The cancer of debt and deficits

[Brother Mark]

Another interesting article by John Mauldin. Here's a couple of excerpts.

We are coming to the point in the United States when even the US government will no longer be able to borrow at very low long-term rates. That point is a few years off, and we have time to change paths; but as I have shown in previous letters, the longer we wait to get the deficit under control, the fewer choices we have and the more painful they are. NO country can run deficits the size we are currently running, along with unfunded deficits over four times the size of the economy and a growing overall debt burden, without consequences. At some point, investors in bonds will start wondering exactly what the process is by which they will be repaid. And what will the value of those future payments be?One by one, the countries of Europe are losing their ability to sell their bonds at an interest rate that is sustainable for their economies and revenue bases without severe and socially disruptive restructuring, even if a central bank that will accommodate their spending by printing money or other countries will tax their citizens to pay for someone else's debts.

and

The Cancer of Debt and Deficits

The growing debt and the deficit is a deadly cancer on the economy. It will deliver a mortal blow to the economy if not dealt with. As I recently experienced in my family, it is better to deal with a cancer as soon as possible. Putting off treatment will not make the cancer go away by itself, and the cancer of our debt is clearly growing and malignant. It will soon overwhelm our national economic body. But dealing with a cancer is not without cost and pain, whether on a real personal level or a metaphorical national level.The problem is solvable. It is not that there are not a lot of solutions. It is that we have not yet found the political will to decide what course of treatment is needed. Let's start with a few basic presuppositions that I think must be addressed in order to marshall an effective set of choices.

http://www.fxstreet.com/fundamental/...ne/2012/02/20/

[Brother Mark]

Got this today from Mr. Mauldin. He sends out these articles for free.

As a quick note, the feedback on this weekend's letter on taxes has been substantial, and a great deal of it is quite good and worth thinking about. Many bring up real problems with the position I took in my letter, and I may surprise you by agreeing with some of them. My intention right now (barring something happening between now and Friday night) is to take some of the better statements and questions, and answer them. I am not married to any specific plan. I just want to solve the problem and am open to anything that is politically feasible and makes sense, as long as we solve the basic problem of the deficit. I think it will make for a very interesting letter. I do read your feedback, by the way. So if you wanted to respond and wondered if I might actually read it, the answer is yes I do, and this week will answer as many as I can.

[Fenris]

Rep. Paul Ryan has a solution, but everyone else seems content to kick the can down field.

[Dravenhawk]

The thing about the growing national debt / deficet is that politicians can spend as much as they wish and never be accountable for the bill. By the time the bill comes due the politicians responsible for causing the mess in the first place are long gone. Take our entitlement programs. FDRs administration which was responsible for creating Social Security and LBJs administration who is responsible for creating medicare and welfare as well as raiding Social Security have left in their wake a colossal mess on an epic scale. Over the course of the last fifty years every administration has added on to this growing tumor without the slightest thought of the concionquences of future generations. It is in my honest opinion that our country has long ago gone past the point of no return. Even in the administration of the highly estemed Ronald Reagan the real principal of the debt never went down. In fact Reagan failed to make genuine spending cuts that directly affected the principal whats worse is the debt actually grew! Even during the much heralded Clinton years when there was a "surplus" nothing was actually done to bring down the principal. What was even worse is that that surplus was squandered away in two ten year long drawn out military occupations in which victory was never quite achieved. The only way to bring this debt juggernaut under control is to STOP SPENDING. Maybe if politicians were held accountable such as prision for running up huge deficets things would change for the better. - - - - Dravenhawk

[tango]

I think one key issue is the concept of what some call an implicit default, and I'm surprised it doesn't seem to have registered among the people who buy bonds, especially long-dated bonds.

It's pretty clear that a government that doesn't repay its bonds is in a state of default, a state of explicit default. A state where it just says "we can't pay you back, you'll have to take 50 cents on the dollar" or whatever it turns out to be.

When a government is in control of its own currency it can create the money it needs to repay its bonds if needs be, and so the possibility of an explicit default is taken away. If the US needs $1trn to pay some bonds it can pretty much create that trillion out of the air and pay the bonds. But this is really a default in all but name, hence the term "implicit default". The issuer can repay the bonds but only by devaluing its currency.

