Boeckh Letter: US Government Debt Sep 21 2010

8/8/2019 Boeckh Letter: US Government Debt Sep 21 2010

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BOECKHINVESTMENTSINC.,17501002SHERBROOKESTREETWEST,MONTREAL,QUEBEC.H3A3L6TEL.5149040551,[email protected]

VOLUME 2.14SEPTEMBER 21,2010

U.S.GovernmentDebt:TheUpwardSpiralContinues

The great reflationa combination of various stimulus packages, bank bailouts

and built-in fiscal stabilizersworked its magic in preventing the economic downturn of

2008-2009 from morphing into another great depression. Calculations by Alan Blinder

and Mark Zandi1

indicate that, without those actions the economic downturn would have

been three times deeper and unemployment would have almost doubled from its 10%

peak. Our sense is that the economic and financial crisis would have been even more

devastating than that because those calculations ignore the psychology of panic.

Failure to put out the fire would have risked burning the whole forest down.

The reflation, however, was only Act I. Now we are into Act II which is all about

dealing with the long-run consequences of massive and escalating government debt. In

addition, governments will soon have to face age-related effects on their expenditures

for health and social security and on economic growth.

Total gross U.S. government debt was approximately 90% of GDP in 2010, of

which over 80% is Federal. Chart 1 provides comparisons of the U.S. with some other

1 Alan S. Blinder and Mark Zandi, How the Great Recession was Brought to an End, Blinder-Zandi Report, July 27, 2010.


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THEBOECKHINVESTMENTLETTER WWW.BOECKHINVESTMENTLETTER.COM 2

big debtors. The U.S. is well behind Japan, Italy and Greece but ahead of the UK and

the Euro area.

CHART 1

That the U.S. is in a dangerous debt situation is hardly a secret. Yet nothing will

be done about it any time soon. Politicians, now back from their holidays, are focused

on securing re-election. Republicans are moving further to the populist right. Cutting

deficits has once again taken a back seat to spending and minimizing taxation. It is

often said that the electorate get what they deserve and one of those things is huge

government debt, which is going to get much bigger. There is a rapidly escalating

Greek-style debt:GDP scenario unfolding and all the consequences that go with it.

Below we discuss how fast and how far the debt trajectory will track. But first, lets look

at some of those consequences.


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TheConsequencesofExcessiveGovernmentDebtThe long-term structural consequences of growing U.S. government deficits must

be seen in the context of declining U.S. private savings. Chart 2 shows that U.S. private

savings have fallen progressively since the era of the bubble began in 1982, reaching a

post-war low around 1.2% of income just prior to the crash. Savings have since

rebounded as households and businesses are trying to reduce debt, but it remains to be

seen how long this will last. Federal budget deficits have absorbed an increasing share

of those dwindling savings ultimately taking almost 100% prior to the crash (Chart 3).

The consequence has been that non-residential net investment has fallen from 6% of

GDP to near zero before the crash. That dwindling amount of investment has

increasingly been financed by the Chinese and other surplus countries which now hold

about $3-4 trillion in highly liquid U.S. dollar balances and short-term Treasury bonds.

This is a reflection of the steady and dramatic deterioration of the U.S. net international

investment position over the 25 bubble years (Chart 5).

As we point out in our calculations below, the total debt of the Federal, state and

local governments is likely to be over 110% of GDP by 2020 if nothing happens to

reverse current trends. To put this in perspective, Iceland, Spain and Ireland, three of

the most over-extended debtor countries went into the crisis period with debt between

25% and 36% of GDP. Greece, the poster country for sovereign debt catastrophe, went

into the crisis with debt at close to 100% of GDP, where the U.S. is likely to be in five

years according to the IMF.


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CHART 2 CHART 3

CHART 4 CHART 5

The dynamic in which government deficits absorb a high proportion of private

savings leads to crowding out of private investment. In the absence of an inflow of

foreign savings, for example from China, domestic investment would decline even

faster. A countrys growth rate diminishes as investment in plant and equipment gets

crowded out, eliminating the only painless exit from a debt trap. In the U.S. the deficits


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will continue to be financed in good part by foreigners for the time being, adding to an

already massive amount of foreign liabilities. Italy and Japan, two highly indebted

countries have financed most of their deficits internally. This makes them much less

vulnerable and helps to explain why they have not yet experienced a fiscal or currency

crisis.

