Making Unique Observations in a Very Cluttered World

Wednesday, 12 January 2011

The U.S. government is insolvent. Who says so? Timothy F. Geithner, the U.S. Secretary of the Treasury -

The U.S. government is insolvent. Who says so?  Timothy F. Geithner, the U.S. Secretary of the Treasury - 

The U.S. government is insolvent. Who says so?  Timothy F. Geithner, the U.S. Secretary of the Treasury.  Geithner sent a letter to Congress on Jan. 6, 2011 asking for the debt limit to be raised.  If it is not raised, he warned, the U.S. will default on its debt.
In his words:
  • "Never in our history has Congress failed to increase the debt limit when necessary.  Failure to raise the limit would precipitate a default by the United States."
He didn’t say that the government will be inconvenienced.  He didn’t say that the government would be forced to muddle through by delaying payments, raising taxes, and cutting non-obligatory programs and services.  He said the government will default.  This means that the government doesn’t have enough cash to pay its obligations to the many and sundry persons to whom it owes cash unless Congress authorizes an issue of even more debt.

After the government issues the new debt, its overall debt will be even higher than before. Unless its obligations that require cash payments are reduced, or unless it finds new sources of revenue, or unless the interest rates that it pays decline, the same situation will surely occur again and occur even faster because its overall debt will have risen. It will run short of cash to pay its obligations.

Suppose that you had a debt of $10,000 that required a payment of $500 in order to stave off your creditors’ seizing your assets. Suppose that you didn’t have the $500. One way out would be to borrow $500 from a new lender and use that $500 to pay off the old lenders. That buys you time. However, now you have debts of $10,500. You have to find ways of lowering this or else you will again be faced with an even worse situation.

You are approaching insolvency when you begin to run out of new lenders who are willing to add to your debt. The willing lenders dry up because they know that they have to get in line to get their promised payments while you continually seek out new borrowers, all the while making your situation worse and worse.

Knowing their precarious position, the new lenders are likely to demand rising default risk premiums.

That means they demand higher interest rates.

That means your cash payment obligations go up. That hastens your approach to insolvency.

Insolvency occurs when you cannot find enough cash from any source, even new lenders, in order to make required payments.

The U.S. is approaching insolvency, according to its Treasury Secretary. He didn’t put the matter in precisely that way, but he put it in words that are as close as you can get to it. He said that the U.S. would default, and its only way out at this moment is to issue more debt.

The increases in the debt limit have necessarily accompanied the increase in the government’s overall debt. Those increases have been especially astonishing in the last 10 years. The ceiling is now $14.29 trillion. The ceiling was $5.73 trillion in September of 2001. That’s a growth rate of over 10 percent a year.

A few months back, Laurence Kotlikoff wrote that "The U.S. is bankrupt."  Using the government’s numbers properly labeled, he found that the U.S. fiscal gap, which is the difference between the present value of projected spending and revenues, is $202 trillion.   An IMF study of the U.S. finances found that it would have to double taxes to close its fiscal gap.  This is an impossibility.  It would destroy the struggling economy.

Geithner’s statement confirms those of other analysts outside of the U.S. government.

According to Kotlikoff, the government’s sixty-year "massive Ponzi scheme" will end when there are not enough revenues to pay for Social Security, Medicare, and Medicaid. He sees large benefit cuts, large tax increases, and high inflation ahead when the government seeks to survive.

How will the U.S. extricate itself from this situation? That’s a matter of speculation because there are many interacting variables involved. There are lots of ifs, ands, and buts.

When a state cannot meet its promised obligations, there is no bankruptcy code to guide a reorganization, as there is with a company. There is no court to oversee a restructuring. There is no judge or panel that decides on the priority of claims. Instead, the government itself decides how to handle its inability to pay cash to fulfill its promises.

In the immediate future, the U.S. government will not default on its bonds. They will have priority of payment. The reason the government will do that is to maintain its capacity to borrow at reasonable rates of interest so that it can maintain its size and programs. If the government defaulted on its bonds as a way of solving its financial problem, it would have immediately to cut back its spending severely. The government would shrink radically all at once. The government would take a big bath. Congress doesn’t want to do that. It would rather stretch out the default process and inflict the pain over time and among more groups than bondholders. Congressmen prefer to maintain themselves in power while managing a large government. Other branches and bureaucracies also prefer to keep their pet programs and activities afloat.

Therefore, as usual, Congress will raise the debt limit again. That doesn’t end the financial problem. It adds to it even as it postpones and enhances possible insolvency.

The new lenders that the government seeks out to lend it new cash are likely to demand higher interest rates, except for one major lender, which is the Federal Reserve System.

Bond yields are subject to numerous worldwide influences. They include the default risk premiums demanded by foreign lenders, including Asian central banks. Those risk premiums are likely to rise.

In contrast, the Federal Reserve has committed itself to buying $600 billion of new government debt in the next few months. Its purchases tend to support bond prices and keep interest rates down, other things equal.
As the Federal Reserve keeps buying more and more government debt, with no prospect of reducing its holdings unless and until the government gets its house in order, bond yields are likely to rise, despite Fed buying, because yields also reflect inflation premiums. The prospect of inflation will rise as the Fed monetizes the debt. We would then see yields rising accompanied by firm prices of commodities and metals.

The inflationary participation by the Fed, which postpones the inevitable fiscal decisions of the government, harms all holders of fixed-dollar assets and all those whose receipts of dollars are fixed and lag behind the Fed’s production of new dollars. In addition and more importantly, the inflation sets in motion another boom-bust cycle.

Continued debt monetization by the Fed is quite likely for many reasons.