To put what that means into something that resounds with the average person more than numbers with lots of zeroes on the end, let's say a pizza costs $20 but you invest that $20 in a government bond paying 5% per year. Inflation is running at 5% so even though next year you get $21 back from your bond, it costs you $21 to buy a pizza. So effectively what happened is that you invested a pizza, and you got back a pizza.

Now let's see what happens if the government has to repay your $20 but only has $10. So it prints another crisp $10 bill to repay you. All else being equal the price of things increases, as there are more dollars chasing them, so your pizza now costs $30. So you invested $20, you got back your $21 (including interest) but a pizza now costs $30. In other words you invested a pizza and got back 2/3 of a pizza.

If a government goes into explicit default it becomes much more expensive to borrow, as lenders want a risk premium built into the price at which they lend. If a government goes into implicit default then sooner or later the same happens, as lenders realise the money they get back at the end has less buying power than they expected and demand a higher rate to compensate.

I find it mind boggling that anyone is willing to lend to the US government for 10 years at a rate that's comparable to the official inflation figures.

[Watchman]

Rep. Paul Ryan has a solution, but everyone else seems content to kick the can down field.

Spineless politicians eager to protect their own position will not make the kind of steps Mr Ryan proposed. We have selfish, gutless wonders running the show at present.

[Brother Mark]

I think one key issue is the concept of what some call an implicit default, and I'm surprised it doesn't seem to have registered among the people who buy bonds, especially long-dated bonds.

I agree with you somewhat in this. However, keep in mind that just because a long term bond is bought, that doesn't mean the buyer intends on keeping it long term. If the Euro was in better shape right now, I think the bond vigilantes would be dealing with the US instead of Europe.

It's pretty clear that a government that doesn't repay its bonds is in a state of default, a state of explicit default. A state where it just says "we can't pay you back, you'll have to take 50 cents on the dollar" or whatever it turns out to be.

When a government is in control of its own currency it can create the money it needs to repay its bonds if needs be, and so the possibility of an explicit default is taken away. If the US needs $1trn to pay some bonds it can pretty much create that trillion out of the air and pay the bonds. But this is really a default in all but name, hence the term "implicit default". The issuer can repay the bonds but only by devaluing its currency.

To put what that means into something that resounds with the average person more than numbers with lots of zeroes on the end, let's say a pizza costs $20 but you invest that $20 in a government bond paying 5% per year. Inflation is running at 5% so even though next year you get $21 back from your bond, it costs you $21 to buy a pizza. So effectively what happened is that you invested a pizza, and you got back a pizza.

Now let's see what happens if the government has to repay your $20 but only has $10. So it prints another crisp $10 bill to repay you. All else being equal the price of things increases, as there are more dollars chasing them, so your pizza now costs $30. So you invested $20, you got back your $21 (including interest) but a pizza now costs $30. In other words you invested a pizza and got back 2/3 of a pizza.

If a government goes into explicit default it becomes much more expensive to borrow, as lenders want a risk premium built into the price at which they lend. If a government goes into implicit default then sooner or later the same happens, as lenders realise the money they get back at the end has less buying power than they expected and demand a higher rate to compensate.

I find it mind boggling that anyone is willing to lend to the US government for 10 years at a rate that's comparable to the official inflation figures.

When the bond market finally does react to the debt, it will probably do so all at once. IOW, it won't be 1 or 2 individuals that can be ignored. Eventually, enough will react and then it will be a stampede. That's the way markets work. I don't think it will be too far out into the future. There's simply no way we can pay what we have promised now anyway. The US government has many unfunded promises to the citizens. Thing is, it so high, that the promises simply won't be kept. They can't be. The only question now, IMO, is will we deal with the debt responsibly now, or will we wait till the market forces us to deal with it.

[IMINXTC]

[tango]

I agree with you somewhat in this. However, keep in mind that just because a long term bond is bought, that doesn't mean the buyer intends on keeping it long term. If the Euro was in better shape right now, I think the bond vigilantes would be dealing with the US instead of Europe.

Sure, that's a good point. Even so if you buy a bond you're taking on the risk of the price changing until you can offload it on someone else. If interest rates rise (and they can't go much lower than this) the value of your bond falls. If the currency devalues (which it has been, fairly steadily, for some time now) the value of your bond falls. If the country goes into a default (explicit or implicit) the value of your bond falls. Taking on that kind of risk in exchange for 3% return or less just doesn't seem like a smart move to me.