Similar to Greece, the U.S. has a high proportion of its liabilities due to foreigners

and those liabilities are highly liquid. Much of them are owned by central banks as part

of their dollar reserves. On the other hand, central banks are already in the category of

owning so many dollars they dont want the dollar to collapse. Moreover, in a deflation

all countries want a cheap currency. Recently Japan has panicked over an excessive

rise in the yen and is actively trying to devalue it. So the balance of financial terror (a

term coined by Larry Summers) could well prevail for some time. Excess dollar supplies

are bought by foreigners in order to preserve or boost their exports. This mitigates

pressure on the U.S. government to cut spending. Foreign support of the dollar buys

time and allows the U.S. to procrastinate in fixing its fiscal problems. This encourages

the house of cards to become bigger and increasingly unstable. Ultimately a

combination of declining growth, dwindling investment and rising debt to foreigners is

unsustainable, with serious implications for interest rates and inflation.

TheGovernment

Debt

Trajectory

There are a number of assumptions needed to calculate the growth in


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government debt relative to GDP, some more plausible than others. The key

ingredients are the starting primary balance (the deficit net of interest payments),

estimates of how it will change and the difference between the growth rate of the

economy and the rate of interest. We use the Congressional Budget Office (CBO)

calculations as a starting point as it is generally recognized as the authority. The CBO

baseline projection assumes no change in basic laws (e.g., all of Bushs tax cuts expire)

or discretionary spending and is totally unrealistic.

The most plausible projection is the CBOs alternative fiscal scenario2 which is

based on several fairly conservative assumptions regarding increased spending, for

example in Medicaid payments to physicians as well as the reinstatement of Bushs tax

cuts for all but the wealthy. This scenario forecasts Federal debt to GDP rising 25

percentage points by 2020. Assuming state and local government debt to GDP remains

around 16%, the total U.S. government debt level would be over 110% of GDP by 2020.

This is not too far from Greeces current level and well above its pre-crisis ratio. The

calculation is pretty close to the IMFs more elaborately constructed outcome. Chart 6

shows the CBOs Federal debt baseline and alternative scenario projections. As can be

seen, the alternative scenario, which we think is the best one to use, rises sharply in the

next ten years and thereafter explodes upwards.

2FordefinitionsofbaselineandalternativescenariopleaseseeCBOwebsite:

http://www.cbo.gov/ftpdocs/115xx/doc11579/SummaryforWeb_LTBO.pdf


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CHART 6

However, even the CBOs alternative projection for the U.S. is naively optimistic

because it assumes GDP growth averaging 2.9% for the next ten years and no

recession. The U.S. has never experienced a ten-year period with no recession, and

the growth rate they assume is the same as that during the debt-fuelled bubble years of

1980-2007. If we assume that the 2010-2020 period will be one of deleveraging and

crowding out of private investment, growth is likely to be significantly less than in that

earlier period.

Interest rate and inflation assumptions are much more vulnerable to error. The

key here is the gap between real growth and the interest rate the government has to

pay on its debt. When the gap is unfavorable (rates above growth), debt explodes

upward. In the U.S. currently the two are fairly close. The 10-year inflation adjusted

(TIPS) bond yield is currently 1%, about the same as the economys current growth

rate. However, as we recently saw in Greece, when the market smells trouble, capital


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will flee, causing growth to head south and interest rates north with little or no warning

(Chart 7).

CHART 7

The bottom line is that a total U.S. government debt (including state and local)

above 110% of GDP by 2020 will turn out to be a significant under-estimate, if no

serious action aimed at fiscal consolidation occurs. It should also be noted that age and

health related spending are not the key factors pushing up debt by 2020. Those

pressures come to bear after 2020 and will eventually play total havoc with the U.S.

fiscal position, as shown in Chart 6, if swift, decisive action is not taken now.

Assuming no congressional miracle occurs by 2020, the government debt:GDP

ratio would move into the stratosphere, far beyond where Greece is now. By 2035, U.S.

government debt would rise to over twice GDP according to the CBOs conservative

assumptions. Such an outcome is so untenable that it wont happen. The issue is the


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circumstances under which fiscal retrenchment occurs. Will the U.S. follow the Greek

model and wait for a crisis to drive change? Or will enlightened politicians figure out

how to sell fiscal austerity to a complacent public? Given the permanent state of

electioneering and partisan gridlock in the U.S., it would not be wise to assume a timely

and sufficient cut in the deficit.

FiscalAdjustmentThere are two ways to approach the issues of when and how much to cut the

deficit. The IMF has done considerable work on this question both for the U.S. and

other heavily indebted governments for comparison.

