Covestor model: Relative Value
In 2011, the American economy has crossed the 90% sovereign debt to GDP number that modern economic textbooks define as the Rubicon point of diminishing returns for long-term productivity growth and wealth creation for a nation.
Regarding this figure, I strongly suggest investors familiarize themselves with the comprehensive study released last year by Carmen Reinhart and Kenneth Rogoff regarding national debt levels and expected economic growth rates, as viewed through the lens of the latest 200- ears of wealth of nations history.
Sky-high and rising sovereign debt levels will soon explode the annual interest expense for Uncle Sam, and crowd out options to hold up the economy, encourage savings, and invest in government programs of any significance for years to come. Particularly disturbing for America is that we have already reached a level of annual deficit spending in 2010 and 2011, where Ponzi buying of Treasury securities is required of the Federal Reserve bank to keep the federal government solvent. Internal savings by American investors, banks and corporations are inadequate to purchase the massive demands of near weekly bond and note auctions, on top of weekly auctions of Treasury Bills each Monday of better than $50 billion, or $2.7 trillion annualized.
America has dumped at least $7 trillion in funny money into the economy the last four years, or about $60,000 per U.S. household. The astronomical $2 trillion increase (250% rise) in the Federal Reserve bank’s balance sheet through direct money printing and Ponzi purchases of mortgage busted assets [QE1] and Treasury securities [QE2], alongside an unprecedented $5 trillion increase in Treasury borrowing from economic stimulus packages and mandated welfare and economic supports (including tax breaks for working class and upper class wage earners alike, unemployment benefits, food stamps, Medicaid and bailouts for states and local governments, to name a few), are beginning to act as heavy weights or burdens on economic growth, as the initial injection of liquidity and stimulus comes to an end and/or fade in relevance.
While the once-in-a-lifetime money printing experiment by the world’s central banks, engineered by the U.S Federal Reserve, undoubtedly prevented a 1930s-like Depression or worse in global economic activity in 2009-2011, this effort will come at a real economic cost to future growth and the demands of debt repayment by future generations. Lost in the conversation, as the stock market has careened into the stratosphere in 2009-2011, is the long-term damage being done to America’s economic potential down the road. The new debt borrowed by our government annually is reducing our expected growth rates in the next 5-10 years by leaps and bounds. Potential economic growth rates have already been reduced by 2%-3% annually for the coming decade, by my calculations, and this trade-off of short-term gain in return for long-term pain is going largely unreported by the short-sighted mainstream media.
We as a free society, and our policy maker leaders more specifically, are being backed into a tight corner, where only two legitimate options remain to prevent national bankruptcy a few years down the road. On the present course, if our deficit spending (living well, well beyond our means each day) and money printing direction is not changed, we will quickly become Greece or Japan. Basically, too much debt will actually have consequences for the economy. In my opinion, an honest and balanced economy that is sustainable is likely a good 20% smaller than the one we enjoy today (to balance both our trade and federal spending deficits). The dirty secret our leaders and politicians are keeping under wraps, and are completely unwilling to tackle, is that the longer we wait to deal with reality, the greater the pain will be in the future.
Starting in 2011, America can choose: (1) austerity and a lost decade or two of economic growth, while risking a deflationary depression in 2012; or (2) raising the debt ceiling in coming weeks without much deficit reduction, which will require a new round of (Ponzi) Federal Reserve accumulation of Treasury debt. Following the present course, new money printing will likely hit the economy in successively larger waves each year to paper over the previous year’s debt and interest payment obligations. The net result will be skyrocketing inflation and backwards economic growth in 2012 - stagflation or hyperinflation, depending on your view of things.
Our leaders are currently faced with this dilemma, with Tea Party Republicans desiring choice #1, and Democrats (and moderate Republicans) desiring choice #2, as groups. Either way more economic pain and dislocation is coming, as we get to choose our own destructor (Ghostbusters movie reference).
Not only have we accumulated a massive new sovereign debt load in 2008-2011, but baby-boomers have reached Social Security payout retirement age and related health care expenses for Uncle Sam will now rise at double the average rate during the next decade, as compared to the last decade. Slowing consumer spending trends, falling income tax collections and rising government obligations to pay out, are here and now, a direct result of naturally changing and long predicted demographics for America.
