October 21, 2009

Tick, Tick, Tick, Tick – the Sound of Four Newly Planted Economic Time Bombs

Posted in Banking, Finance, investments, Uncategorized tagged ancora, ancora west, ancora west advisors, bonuses, congress, deficits, devaluation, devaluing US dollar, gold, government's projections, Joshua Barone, Matt Marcewicz, medicare, Obama, rapid inflation, Robert Barone, secret meetings, social security, TARP, tax, The national Debt, The Tax Shortfall, Tick Tick Tick Tick, time bombs, To Big to Fail, Treasury Debt, unemployment, World's Reserve Currency at 10:45 PM by Robert Barone

Current monetary, fiscal, and government policies toward business in general, have planted “time bombs” in the economic fabric that will surely cause additional economic pain in the future.

The National Debt

The most significant “time bomb” is the ballooning national debt. Nine years ago, the national debt was $5.7 trillion; today, it is approaching $12 trillion.  In 1981, the ratio of debt to GDP was 32%.  At the end of September, it was 90% and projected to be 98% next September 30.  This puts the U.S. in the top 10 of the world’s debtor nations. Currently, the debt cost $383 billion annually, or about 2.7% of the $14 trillion GDP.  The current rate on the marketable Treasury debt averages 2.58%, down from 3.67% a year ago.  Assume that we run $1 trillion deficits for the next 10 years per the government’s projections, and assume that GDP will grow 3% on average.  The national debt will be $22 trillion, and GDP will be $18.8 trillion for a debt to GDP ratio of 117%.  As interest rates move up from their historic lows, the cost of interest on the debt skyrockets.  For example, if the debt cost rises to 5%, the interest will be $1.1 trillion, or nearly 6% of GDP.  And if rates rise higher, either due to inflation or to a weakening dollar (foreigners will require higher interest rates to offset the falling value of the dollar), say, to 8%, the cost of interest on the debt rises to $1.76 trillion annually, or 9.4% of GDP.  That means nearly 10% of U.S. national output would have to be paid to the debt holders, most of which will be foreigners.

The solution to such debt that has historically been used by governments is either rapid inflation (pay back the debt in newly created paper money) or directly through devaluation.  Today, devaluation occurs daily as the dollar gets weaker and weaker.  It isn’t any real mystery, then, why the prices of gold, other precious metals, and commodities have risen rapidly – it’s the debt!

Our recent experience with overspending and burgeoning consumer debt in the U.S. should teach us a lesson about the consequences of too much debt, i.e., the current recession has been the result.

The World’s Reserve Currency

As a corollary to the “time bomb” of a devaluing dollar, there are dire implications for the U.S. if the dollar loses its status as the world’s reserve currency.  In early October, the financial media discovered that China, Russia and the Arab Gulf States had held “secret” meetings to discuss the pricing of oil in a currency or currencies other than the dollar.  It was reported that the goal was to accomplish the currency changeover within nine years.

Today, most international transactions, including oil, are priced and clear in dollars and, as a result, there is an international demand for dollars for these transactions.  This keeps the dollar’s value high relative to other currencies.  If another currency or basket of currencies became the clearing currency for international transactions, the dollar’s value would erode at a pace far faster than that which we are currently witnessing.

Without world reserve currency status, the U.S. might face a “borrowing crisis”, especially if the federal deficit continues at $1 trillion + per year.  History shows that out of balance countries pay double digit interest rates to induce foreigners (and agencies like the IMF) to purchase their debt.

If the dollar loses its status as the reserve currency, policy choices in the U.S. will become much more limited.  The U.S. will have less status in international negotiations and much less world influence.  It will become more and more difficult and costly to have an international military presence.  Another power or powers will fill this void.  They may be hostile to U.S. interests, and it is likely that, with the proliferation of nuclear weapons, the world will be even more volatile than it already is.

It appears that the policy model currently deployed – high deficits, money printing, and the acceptance of a weak and deteriorating dollar will result in the loss of reserve currency status.  This would result in high interest rates, a significant inflation, and/or a dollar devaluation.  This is what has historically happened to third world countries which have pursued similar fiscal and monetary imbalances.

