March 29, 2011

Fiscal Plight of the U.S.

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 7:50 PM by Robert Barone

Simple math is often revealing.  That is why what follows is so scary.  It’s about the debt of the U.S. and the near impossibility to fix the federal budget almost no matter what steps are taken today.  Unfortunately, even the difficult steps that must be taken, and that are being avoided by the political process, won’t solve the basic issue.

Let’s first look at the level of debt in the U.S.   The table below shows the level of personal debt, and the level of local, state and federal debt, all per capita, as currently estimated (2011) and what it would look like in 2015 if the growth of debt over the past year were to continue at the same pace (source: USDebtClock.org).

2011 2015 CAGR
Personal Debt/Citizen $51,955 $45,339 -3.3%
Local Gov’t Debt/Citizen $5,512 $6,378 3.7%
State Debt/Citizen $3,757 $4,753 6.1%
Federal Debt/Citizen $45,791 $69,242 10.9%

Clearly, U.S. households are attempting to lower their debt levels.  And while it appears that state and local debt loads are still growing, public pressure, the balanced budget requirement in most states, a taxpayer revolt, and the inability to print money on the part of these entities will cause a significant slowdown in the growth of debt at these levels.  Unfortunately, this is not the case at the federal level.  As Stan Laurel often said to Oliver Hardy, “This is a fine mess you’ve gotten us into”.  The rest of this piece analyzes the “mess” that the federal government has put onto the American people.

U.S. Federal Budget Trends

The table below shows the rates of, and rates of growth of federal spending for the year ending in mid-March for the various years shown (source: USDebtClock.org).  For example, the spending levels and growth rates for 2004 are from mid-March 2003 to mid-March 2004.  Using the latest actual data and growth rates (mid-March 2010 to mid-March 2011) the table projects what those spending levels would be in 2015.  The growth rates are shown in Compounded Annual Growth Rate form (CAGR).  Also shown are the levels of federal revenue collection, the implied deficits, and projected GDPs.  Because this table is based on actual revenues and expense trends in mid-March of each year, the deficit shown for 2011, $1.33 trillion, is lower than the current projections of $1.6+ trillion due to the extension of the Bush tax cuts and the temporary lowering of the social security tax on wage earners.  The 2004 deficit was actually $413 billion, higher than shown in the table, for the same reason, i.e., the table projects from mid-march 2004 based on the one year trend.  The column labeled CBO is the Congressional Budget Offices’ (CBO) 2015 projections.  While these are generally discredited, they add context to the debate.

(Bill$) 

2004

(Bill$)  

2011

CAGR (Bill$)  

2015

CAGR (Bill$)  

CBO 2015

CAGR
Medicare/ 

Medicaid

443.4 804.1 8.88% 1,111.2 8.42% 990.8 5.36%
Social Security 474.9 706.5 5.83% 817.2 3.71% 852.4 4.81%
Income Security 194.9 431.9 12.04% 328.4 -6.62% 284.3 -9.93%
Federal Pensions 130.3 202.7 6.52% 338.8 13.70% 227.3 2.90%
Defense 415.8 693.8 7.59% 791.2 3.34% 741.1 1.66%
Debt Interest 154.7 202.9 3.95% 345.6 14.24% 408.3 19.10%
Sub-total 1814.0 3,041.9 7.66% 3,732.4 5.25% 3,504.2 3.60%
Discretionary 375.3 467.0 3.17% 919.9 18.47% 520.9 2.77%
Total Spending 2,189.3 3,508.9 6.97% 4,652.3 7.31% 4025.1 3.49%
Revenue 1803.9 2,175.8 2.71% 2,454.0 3.05% 3,488.1 12.52%
Deficit -385.4 -1,333.1 19.4% -2,198.3 13.32% -537.0 -20.33%
GDP 11,135.9 14,622.3 3.97% 16,837.8 3.59% 17,464.8 4.54%
Rev/Expenses 82.40% 62.01% 52.75% 86.66%
Rev/GDP 16.19% 14.88% 14.57% 19.97%

Looking at each line item, Medicare/Medicaid and Social Security are dependent on demographics.  With the baby boomers now entering retirement, the growth rates shown are likely to get larger over the next few years.  As is shown in the table, the CBO projects a growth rate of only 5.36% for Medicare/Medicaid.  Given the 7 year growth rate from 2004 to 2011 of 8.88%, the CBO estimate most likely assumed that Congress would take some actions to reduce the growth.  The growth rate in Social Security is higher under the CBO projections than the most recent growth rate observed and projected into 2015.  Income Security is composed of the unemployment and other social safety net programs, is currently 12.3% of federal spending, and is projected to fall to 7.8%.  As a benchmark, this item was 8.9% of the budget in 2004, so its 2015 projected level appears reasonable.  The growth in Federal Pensions appears extremely high, but this is not surprising given the recent brouhaha over government employee unions, wages and benefits.  Using the recent growth rates, the 2015 projections dwarf the CBO estimates.  The growth of Defense appears about in line with the growth of GDP.  Debt Interest is a wild card.  Because the method employed by USDebtClock.org simply projects the growth over the past year into the future, there is the growth in the debt itself, but no assumption of any increase in interest rates.  Thus, it is likely that the figure shown for 2015 is extremely low.  Even the CBO projects debt interest cost at over $408 billion in 2015.  There have been many blogs written on the potential explosive nature of future debt costs (see my blog, What Happens to the Cost of Debt if Interest Rates Rise? Minyanville, November 29, 2010).