With current “net” interest costs a little above $200 billion annually, or 1.5% on $14.3 trillion in outstanding debt, the Federal Reserve and Uncle Sam's biggest problem is containing inflation rates and "expectations." America needs to keep a low level of interest and a stable value for each Dollar as believable options and alternatives for quick moving investment capital.
The sky-rocketing rate of interest expense is what has destroyed Greek society in 2010-2011, and forced bailout after bailout, on top of austerity programs including rising tax rates and spending cuts to balance tax receipts with government expenditures.
If foreign investors lose faith in the low inflation fiction Chairman Ben Bernanke of the Federal Reserve is trying to write, the Dollar will implode in value and interest rates (expense) will explode yearly as we refinance all our short-term term debt at higher rollover rates. We now have ultra-low and unsustainable "teaser" rates on our debt financed almost entirely under five years in duration. During Fiscal 2012 (October 2011 to September 2012), the Treasury will finance new deficits and refinance maturing debts of $3+ trillion in total, or the equivalent size of 20% of annual GDP, at a minimum, if the economy does not slip.
This situation is strikingly similar to the end phase of the real estate boom years of 2002-2007, where ultra-low teaser rates encouraged excessive borrowing, and ever rising adjustable rates eventually bankrupted millions of Americans. It is my firm belief that the effective transfer of bad debts and loans from the private sector banking system to Uncle Sam’s balance sheet during 2007-2011 is a horrible long-term policy and threatens not only the monetary solvency of our government, but puts American democracy at risk.
Here are some numbers to contemplate. If you put a 5% interest rate on roughly $20 trillion in total debt in five years, you come up with $1,000 billion in annual interest expense, not $200 billion. That’s an increase of nearly $200 billion annually, successively in the near future. Congress cannot even agree on $100 billion in one-time static annual cuts, so their budget debate is quite meaningless at this late stage, if we do not support a strong Dollar, low inflation policy at the Fed. A $20 trillion debt total is one of the more optimistic projections out there, and is pushed by the Obama Administration.
And this is the rosy scenario of keeping inflation well below average. The truth of the matter is inflation rates, as calculated based on the 1990 formula for CPI, are already running at +6% year over year, so short-term rates of zero cannot last much longer without running the potential of a collapse in the U.S. Dollar’s value in world markets. For a sustainable balance in the economy and markets, “real” interest rates of some sort are usually required historically, where short and intermediate-term interest rates in the free market at least cover current inflation increases and some income tax. American authorities have continually revised how inflation is calculated to suppress its negative effect on consumer confidence and hold official CPI dependent increases in government spending as low as possible. For example, if CPI was calculated using the same methodology as 1980, today’s inflation rate is +11%, not the trailing +3.6% reported for May 2011 by our government.
Worst case scenario: given a major destabilizing, black swan event such as Saudi Arabia's regime being overthrown in 2011 or 2012, we will surely get US$150-$200 a barrel oil, and inflation rates beyond 10% annually for several years. Given a 10% interest rate and rollover of debts for the next five years alongside new deficit borrowing, you get closer to $2 trillion ($2,000 billion) in annual interest expense and a potential double in the total deficit into the banana republic range of 15%-20% of GDP per year, depending on economic growth trends.
All things being equal, a large rise in oil prices in the second half of 2011 could destroy the western world's economy, dependent as it is on record high and rising debt levels with almost no interest expense. That's why the Arab spring revolutions and still uncertain outcome of who will control the world’s largest oil reserves and pricing is very unsettling for our leaders. The reason we support Yemen, Bahrain, Kuwait and Saudi dictators, and why we are trying to get a say in Libya's resolution, revolves around controlling inflation rates the next few years. In the Federal Reserve's Ponzi-generated backwards world, saving American and European democracy depends on our support of dictatorships overseas. Nice...
Less debt would be a much better strategy at this stage to keep inflation rates low and confidence in the Dollar’s value high. A sharp $300 billion deficit reduction package annually would be quite painful and push U.S. back into recession, but the long-term benefits of low inflation and keeping the Treasury debt rollovers funded should now be a paramount concern, not jobs and economic growth at all and any cost. My argument is based in a classic short-term pain, long-term fix debate. Politicians and Americans in general, however, want short-term gain and gratification above all else. What have we become?
