What if the U.S. Government was a maxed out consumer?

Tune into the news and you cannot escape without hearing what will happen if the United States Congress does not increase the federal debt ceiling by the August 2 deadline.  Prevalent among all the voices is the refrain stating that the United States will default on its debt, plunging the world economy into deep depression, if the debt limit is not raised.

Is default a possibility? Sure, it is, but the probability of default in the near term is small.  The challenge of trying to assess the situation for yourself is that the complexity of the federal government,  the bond market, and the global economy make simple answers unattainable and open to a variety of interpretation and opinions;  Many of them slanted by political identification.

As a consumer lender for many years, I will look at the possibility of a United States’ bond default from the standpoint of a lender making a loan to an individual.  The moving parts of the world economy and the United States position within it make the comparison less than exact but may lend some perspective for making your own decision.

The federal government is presently spending $1.40 for every $1.00 it collects from taxes.  An individual in this circumstance would need to borrow from their credit cards or line of credit in order to maintain this ratio of spending to income.  Eventually, when the credit limit is maxed out, the individual will need to reduce spending, increase income or a
combination of both.  The federal government does not have a pre-set credit limit like an individual but it does have a debt ceiling, which is similar to a credit limit.  The federal government credit limit is currently set at $14.3 trillion.

If Congress does not increase the debt ceiling/credit limit by August 2, The U.S. government will need to cut spending, increase income or employ some combination of both in order to get spending aligned with revenue.  Federal government spending can be divided into three categories.  Mandated spending which includes Social Security and Medicare.  Discretionary spending which are items the Congress can increase or decrease.  Military spending is the prime
discretionary item as it makes up nearly 60 percent of all discretionary spending.  The third category of federal
spending is interest paid to the holders of its debt.  The debt of the United States is held in the form of U.S. Treasury notes and bonds and savings bonds.

The equivalent of mandated spending for the individual is the rent or mortgage payment.  You cannot stop paying the mandatory items without immediate repercussions.  Examples of discretionary spending for the individual are food and entertainment.  You have a choice where to spend your money.  The interest payment for the individual is the money paid to the credit card companies and the bank and finance company for your installment loans.

The U.S. government has a debt rating of AAA, which is the highest rating for a bond issuing entity.  The rating tells investors the investment is safe and the probability of default is very small.  A downgrade in the rating signifies that the risk of default is a little higher, entitling the investor a higher rate of return for taking on the additional risk.  A small increase in the interest rate that investors command for financing the debt of the United States government, may translate into hundreds of billions of dollars of additional interest paid annually.

A consumer lender will not change the terms of existing contracts, just because a customer has maxed out all available lines of credit.  If you max out your credit, your credit score will drop, making future borrowing more expensive.  Even if you pay me on time, I will charge you a higher rate of interest in the future, because a lower credit score indicates that your probability of defaulting on the next loan is slightly higher.  Fair or not, that is how things work.

If Congress does not raise the debt ceiling beyond the current limit of $14.3 trillion dollars, the U.S. government will be maxed out on its debt.  The federal government will be unable to borrow additional money.  Is that a good thing?

The government does not have a credit score but it does have a bond rating.  As with the individual, who finds that his or her credit score drops after maxing out the credit cards, the federal government will likely find its bond rating drop if it is unable to borrow additional money to continue operations.

You or I max out all of our credit; we will have a difficult time getting new credit.  If we do, the interest rate will be high.   The effect of a lower bond rating for the United States will be felt when current Treasury bonds become payable.  The investors of the T-bills such as China and U.S. mutual fund companies will require a higher rate of return when it renews the bond debt because the chance that the U.S. will default on the debt has increased.  If U.S. is currently paying $300 billion per year in interest to the bond investors, a lower credit rating for the U.S. may increase the annual interest payments to $400 billion or more.

The federal government being unable to create more debt to pay off the old debt would need to redirect spending from the military or maybe social security to pay for the increased interest payments.  The equivalent for the individual would be increased interest rates paid to the credit card companies after charging a purchase that pushed the credit card balance over the credit limit.  Money would need to be diverted from something else to pay for the increased credit card payments.  Default on the debt, the holder of the debt demands payment in full.

The probability of the U.S. defaulting on its debt is not a high probability, paying a higher rate of interest on its debt is a higher probability.

