Deficit and National Bankruptcy

Roy C. wrote me this message: “Last night on FOX News, Dick Morris said that if the interest rates go up to 6%, something more normal, the cost of servicing the debt will rise to an amount equivalent to all the taxes we collect each year.
So, if true, for me, it means that we will be bankrupt de facto, since technically a country cannot go bankrupt in legal terms. Got something concrete to tell us about this?”

It is correct what Dick Morris said. Consequently the US - UK – Japan and Iceland are the facto bankrupt. That's why the Obama team is ruining the dollar by inflating it to pay back less worth money.

At present the government calculates its debt and deficit on a cash basis. This means that deficit accounting does not take into account the cost of future promises until the moment the money has to be paid. According to shadowstats.com, “if the federal government counted the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are over $60 trillion. And that was before the crisis.” Not a great deal of imagination is needed to understand that nowadays the debt will be much higher and worse.

The near term deficit on a cash basis is about $1.6 trillion or 11% of GDP. “President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade.” In other words to be gracious the State's balance sheet is in a deplorable state. If this situation continues it will be the basis for a future hyperinflation. It is going to look alike the economic environment that lead to Great Depression in the 30s.

The American Enterprise Institute for Public Policy Research recently published a study that indicated, "By all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default."

Further, the Federal Open Market Committee members may not recognize inflation when they see it, as they look at inflation solely through the prices of goods and services, while ignoring asset inflation, which can lead to a repeat of the last policy error of holding rates too low for too long.

“At the same time, the Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.”

Japan appears even more vulnerable, because it is far more indebted and its poor demographics are a decade ahead of the west. Japan may already have past the point of no return. When a country cannot reduce its ratio of debt to GDP over a foreseeable time horizon, it means it can only refinance, but can never repay its debts. “Japan has about 190% debt-to-GDP financed at an average cost of less than 2%. Even with the benefit of cheap financing the Japanese deficit is expected to be 10% of GDP this year.” Imagine the fiscal impact of the market when resetting Japanese borrowing costs to 6%.

Over the last few years, Japanese savers have been willing to finance their government deficit. However, with Japan's population aging, it's likely that the domestic savers will begin using those savings to fund their retirements. “The newly elected DPJ party that favours domestic consumption might speed up this development. Should the market re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral.”

These structural risks are made worse by the continued presence of credit rating agencies that inspire false confidence with potentially catastrophic results by over-rating the sovereign debt of the largest countries.

Paul Volcker was an unusual public official when he in the 80s made unpopular decisions for which he was unpopular at the time. However history, proved him right for the era of prosperity that followed.

Presently, Ben Bernanke and Tim Geithner have become the typical short-term decision makers. They explicitly "do whatever it takes" to "solve one problem at a time" and deal with the unforeseen consequences later.

In the context of the recent economic crisis, a highly motivated and organized banking lobby has demonstrated enormous influence. Bankers promote ideas like, "without banks, we would have no economy." Of course, there was a public interest in protecting the backbone of the system, “but the ATMs could have continued working, even with forced debt-to-equity conversions that would not have required any public funds.” Instead, B&B responded, “by handing over hundreds of billions of taxpayer dollars to protect the speculative investments of bank shareholders and creditors.” Forgotten was that the same banks created this financial crisis in the first place, which has thrown millions out of their homes and jobs!

Actually Washington has rewarded the least deserving Wall Street people at the expense of the prudent taxpayers.

On the anniversary of Lehman's failure, President Obama gave a speech. He said, "Those on Wall Street cannot resume taking risks without regard for the consequences, and expect that next time, American taxpayers will be there to break the fall." And he advocated “an end of too big to fail… For a market to function, those who invest and lend in that market must believe that their money is actually at risk." These are good points that he should run by his policy team, however Secretary Geithner's reform proposal does exactly the opposite.

The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to make sure that no institution is too big or inter-connected to fail. The real solution is to break up the big financial institutions into separate units in accordance to its activity.

The lesson of Lehman should not be that the government should have prevented its failure.  Lehman should not have existed at a scale that allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie, Freddie, Bear Stearns, Citigroup and numbers of others.

The bailouts have created a moral risk, which in the absence of radical change will be reinforced and thereby grant every big institution a permanent "implicit" government support. This generates an ongoing subsidy obligation for the ‘too big to fails’, making it more difficult for the smaller ones to compete.