When the bond market finally does react to the debt, it will probably do so all at once. IOW, it won't be 1 or 2 individuals that can be ignored. Eventually, enough will react and then it will be a stampede. That's the way markets work. I don't think it will be too far out into the future. There's simply no way we can pay what we have promised now anyway. The US government has many unfunded promises to the citizens. Thing is, it so high, that the promises simply won't be kept. They can't be. The only question now, IMO, is will we deal with the debt responsibly now, or will we wait till the market forces us to deal with it.

Probably the latter would be my guess. To do something through choice would be political suicide, and for as long as people can vote themselves the right to dip into someone else's pockets they'll vote out any politician who says we need swingeing cutbacks in favour of one who promises them milk and honey on someone else's tab. Even when the government hits the wall the chances are the people will be screaming for Someone Else to pay the bill to dig them out of the whole while still providing milk and honey on tap.

[tango]

Hahaha, priceless!

[Brother Mark]

Sure, that's a good point. Even so if you buy a bond you're taking on the risk of the price changing until you can offload it on someone else. If interest rates rise (and they can't go much lower than this) the value of your bond falls. If the currency devalues (which it has been, fairly steadily, for some time now) the value of your bond falls. If the country goes into a default (explicit or implicit) the value of your bond falls. Taking on that kind of risk in exchange for 3% return or less just doesn't seem like a smart move to me.

I agree with you. It doesn't make sense to me either. The short term rates are so low, that it's almost like saying "Here, hold my cash and just give me my cash back in a few months." I don't understand it at all from an investor perspective.

However, keep in mind that many buyers are not investors but other countries that are looking to influence the currency market. When those guys get frightened, look out.

Probably the latter would be my guess. To do something through choice would be political suicide, and for as long as people can vote themselves the right to dip into someone else's pockets they'll vote out any politician who says we need swingeing cutbacks in favour of one who promises them milk and honey on someone else's tab. Even when the government hits the wall the chances are the people will be screaming for Someone Else to pay the bill to dig them out of the whole while still providing milk and honey on tap.

I had a discussion with an acquaintance one time about politics in the poorer states. He could not understand why they voted republican and against the wealth transfer policies of the democrats. In his reasoning, the poorer states were voting against their own best interest. What he didn't understand was the character behind the voting. People have convictions about earning your own way. However, we are losing our moral character in our great country. There are many people now that look to government to save and feel entitled to certain rights. There are people in my country that now view health care as a right!

There was a time when we saw rights, not about what we deserved, but as a limit to government power. For instance, free speech is a right. So we limited how government could regulate it. Free exercise of religion is a right so we limited how government could regulate it. Now, we are saying the government can grant a right to health care and therefore, force people to provide it for others and purchase it for themselves. So rights now, instead of limiting government, cause it to bloat! It is a vastly different way of thinking. Rights now come from government fiat instead of being seen as bestowed by our Creator and something that government should not infringe upon.

I like what the preacher Vance Havner said years ago. This is not an exact quote but it gets the point across. "If government programs would have been around during the day of the prodigal son, he would not have returned home." Government has replaced the need for God and churches on the physical level. It's showing up in our moral fiber and I think, like you, that we no longer have the moral character to deal with our rising deficit before it is too late.

[tango]

I agree with you. It doesn't make sense to me either. The short term rates are so low, that it's almost like saying "Here, hold my cash and just give me my cash back in a few months." I don't understand it at all from an investor perspective.

Yes, it doesn't even have the safety of burying your cash in a big hole in the ground because the person holding your cash might not give it back.

However, keep in mind that many buyers are not investors but other countries that are looking to influence the currency market. When those guys get frightened, look out.

True, when the really big players get spooked things can move very fast indeed.

I had a discussion with an acquaintance one time about politics in the poorer states. He could not understand why they voted republican and against the wealth transfer policies of the democrats. In his reasoning, the poorer states were voting against their own best interest. What he didn't understand was the character behind the voting. People have convictions about earning your own way. However, we are losing our moral character in our great country. There are many people now that look to government to save and feel entitled to certain rights. There are people in my country that now view health care as a right!