How else might the frozen debt ceiling scenario pay out?  The U.S. bond rating may not be lowered immediately, but if the federal government begins missing payroll or holds off reimbursing hospitals on Medicare payments, the investors will demand payment in full either when the bond becomes due or will require a higher interest rate to renew the debt.  As a consumer lender, if my customer comes to me to refinance their debt, after making their payments on time and I find they have been slow paying their other creditors, I will decline the request or if I approve the refinance, the interest rate will be higher.

The point can be further illustrated with a plausible example.  Let us say Japan has $100 billion in T-bills coming due in a two months and sees the U.S. government is not paying its bills.  The treasury department expects Japan to renew the bond but at the last moment, it states we fear you will default and we want our principal back.  The United States is faced with the option of possibly liquidating assets to pay its debt or paying a higher interest rate to renew the bond.  After intense negotiations, Japan agrees to refinance the debt but at a higher rate.  The U.S. now has to pay a greater percentage of its revenue towards interest on the debt.
I do not know what will happen to the United States if the debt ceiling is not raised, but I have been witness to hundreds if not thousands of consumers who became overloaded with debt and lost the ability to borrow additional funds.

I have observed approximately 40 percent of the individuals who end up in this situation file for bankruptcy.  A smaller percentage secures a second job or is awarded a timely promotion enabling them to get a handle on their
budget.  Some people rent a room for additional income.  Others cut back expenses to bare bones and struggle along until finally paying down enough debt to get back on their feet.  What path will the United States government follow???

Is the Government’s Spending Gusher Subsiding?

An uncommon word was heard echoing in the senatorial chambers the other day.  The Senate said NO to more stimulus spending by a 52 – 45 vote.  It seems the fear of being booted from office in the mid-term elections influenced more votes than the threat of the dreaded double-dip recession.  Did the Senate finally figure out the taxpayer is fed up with Federal Government spending it’s money faster than the oil spewing from BP’s Deepwater Horizon?

The real question is; is the Federal Governments spending gusher slowing down or is this just a blip on proverbial radar?  Are we in the midst of a grand social experiment testing the theory that there is no such thing as a credit limit when it comes to Federal Government spending?

Treasury Secretary Tim Geithner sounding vindicated in an interview with The Atlantic magazines Joshua Green in April of this year, he boasted the government had, “put in place the conditions and the foundation for a resumption of growth and recovery.”  Many economics agree that global financial collapse would have occurred without the federal government pumping trillions of dollars into the world economy.  That may be true but there really is no concrete way to test the theory.

The narrow-minded take on one’s own actions are definitive when you presuppose all other courses of action would have resulted in failure.  Parents commonly use this rational on their children.  If I had not forbidden you from hanging out with that group of kids in the park, you would have ended up in jail and your life would have been ruined.  Yes, jail may have been one outcome if the child hung out in the park, but so could have many other possible outcomes, some of which could have had a positive benefit on the child’s life. 

The bailout may have saved the economy but to set it up as the ultimate, best, highest course of action is insulting to millions of Americans.  The credibility gap is further solidified when undefined yet soaring rhetoric is not followed up with action.  Instead of counting jobs created, we count jobs saved.  The relief pitcher in baseball saves the game for the winning picture.  The taxpaying public can’t help but seeing Wall Street Banks, trial lawyers and public sector unions as the winners while the middle class is relegated to having a “kick me” sign taped to its back.

So what happens if the national debt exceeds 100% of the GDP?  Nothing special happens if the debt hits 100%.  It’s not a magic number.  Higher debt can lead to higher inflation, higher interest rates, and reduction in economic growth as more money goes to service the debt.

The Federal government would be under pressure to raise tax rates to increase revenue to pay for the debt.  Some believe raising taxes will lower revenue because of the disincentive to produce at higher tax rates.

The primary concern for today is the rate of deficit growth.  The Government Accountability Office (GAO) describes the current debt growth trajectory as unsustainable.  Under current laws, mandatory spending, Social Security, Medicare, and Medicaid will exceed the revenue collected in taxes.  Benefits will be cut, taxes raised and the unwashed masses will garner their pitch forks and march on Washington, or not.  By 2017 the Medicare Trust Fund is projected to become insolvent.  If all tax revenue collected is used to pay the deficit held in large part by foreign entities, the United States risks compromising its sovereignty.  Will the United States be transformed in less than two generations to a dead beat debtor from a beacon of light, time will tell? 