The Tax “Shortfall”

Tax issues are probably the most imminent of the embedded economic “time bombs”.  On the federal level, it is estimated that tax receipts dropped at least 18% in the fiscal year ended on September 30.  Besides the rapid slide in income taxes due both to rising unemployment and non-existent capital gains, excise tax receipts (fuel) are also down significantly.  The issue is that Congress has decided to increase spending and is currently considering legislation (e.g., health care) that will require still more funding.  Meanwhile, existing social programs like Medicare and Social Security are now projected for insolvency earlier than previously thought.  Social Security, for example, may begin running in the red as early as 2013 with fund depletion by 2029.  As a result, Congress will be forced to spend even more.  Clearly, this situation has resulted from political over promises and commitment of resources that just aren’t available.

Meanwhile, state and local government finances are no better off.  Tax receipts in the second quarter fell 12.2% marking the 3^rd consecutive quarter of decline.  Of the four largest sources of state and local revenue, property taxes actually rose in the second quarter, although barely.  I expect that this will reverse going forward due to rapidly falling real estate values.

General sales tax revenues fell 9.2% ($7.5 billion) in the second quarter, again the third consecutive decline.  For those states and localities with income taxation, revenues fell a whopping 27.2%, or by nearly $29 billion.  As unemployment continues to rise, it appears that this downtrend will persist.

Only corporate income taxes showed positive growth (3.6%, or $.6 billion) on the state and local level in the second quarter.  For both the second and third quarters, slowly rising corporate profits have been a function of cost cutting, including layoffs.  It appears to me that a continuation of such corporate cost cuts, while making profits and therefore tax receipts marginally better, will only make the sales and income taxes fall further and faster.

There are no easy answers here.  At the state and local levels, property values aren’t likely to bounce back anytime soon, and without new jobs, neither will general sales, income or corporate taxes.  The same is true for the federal tax take.

The danger is that the Congress, state legislatures and taxing districts decide to increase their rates or add new taxes in order to support their spending habits.  This appears to be the first instinct of the taxing authorities.  However, governments, like households, have to figure out how to make ends meet on lower incomes.  If they don’t, their decisions to raise taxes are prescriptions for continued economic stagnation.

Too Big To Fail

Perhaps the most insidious “time bomb” in our economy is the “Too Big To Fail” (TBTF) policy.  This bomb was originally planted during the S&L crisis of the late 80s, and its implosion has been one of the main ingredients of the financial meltdown.  The TARP solution (saving the giants) has only made this problem worse, as now, the largest four banks control 39% of the deposits versus 32% before the crisis.

A major issue with this policy is that it allows excessive risk taking (purchases of toxic assets and over leveraging of balance sheets).  Success in their risky bets rewards management with outsized “bonuses”; failure initiates a bail out by taxpayers (with continued unconscionable “bonuses”).

Another issue with TBTF is that it allows the government to pick the winners and the losers.  TARP funds were given mainly to those TBTF, while small regional and community banks, which did not over leverage their balance sheets nor invest in toxic assets, have been denied.  In addition, small shops have effectively been prohibited from raising capital by the FDIC’s “resolution” methodology which “sells” a closed institution to a larger entity at a below fair value price and guarantees the buyer against loan portfolio losses.  Why would any investor put capital in prior to an FDIC “resolution”?

The upshot of TBTF policies is that two major industries in the U.S. are now run with “state” capitalism (banks and autos), not free-market capitalism.  It is the way the Kremlin ran the USSR in the 70s and 80s and how China works today.

In the aggregate, TBTF institutions have not used TARP funds to help their business clients.  Commercial loans have fallen every month since the crisis began.  In addition, most of the excess liquidity created by the Fed to purchase the toxic assets from the TBTF institutions has been used to purchase much of the massive new federal debt.

It looks like a quid pro quo – TBTF get TARP, liquidity, they get to shed toxic assets, and they are allowed to continue to pay grossly unconscionable bonuses – in return they purchase newly issued Treasury debt (at a large spread to their cost of funds) and become the institutions through which new Treasury and Fed programs are implemented, at handsome gross margins.

TBTF ignited the current crisis.  It’s distortions of pay and markets continue to haunt us.  And if not fixed through break-ups (like was done to AT&T in 1982), it will someday, maybe soon, cause another calamity.

Robert Barone, Ph.D.

October 20, 2009

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