn't happened yet.  So.....how much is too much?  $20T? $50T?  

I think people get too wrapped up in "how much" without looking at the ability to service the debt.  It's like saying to your free spending buddy, "How could you rack up $500,000 in debt?  You only make $50,000 a year!"  Then your buddy says, "true, but my lenders only charge me 1.2%, so all I need to do is pay $6,000/yr and I'm fine.  I don't actually have to pay it back."
...
So what's the moral of the story?  Relax, the U.S. isn't going to default any time soon and in reality has plenty of time to get the financial house in order.  The U.S. could deficit spend $1T/yr for 40 years and still be able to service the debt.  Just watch the monkey to the east called Japan.  Whatever happens to them will most likely happen to us in due time.

I agree that the real issue is service of the debt.  This is precisely why we don't know exactly when this will all play out.  Unfortunately, this is precisely what concerns me so much about our debt problem.

What your free spending buddy doesn't understand is that his lenders charge him 1.2% today.  However, he (and the United States) are operating under an adjustable-rate mortgage.  The United States (and your buddy) are continuously rolling over and refinancing debt at the prevailing interest rate.  This is the basic mechanism behind an ARM and comes with the same hazards.

The problem is that if interest rates rise, the day of reckoning can arrive much, much faster.  Let's look at your buddy again.  Let's say that for whatever reason interest rates rise to a higher-but-still-modest 5%.  Your buddy is now on the hook for $25,000 that year.  He only makes $50,000 and as you said, he is a free spender.  He's going to have to borrow the entire sum (in addition to what he already borrows every year, which is enormous.)  This new debt is going to be compounding the whole way, because he is constantly rolling his debt over.

And God help your buddy (and us) if interest rates hit 11 or 12%.  This was the average rate of interest from 1979 to 1982 so it's not outside the realm of possibility.  Your buddy didn't "lock in" his 1.2% rate and neither did we.  If we hit 11%, he's going to owe $55,000, more than his entire before-tax income!  Likewise if the United States had to pay 11% on $14 trillion, that's $1.5 trillion in interest payments alone.  (Even if we consider only our short term debt, approximately $7T, that's still $750B on just the short term debt.)  I am telling you, that would be some seriously bad news.

Once we've exhausted our ability to effectively service this debt, the only remaining options are default or inflation.

Inflation is nothing but a wealth transfer from savers to debtors. Capital investment (which is enabled by savings) determines our level of productivity and standard of living.  Solving this problem via inflation would be a nightmare for those not holding hard assets.  (That's even setting aside the fact that widespread inflation is a tremendous threat to property rights, which would be another terrible blow to the economy and individual freedom.)

Default is much less likely (IMO.)  I believe that this would only occur if politicians realized that the debt could no longer be serviced and paid off... but that the political consequences of attempting to "inflate the problem away" would be too devastating.  They might then choose to instead just bite the bullet and restructure the debt into something more sustainable.  It's a fringe scenario, but not to the point where I'd completely write it off as a 0% chance.

On the whole, I see this situation as much more dangerous than you do.  I do agree that for now we have time but we have no idea how much.  It's time that we might piss away racking up more unsustainable debt or we might (as you say) get our fiscal house in order.  Three years ago I never would have foreseen that we'd start racking up these kinds of deficits... but I also never would have foreseen the rise of the Tea Party movement.  Our choices will be our own.  For the moment I don't know what we'll do, but there's cause for lots of anxiety as well as cause for hope.

LW,

I do see the danger in the situation, but I don't think the consequences are likely to be catastrophic.  While there's always the possibility of a cataclysmic currency event, I don't think it's probable.  More likely will be a gradual phase-out of U.S. hegemony in world trade and currency markets.  This is still incredibly significant from a military perspective.  Control of the issuance of money has been at the epicenter of all the superpowers in history.  Not having exclusive dominance in this area puts the U.S. in a much weaker state.

I've come to grips with the fact that there will be a price to pay at some point in the future.  What keeps me optimistic is I feel confident in the ability to adapt and problem solve.  I think those are the most important assets to have during times of strife and change.  Still, the U.S. future I see is on par with England of the 20th century.  A proud, once-great world power in slow decline and increasing impotence in world affairs.  Sort of like the high-school quarterback who, after 20 years, thinks he's still "got it."

Adam1226 wrote: So the real question is, will the rest of the world continue to allow the US to consume resources that are made abroad in the form of accepting our dollars in exchange for the things that they have that we need?

Adam, the below article references what you've said and is a disturbing trend:

http://articles.economictimes.indiatime ... currencies

Here are the advantages of the U.S., some of which will decline with time, and others are likely to remain a while longer:

1. Largest economy in the world
2. Most potent military in the world
3. Owner of reserve currency
4. Most richly endowed country in the world in natural resources (I'm speaking of the overall basket of natural resources, but especially coal and natural gas)
5. Remarkable political stability
6. Well placed geographically for purposes of trade and national security
7. Ability to produce enormous amounts of food
8. Access to world's largest supplies of fresh water

These are some pretty stout competitive advantages, and some of them are hard to mess up, no matter how dumb the people in charge are.

***

With respect to the debt and default issue, I think one look at Japan should tell anyone that there is absolutely no way to predict what the effect will be of huge deficits and central bank incompetence.  Intuition in this area is not a good guide.

Wonk wrote: Adam, the below article references what you've said and is a disturbing trend:

http://articles.economictimes.indiatime ... currencies

I've heard about this kind of thing for a while now. 

I'm a little skeptical of the BRIC's ability to pull this off for a couple of reasons.

1.  The trust issue (discussed elsewhere on this board)  Brazil, Russia, China and India are not really known for providing a trustworthy environment for routine economic activities.  Although their economies are expanding at present, I think the average person probably still has issues with basic everyday transactions in the form of petty rip-offs (I've heard stories of having to bribe airport workers to get luggage after flights and similar gossip...might not be true, but if it is, I doubt these currencies will be able to replace the dollar any time soon).

2.  It's becoming almost an economic cliche to assume that the BRIC countries will eventually replace the US economically, complete with the catchy acronym.  Although certainly not a rigorous analysis, this alone makes me doubtful. 

I think the real issue is that stuff (oil and food) just ain't that cheap any more and a lot more people want a lot more of it.  As this reality slowly sets in, I can't see the BRIC countries continuing to do so well, at which time I think there will be less chatter about their currencies replacing the US dollar and more disbelief as US debt continues to remain valuable...