Healthcare is always something of a thorny issue, and one of many issues where I think the US is too far one way and the UK is too far the other way. Here in the UK we periodically get newspapers publishing outraged stories about illegal immigrants being given IVF so they can start a family (free of charge, naturally), teenagers being given breast enhancements, prisoners being given sex change operations and the like. That said, the outrageous prices aside (which to me smacks of huge government interference rather than anything even remotely like a free market), I'm broadly minded to agree that health care is something that isn't an automatic entitlement. Even so I do like the peace of mind of knowing that if I have a nasty accident or similar the NHS (our public healthcare system) will put me back together again without presenting me with a monstrous bill at the end of it all.

There was a time when we saw rights, not about what we deserved, but as a limit to government power. For instance, free speech is a right. So we limited how government could regulate it. Free exercise of religion is a right so we limited how government could regulate it. Now, we are saying the government can grant a right to health care and therefore, force people to provide it for others and purchase it for themselves. So rights now, instead of limiting government, cause it to bloat! It is a vastly different way of thinking. Rights now come from government fiat instead of being seen as bestowed by our Creator and something that government should not infringe upon.

I agree - rights are all well and good when they are something intrinsic to ourselves. When my right inherently becomes your obligation something is wrong. And for all people like to claim their rights they are usually remarkably blind as to the fact all it means is that Someone Else is getting stuck with the bill. Of course when they realise they just got stuck with the bill for Someone Else to get something for nothing they like the idea less.

I like what the preacher Vance Havner said years ago. This is not an exact quote but it gets the point across. "If government programs would have been around during the day of the prodigal son, he would not have returned home." Government has replaced the need for God and churches on the physical level. It's showing up in our moral fiber and I think, like you, that we no longer have the moral character to deal with our rising deficit before it is too late.

This is something I've noticed more in the US than in the UK, although in fairness I'll pre-emptively agree that a small sample size isn't indicative of a whole nation. In the US I see more of an attitude of "I'm an American, therefore I deserve..." than in other nations. I think of a couple of friends in particular who seem to have fully bought into the line that since they are Americans they have an automatic right to a big house, a nice car, foreign holidays, everything just how they want it when they want it and so on. I'm sure it won't come as a surprise that this particular couple carry a whole stack of debt.

It has been said that if you rob Peter to pay Paul you can be sure of Paul's support. Substitute the word "tax" for "rob" and you've got all the reason you need to deny the vote to those who are net beneficiaries of the state.

[Brother Mark]

Healthcare is always something of a thorny issue, and one of many issues where I think the US is too far one way and the UK is too far the other way.

Depends on how you view the role of government and if health care is a right.

I agree - rights are all well and good when they are something intrinsic to ourselves. When my right inherently becomes your obligation something is wrong. And for all people like to claim their rights they are usually remarkably blind as to the fact all it means is that Someone Else is getting stuck with the bill. Of course when they realise they just got stuck with the bill for Someone Else to get something for nothing they like the idea less.

It's a subtle thing. When did rights move to government had to provide instead of government couldn't infringe upon? Our constitution/preamble talks about the right to life, liberty, and the pursuit of happiness. Government doesn't grant those rights. The US constitution is meant to limit government and liberals hate that.

This is something I've noticed more in the US than in the UK, although in fairness I'll pre-emptively agree that a small sample size isn't indicative of a whole nation. In the US I see more of an attitude of "I'm an American, therefore I deserve..." than in other nations. I think of a couple of friends in particular who seem to have fully bought into the line that since they are Americans they have an automatic right to a big house, a nice car, foreign holidays, everything just how they want it when they want it and so on. I'm sure it won't come as a surprise that this particular couple carry a whole stack of debt.

We have a right to social security, health care, etc. etc. etc. It's a moral failing IMO when we depend on government for such things instead of God, the church and the sweat of our own brow.

It has been said that if you rob Peter to pay Paul you can be sure of Paul's support. Substitute the word "tax" for "rob" and you've got all the reason you need to deny the vote to those who are net beneficiaries of the state.

No doubt. The problem in the US though is that we are fast approaching the point where more people do not pay income taxes than do pay them. That means almost half the population takes from government with very little support in taxes for government. It's not a good situation.