Saturday, January 22, 2011


There's been a lot of talk lately about federal "entitlements," like Social Security, Medicare and Medicaid. Eternal Optimist says entitle this: we are cruising fast toward a U.S. bond and currency crash.

See officer, I only had one beer . . .

Right now the federal government's annual expenditures are running 50% over its income. The government's income (taxes) is about 2.5 trillion, while expenditures are at about 3.8 trillion. Eternal Optimist wrote about this in "Budget Art."

This means we have to borrow 1.3 trillion just to cover this year's expenses. That's a big credit card bill.

Big Credit Card People.

We have a fragile economy. In 2009-2010 we borrowed an extra 2 trillion, over and above our normal borrowing, to try to fix it, with limited success. Increasing tax rates to pay for our spending is not a good option, since tax increases torpedo the economy.

Our total indebtedness is about $14 trillion. Which is more than our nation's annual income, or GNP. That's a hefty mortgage.

U.S. treasury bonds are promises people buy from us: promises to pay them interest over time. People give us cash for our bonds because the bonds are liquid and safe. "Liquid" means they are accepted by just about everyone for various purposes - collateral, payment of debts, outright sale. "Safe" because they are backed by a large, powerful and relatively well run economy and government.

For the last 50 years it has been smart for investors to buy U.S. bonds (treasuries). People got paid their interest, in a currency (the dollar) that wasn't depreciating much, if at all, compared with other currencies. We seemed safe, dependable and strong.

Uncle Sam, before he went on a bender.

Perceptions are changing. Investors looking at the U.S. see a government that can't pay its bills from current revenues, and has no plans to fix the problem. This strikes the casual observer as unsafe, undependable and weak.

New American Image
Our "plan" right now is to keep borrowing indefinitely. So just ask yourself: would you feel good about lending money to a guy who had no prospects of increased income, was making $25,000 a year, spending $38,000 a year, and had no observable intention of changing this situation? And oh, by the way, the prospective borrower is already $140,000 in debt.

That sound like a good credit risk?

If things continue as they are, investors will come to the same conclusion about our bonds that they came to about our housing market. Which is that prospects for getting repaid are actually worse than they thought. They've under-estimated the risk of default, and over-valued our bonds. Which means our bonds get devalued harshly and quickly, and our cost of borrowing skyrockets.

Barbarian investor about to trash U.S. treasuries.

The risk of simple default ("we won't be paying interest on our bonds this month") by the U.S. is probably still negligible, although "never say never." But the risk of loss through currency devaluation is significant. The U.S. can cheapen the dollar by expanding the money supply.

The effect is that a $100 debt incurred today is paid back "in full" with dollars in 12 months, but the dollars have depreciated. The 100 "payback" dollars are only worth, say, $75. So the investor (maybe you) loses money, even if the borrower (the U.S.) fulfills the letter of its loan agreement.

Right now investors are uneasy, but if one of our big states, like California or New York, actually declares a default on their bonds, it will start looking like the first half-hour of "Independence Day," when the aliens are busy destroying the earth.

Investors devaluing U.S. bonds.

When investors look around to see who else might default (that's what they do when they take a hit) they will think this: "the feds are in worse financial shape than California, except that the feds can totally screw me by printing money instead of "honestly" defaulting."

This will dampen enthusiasm for federal bonds.

Of course, investors may shrug their shoulders and say "we better buy fed bonds rather than invest in state bonds." But they might also say "we better buy Chinese, Brazilian, German or Indian bonds rather than any of that U.S. crap." Nowadays there are plenty of other economies to bet on. Depends on who is behaving better at the moment.

Brazilian banker: all that money, and Carnival, too!

There are dozens of our states in bad financial condition right now, with political cultures that will not permit them to make the budget cuts they need to avoid defaults. The chances of one of them going over the edge in the next 12 months is high.

Just the fact that this argument is plausible today, as opposed to even 4 years ago, should be cause for concern. Bond prices are based on market estimates of the probability of future events. When default becomes more plausible, for any reason, bond interest rates push up, and bond prices push down.

To think that the market in U.S. bonds is immune to the loss of investor confidence that hit the mortgage and housing markets in 2007-2008 is "magical thinking." Especially when we Americans are presently doing everything in our power to convince lenders that we are financial idiots.

New American Financial Image.

So either put a credible plan in place to cut federal spending by about 1.3 trillion, or the markets will make us do it shortly by turning off the debt tap and telling us to go home, it's closing time.

Closing Time.

I'm just saying.

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