In the soft approach, the IMF calculates that the U.S. would have to cut the

cyclically adjusted primary deficit3 by a total of 12%, spread over ten years to bring the

federal net debt back to 40% of GDP by 2030. This would be 60% gross debt, which is

the Maastricht Treaty requirement. The calculation assumes no recession over this

lengthy period of 20 years. It should also be noted that net debt of 40% is not a

conservative target. It was just slightly higher than that in 2007 and thus provided no

protection against a debt spiral once the crisis hit. Given the precarious shape

advanced economies are in, we must expect further economic crises and hence, it is

imperative to build a sound buffer into government finances so as to deal with future

economic crises without inducing fiscal crises.

3Thecyclicaladjustedprimarydeficitiswhatthedeficitisestimatedtobeiftheeconomywasatfull

employmentandinterestpaymentsareexcluded.


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The faster the deficit is cut, the smaller the adjustment needs to be, but at the

risk of hitting the economy with another shock. Calculations by the IMF and CBO

suggest that a one-time cut of around 5% of the cyclically adjusted primary deficit might

get the U.S. Federal net debt back to 40% before the end of the decade. However,

policy is moving in the opposite direction and too rapid an adjustment risks creating a

double-dip recession which would actually widen the deficit sharply. Clearly it is a

delicate balancing act between avoiding a fiscal crisis on the one hand, and nurturing a

sick, deleveraging private economy back to health on the other. At present, policy

makers are leaning heavily towards the latter. Therefore, bet on a continuation of a

sharply rising U.S. government debt:GDP ratio.

WouldSevereFiscalAdjustmentintheU.S.Work?There are clearly huge risks of cutting either too fast or too slowly. Even if the

U.S. imposed the right degree of fiscal austerity the result might be disappointing.

The IMF has studied many cases of countries trying to cut deficits in order to see what

works and why.4 There were several important conclusions. First, many countries fail

at first and are forced to take a second and third crack at it. Second, it was clear from

their research that cutting spending worked much better than raising taxes. While the

Democrats tend to be more averse to spending cuts than Republicans, the U.S. is

hardly an example of government overspending compared to most developed countries.

4FiscalAdjustment: DeterminantsandMacroeconomicConsequences,Kumar,LeighandPlekhanor, IMF

WorkingPaper,WP/07/178,July2007.


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The fact is there isnt much to cut, compared to say, 1945 when debt was very high but

massive wartime military expenditures were set to collapse.5 Third, successful fiscal

consolidation programs usually involved steep currency devaluations and sharp interest

rate declines. The U.S. cannot easily generate a significant dollar depreciation given its

reserve currency status and need for massive foreign financing of its budget deficit.

Neither would other countries welcome a large drop in the dollar while global

deflationary pressures are acute. Lowering interest rates is also not an option. Short

rates are close to zero and long rates are about two standard deviations on the side of

being too low. Growth is the key but there is no magic bullet there. The U.S. is in a

long wave decline, it is deleveraging, its population is aging and the deficit is crowding

out private investment.

Cutting the deficit will not be easy or painless, which explains why no one really

wants to do it. As we have often said, watch what the politicians do and ignore what

they say. On the other hand, we have to look at the consequences of not cutting the

deficit. With post-war record lows in interest rates and an easily financed deficit, where

is the pressure? With the cost of debt service at a low 1% of GDP and painless, we

assume that the government debt:GDP ratio will continue to escalate. That is, until

something bad happens to interest rates, equities, inflation, the dollar and living

standardsa subject for another letter.

5Whileraisingtaxesisapoorsecondbesttocuttingspending,thecontinuingsuccessoftheTeaPartyis

pushingtheRepublicanagendafurthertotheright. Thatmeanstaxincreasesarenotgoingtohappenanytime

soon.


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TheCurrentScene&InvestmentConclusionsIn our last letter we suggested that stock market investors shift towards a little

more caution as it seemed that investor expectations had not yet adjusted to the fizzling

economic recovery. Revisions to second quarter GDP growth with adjustments for

temporary effects from government stimulus and inventory investment indicate that

underlying growth is around 1% per annum. This is consistent with average growth in

final demand (i.e., excluding inventory investment) of slightly less than 1% p.a. since the

recovery began. This is a record for poor performance following a serious recession. It

is particularly disappointing given near zero short-term interest rates, 2.7% 10-year

bond yields and a budget deficit of 10% of GDP.