I propose an across the board 5% budget spending cut for Fiscal 2012 at every department and program (including Social Security, Medicare, the War Department, Congressional pay, Judicial Branch budgets, EPA, Education, whatever, etc.) alongside a $100 billion increase in taxes on the rich, to help offset the tax cuts they have received the last many decades, and take some pressure off the rising middle class tax burden. That gets you to $300 billion in tax cuts and should piss off everyone about equally. Seems fair to me. GDP in 2012 will likely be negative as a result, and we will have to pick up our boot straps and cut even more next year painfully to maintain a falling deficit situation for 2013, but the alternative is U.S. bankruptcy in 2013-2015 in my humble opinion, not just the Uncle Sam variety.
Unfortunately, the buzzer is also sounding in 2011, as the free-ride period of Chinese and Japanese investment in Treasuries is ending. The “recycling” of international trade imbalances back into Treasury bonds the last few decades is the biggest reason we have not seen major consequences for our national borrowing binge in the bond market.
Both China and Japan are today faced with rising economic imbalances, and will increasingly look to sell U.S. Treasury investments to bring home capital and support their own economies the rest of 2011 and beyond. All told, climbing debt loads and falling confidence in America’s future are combining with economic problems overseas to put upward pressure on annual interest expense for Uncle Sam, for years into the foreseeable future.
We are in quite a pickle now.
Stupid leaders and arrogant policy for decades have brought U.S. to this fateful choice in the world's history. Does anyone remember Ross Perot’s 1992 call for a different direction and the tackling of real budget liability issues? We are already doing a great job messing up the world, with QE2 and the related economic imbalances it has created, like pumping artificial confidence, demand and bubble investment monies into raw energy and food pricing. Our next choice may cause even greater chaos on the planet.
The Federal Reserve strategy of printing and borrowing may have only forestalled an inevitable drop into depression, or could in fact help to create a more painful economy for America for decades to come. Arguing that the economy is back on track and that we have conquered our debt problems is fanciful logic at best, if not based in downright fiction. My favorite term for the 2010-11 economy is that we are living in times of an “illusion of prosperity.” America’s choices from here will have real consequences on stock market pricing, and Quantemonics will stay on top of the developments for serious long-term investing.
U.S. Treasury Direct for outstanding debt, http://www.treasurydirect.gov/NP/BPDLogin?application=np
"Debt and growth revisited" 8/11/10 by Carmen M Reinhart, Kenneth Rogoff, VOX http://www.voxeu.org/index.php?q=node/5395
“Pimco’s Bill Gross: QE2 is a Ponzi Scheme” Wall Street Journal, Matt Phillips,10/27/10 http://blogs.wsj.com/marketbeat/2010/10/27/pimcos-bill-gross-qe2-is-a-ponzi-scheme/
“Treasury Bills’ Mixed Weekly Auction” Yahoo!, 7/5/11 http://news.yahoo.com/treasury-bills-mixed-weekly-auction-221434139.html
2010 U.S. Census data on number of households, http://2010.census.gov/2010census/data/ ; St. Louis Federal Reserve report on balance sheet, 6/29/11
U.S. federal budget data from OMB http://www.gpoaccess.gov/usbudget/index.html
U.S. CBO, ”The Long-Term Budget Outlook” Chapter 2, June 2009, http://www.cbo.gov/ftpdocs/102xx/doc10297/Chapter2.5.1.shtml
Wikipedia entry on U.S. budget obtained from various government agencies, http://en.wikipedia.org/wiki/United_States_federal_budget
"S&P warning adds default threat to Greece's bailout" Angeliki Koutantou 7/4/11 Reuters http://www.reuters.com/article/2011/07/04/us-greece-idUSTRE75O0SA20110704
Source for refinance needs in 2011 and 2012: MSPD, U.S. Treasury
“Geithner Tells Obama Debt Expense to Rise to Record” Bloomberg, 2/14/11, Daniel Kruger and Liz Capo McCormick,
Shadow Stats consumer price data, http://www.shadowstats.com
“Implications of large China holdings of U.S. securities”,1/9/08, Wayne Morrison, Marc Lanonte, http://fpc.state.gov/documents/organization/99496.pdf