The transformation in a humorous take has already begun.  How does China view President Obama?  Obama is the fund manager of China’s largest offshore investment holdings.

All joking aside, the national debt is sure to be a factor in the mid-term elections.  The public mood puts the political football, deficit spending, in play during the next election cycle.  The politics of this deal is not about how much is spent, but how it is spent.  Deficit reduction, according to conventional wisdom is considered in the best interests of the taxpaying public, yet the party in power has yet to restrain its check writing prowess. 

Real deficit reduction will require public sacrifice.  Are we as U.S. citizens ready to make a sacrifice to get debt under control, maybe, it’s not that bad yet, things will fix themselves, and ultimately, somebody else needs to pay?

The Keynesian camp feels further deficit spending is necessary to keep the economy on its upward trajectory and provide funding for a jobs bill.  The budget crisis is contrived by the right as a wedge issue to split unity in the Democratic Party.  The deficit topped 100% of GDP during WWII; we’ll grow our way out. At the end of WWII, the manufacturing base was strong and provided a strong engine for GDP growth well into the 1970’s. 

The next economic engine is not readily apparent as the manufacturing base was at the end of the second war to end all wars.  Alternative energy is a long shot at this point.  Without government mandates, solar, wind, geo-thermal and the like are not likely to gain traction, much less drive the next generation of U.S. GDP growth.  The next economic engine for US growth has not emerged as of yet.  Good luck digging out of this debt hole, oh yeah deficit spending saved us all.

Whenever, signs of supposed real change appear don’t be deceived, the promise of a better way are but vapors of mist that evaporate when exposed to the light of day.  All kidding aside, is your elected official representing you or the high dollar donors who funded the campaign?  Voter vigilance is required, your children and grandchildren may ask you someday, why didn’t you do anything?

GDP Gains, Belay State and Local Pains

Jamie Dimon, Chairman of JP Morgan Chase caused quite a stir in the investment community when he warned American investors should be more worried about the risk of default of the State of California than of Greece’s current debt woes.  Dimon told investors at the bank’s annual meeting that, “there could be contagion” if a state the size of California, the biggest of the United States, had problems making debt repayments. “Greece itself would not be an issue for this company, nor would any other country,” said Mr. Dimon. “We don’t really foresee the European Union coming apart.”  (1)

As a temporary California resident, I was aware of California’s budget shortfalls but wanted to find out why the state was in so much trouble.  The latest report on the Gross Domestic Product (GDP) of the United States for the last quarter of 2009 grew by a revised second estimate of 5.9 percent. (2)  Why should state and local governments have fiscal woes when the federal government is growing at such a brisk pace?

The short answer is revenue is down and expenses like unemployment compensation are up.  States and local governments get revenue from state income tax on individuals and corporations, sales tax, property tax, death and gift tax, and various other licensing and transfer fees.  High unemployment equals less people paying state income tax.  Sales taxes are flat or growing at rates less than projected as individuals cut back on spending.  Property tax collections have decreased in many markets nationwide as county tax assessors have reassessed property values to reflect the depreciation in home values.  In summary, state and local governments are hurting for income in ways they never would have imagined in 2007.

The stimulus package Congress voted on a year ago to stimulate the economy has primarily gone to buoy financially troubled states.  The state extensions of unemployment insurance are federally funded.  Stimulus cash has allowed state governments to prevent or delay letting go public employees under their jurisdiction.  As the federal funding of states dries up in 2011, the gap between obligations and revenue will widen. 

The Center on Budget and Policy Priorities projects that an increasing number of states will struggle to balance their budget in 2010.  The total budget shortfall for all states in the fiscal year could reach $196 billion or 29 percent of the state’s budget – the largest gap on record.   Revenue gaps for 2011 will continue, leading to a combined budget shortfall of $375 billion. (3) 

 Boiling this scenario down to a household, imagine taking home income of $100,000 on expenses of $129,000.  You need to borrow $29,000 to make ends meet.  Now blow this scenario back up again to include all fifty states in aggregate and the gravity of the combined budget shortfall becomes painfully clear.  After a few years of living like this, you would consider bankruptcy to remedy the situation as your total debt exceeded your total assets.  State governments do not have the luxury of this option.