Some economic data looks slightly better in recent weeks but the basic situation

hasnt changed. Growth is far below normal and the economy and financial system are

very distorted and unbalanced. For example, the key housing sector could easily face

another 10% drop or more in prices. Weak growth will sustain high unemployment

keeping the authorities focused on adding more stimuli. The upward debt spiral is

intact.

We believe that the market will most likely remain in a trading range of +/- 10%

around 1,100 on the S&P 500. The rally in recent weeks has been driven by Federal

Reserve assurances of unlimited liquidity, if needed, and the reporting of slightly better

economic data. This has provided investors, wishing to achieve a more conservative

posture, with an opportunity to rebalance their portfolios in a rising market.


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Bonds and gold have recently attracted a flood of investment money. It would be

extreme to call the Treasury bond market a bubble in the sense that huge permanent

losses could be incurred by long-term holders. Worst case, you hold the bonds to

maturity, get your cash back and a return that might be less than the alternatives.

Nonetheless, the move in bond prices seems wildly over-done. According to Ned

Davis, close to $600 billion has moved into bonds in the past three years ($325 billion in

the last 12 months) about the same amount that flowed into stock funds in the three

years prior to the 2000 stock market top. Short-term risk is obvious. Our discussion of

the governments debt trajectory also suggests long-term risks are probably high.

Gold is a somewhat different story. The flow of hot money has been huge, but

unlike bonds, no one knows where the downside limit is. When the previous bubble

broke, the price fell 75% and remained in the doldrums for 20 years. We do not dispute

golds useful role as insurance and as an inflation hedge. However it is expensive

insurance and we believe that deflation and rising real interest rates are a greater threat

than inflation. Having said that, gold is in a bull market, has a huge and growing

following and momentum investors love it. It could possibly go a lot higher, but it is not

a safe place for conservative long-term investors who cant live with extreme volatility.

The big dilemma for stock market investors revolves around the extent to which

the huge drop in real and nominal bond yields has supported stock prices in the face of

deteriorating economic fundamentals and whether it has led to a switching of

investment funds from stocks to bonds. If the latter, it could reverse should the bond

bull market falter and drive stock prices up. In other words, if bonds get re-priced to


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remove their overvaluation, would that hurt or help the stock market? Our guess is that

in the short run only, stocks will do okay in that scenario because bonds would probably

be selling off due to expectations of a stronger economy and profits. In addition, stocks

do not look expensive on a P/E basis (slightly below their long-run average) and on a

free cash flow yield basis.

Since relative value does matter, it is likely that a downward re-pricing of bonds

would ultimately trigger a downward re-pricing of stocks. Of course there are many

other factors which affect stock prices. Corporate liquidity has been extraordinarily

strong as has corporate profitability. The prospect of sustained economic weakness

virtually guarantees low short-term interest rates and huge liquidity in the banking

system, an important offset to the risk of a softer profit outlook.

When we add up the pros and cons for stocks, we come back to our relatively

neutral view of a trading range. Number precision is not very useful but it is likely that

+/- 10% around the 1100 level in the S&P 500 will contain most of the action for the time

being.

As one investment manager wisely and rhetorically asked recently, Where is the

growth? Where is the edge? 6 Investors should always allocate their assets with the

where is the edge? concept in mind. At present there does not appear to be any

compelling thesis which would offer such an edge, given our overall view. Therefore,

we would advocate above average cash positions and general caution until better

6EastCoastAssetManagement,SecondQuarterUpdate,July7,2010


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opportunities arise. Capital preservation is crucial and, as Warren Buffet has often said,

You dont have to swing at every pitch.

Others have very different views. Some believe the bull market in gold has just

begun. Others believe we are headed for a deflationary depression in which high

quality bonds would continue to thrive. Another view is that we are heading into high

inflation and a dollar collapse. Yet others believe there will be a return to the good old

days of stability and growth. In the time frame of most investors, we are in none of

those camps. With bonds significantly overvalued, investors hardly have an edge in

that area, except perhaps to go short. High yield bonds are fair value but the weak

economic picture suggests growing risk for those companies with poor balance sheets

and poor cash flow prospects. Gold as insurance at 5-10% of the portfolio makes sense

but only for the long run and only if volatility can be ignored.

With such a wide range of plausible opinions out there, and very high levels of

uncertainty, it doesnt make sense to bet big in any one sector. Investors should

maintain a defensive, highly diversified allocation and continue to focus on wealth

preservation.

Tony Boeckh / Rob Boeckh

Date: September 21, 2010

[email protected]

New Book by J. Anthony Boeckh

To order a copy, please visit:

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Boeckh Letter: US Government Debt Sep 21 2010