Media outlets in the states of Arizona, California and Illinois have cried our states will go bankrupt if we do not solve our fiscal problems.  The headlines have overlooked one pertinent fact.  States cannot legally file bankruptcy.  Chapter 9 bankruptcy is for municipalities like Vallejo, California, which filed bankruptcy in 2008 because it could not afford its pension obligation. (4)

However, states can default on their bond obligations.  In the 1841, the state of Mississippi defaulted on a bond issued on its behalf by the Planters Bank in 1833.  The bonds were never paid.  If one of our fifty states defaulted on its obligation in 2010, in the near term, it is unlikely the Obama administration would allow that state to stiff the bondholders.  The political implications would outweigh fiscal realities and the federal life-preserver would land on the front steps of the afflicted states’ capital building. 

The financial implications of default would cause the states bond rating to flirt with junk status and make the possibility of borrowing additional money prohibitively expensive.  The dilemma might effectively freeze all state business but the essentials until a viable strategy is enacted.  I see the miss-guided masses marching on the streets demanding their personal bailout benefits. 

Defaulting on debt obligations is the nuclear option, state and local jurisdictions make up budget shortfalls by raising taxes and fees and cutting services.   The majority of services we receive as citizens come from our state and local governments, not the federal government.  As the revenue or income that states receive decline, the state needs to reduce the amount of money it spends.  The cuts in spending may show up as layoffs or reductions in salary for state workers such as schoolteachers.  Many medical and health professionals as well as state police and highway maintenance personnel are other state employees who are affected by fiscal contractions.  Lower and middle-income workers are disproportionately affected when local and state municipalities cut services and raise taxes.

Shifting gears and going national, the GDP growth in large part resulted from the federal governments stimulus spending.  State governments do not have the luxury of printing money through the Federal Reserve and monetizing the newly created debt as the United States Treasury Department does.  The federal government creates money when a commercial bank like Goldman Sachs borrows money from the Federal Reserve at .25% and uses the money to purchase Treasury Bills paying three or four percent interest, presto change, money is created out of thin air.  The resulting increase in the GDP was not a result of organic growth from expansion in the private sector but a further escalation of the federal deficit.

At the city and county level, pay and benefits consume the majority of local budgets.  Bloated pensions will be the downfall for cities all over the country.  Vallejo California filed bankruptcy in 2009 to get out of paying retroactive pension boosts.  Bankruptcy hurts all concerned.  City employees are laid off, budgets are trimmed and the hit to the cities credit rating makes borrowing money for infrastructure and building improvements much more expensive.(5)  According to the Pew Center state pensions are underfunded by almost $1 trillion. (6)  Can you say bailout!

The Dirty Little Secret

In the 2000’s before the Great Recession money managers in small municipalities wore many hats including managing the pension fund.  Riding into town on the white horse was the investment advisor of a prominent investment bank promising returns 2 or 3 percent higher if the money manager only invested a portion of the pension fund into an exotic security backed by so-called quality mortgages.  The exchange was similar to a high school aged kid telling a third grader I will give you three baseball cards for the Alex Rodriguez rookie card in your collection.  The over matched third grader said three for one, of course I will trade, are you crazy?  The pension manager, like the third grader, said of course, the county employees and pensioners will not believe I got them such a good deal.  We all know how that exchange turned out for the pensioners and their municipal money manager.

Do not ask me how things will turn out; my crystal ball is clouded over.  Things do not look brighter on the horizon.  Taking positive GDP figures and letting your guard down is an act of willful ignorance or self-deception at best.  Taking your financial future into your own hands is the prudent course.  In this bloggers opinion, rising revenue in concert with reduction of national debt would be a good start.  Everything else is smoke and mirrors.

Have a nice day! 

 (1)                 http://www.telegraph.co.uk/finance/financetopics/financialcrisis/7326772/California-is-a-greater-risk- than-Greece-warns-JP-Morgan-chief.html

(2)                 http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

(3)                http://www.cbpp.org/cms/index.cfm?fa=view&id=711

(4)                http://www.iddmagazine.com/news/189081-1.html

(5)                http://money.cnn.com/2008/06/02/pf/retirement/vallejo.moneymag/index.htm

(6)                http://www.reuters.com/article/idUSTRE61H13X20100218