The six categories discussed above have been “untouchable” by the last few editions of the U.S. Congress (except to add to them as was done under President G.W. Bush – prescription drugs) and represent 87% of Total Spending.  The other 13% is termed “Discretionary”, as the Congress can control this spending on an annual basis.  You can see how well they have done that over the past year, as those expenditures have risen at an 18.5% rate.  For the 7 years from 2004 to 2011, the growth rate was 3.17%, a somewhat more acceptable level.  The table also shows Revenues relative to Total Spending, and Revenues relative to GDP.  Using 2004 as a benchmark, the Revenue/Total Spending ratio was about 81% (deficit of about $413 billion) and Revenue/GDP was 16.2%.

Scenario 1 Scenario 2 Scenario 3
(Bill$) 2011 CAGR (Bill$) 

2015

CAGR (Bill$) 

2015

CAGR (Bill$)  

2015

Medicare/ 

Medicaid

804.1 8.42% 1,111.2 8.42% 1,111.2 6.32% 1,027.4
Social Security 706.5 3.71% 817.2 3.70% 817.2 2.78% 788.4
Income Security 431.9 -6.62% 328.4 -6.62% 328.4 -6.62% 328.4
Federal Pensions 202.7 13.70% 338.8 10.28% 299.8 10.28% 299.8
Defense 693.8 3.34% 791.2 1.67% 741.3 1.67% 741.3
Debt Interest 202.9 14.24% 345.6 14.24% 345.6 14.24% 345.6
Sub-total 3,041.9 5.25% 3,732.4 4.61% 3,643.5 3.80% 3,530.8
Discretionary 467.0 0.00% 467.0 0.00% 467.0 0.00% 467.0
Total Expenses 3,508.9 4.59% 4,199.4 4.04% 4,110.5 3.31% 3,997.8
Revenue 2,175.8 6.14% 2,761.4 5.83% 2,761.4 7.20% 2,873.4
Deficit -1,333.1 1.91% -1,438.0 .30% -1,349.0 -4.17% -1,124.4
GDP 14,622.3 5.00% 17,773.5 5.00% 17,773.5 5.00% 17,773.5
Rev/Expenses 62.01% 65.76% 67.18% 71.87%
Rev/GDP 14.88% 15.54% 15.54% 16.17%

The Deficit Issue

The U.S. cannot operate much longer at the trillion dollar deficit level without dire consequences.  Some of these include 1) rapidly rising interest rates as bondholders lose confidence in the fiscal integrity of the Treasury; 2) loss of world reserve currency status of the dollar; 3) likely rapid inflation as the Fed creates the fiat money that the government can no longer borrow from the U.S. public or the world’s investors at rates that keep the deficit from exploding even further.

So, what is it that can be done on this issue?  I have developed 3 possible scenarios.  In Scenario 1, by 2015 the Bush tax cuts have expired ($132.6 billion according to the Tax Foundation), and all additional discretionary spending has been reduced to 2011 levels.  Given the current political stalemate, this scenario may seem optimistic.  In addition, I have made the extremely optimistic assumption that the economy has turned around and has averaged a 5% compounded annual growth rate with a commensurate increase in federal revenues.  (I assumed 12 million new jobs are created over the 4 years (250,000/month), and each job generated $14,500 in tax revenue via income and payroll taxes.  Under this scenario, because of the explosive growth in Medicare/Medicaid and Federal Pensions along with normal growth in Defense, the deficit is still hovering at more than $1.4 trillion.  In addition, the apparent unrealistically low costs of the Debt Interest remain.

While Scenario 1 itself seems somewhat optimistic, it is my intent to show the true depth of the fiscal issues.  Scenario 2 takes the results of Scenario 1 and assumes that the Congress cuts the growth rate of Defense spending in half and somehow reduces the growth rate of federal pensions by 25%.  But, just as in Scenario 1, the deficit remains stubbornly high near $1.35 trillion implying that $0.328 of every federal dollar expended is either borrowed or, more likely, printed.

In the final scenario, Scenario 3, all of the previous actions of the other scenarios are accomplished plus the Congress has successfully modified the growth rates of Medicare/Medicaid and Social Security by 25% and has found enough new revenue sources (new taxes) to bring the Revenue/GDP ratio back to 2004 levels (16.2%).  To summarize all of the actions contained in Scenario 3:

  • Discretionary spending is held to 2011 levels;
  • The Bush tax cuts have expired adding $133 billion to government revenues;
  • GDP grows at an astounding 5% CAGR from 2011 to 2015, 12 million new jobs are created, and tax revenues grow commensurately ($174 billion – from new jobs and economic growth);
  • The growth in Defense spending is cut in half;
  • Federal Pension growth is reduced by 25%;
  • Medicare/Medicaid growth rates are reduced by 25%;
  • Social Security growth rate is reduced by 25%;
  • New revenue sources add $112 billion to government coffers (in addition to the revenues from the expiration of the Bush tax cuts and 12 million new jobs).

You are probably shaking your head by now, as the above task list appears impossible to accomplish in the U.S.’s political environment.  The point is that, even if all of these actions would come to pass, the deficit in 2015 is still $1.1 trillion!  And the deficit I am talking about doesn’t include a) a realistic cost of the debt and b) the off balance sheet borrowing needed and deficits created by FNMA and FHLMC nor the additional pressures in the borrowing markets from the FHLB system, the FHA, and the SBA.

Conclusion

The simple math tells us that we are on an unsustainable path.  There appears to be no political will to even get to Scenario 1, much less all the way to Scenario 3.  And what I have ignored throughout this analysis is what will happen to the interest cost of the debt should the U.S. continue along its current irresponsible path.  Easily, the debt costs could be $300-$500 billion higher than shown.  Just add that to the deficits in the three scenarios.

In their groundbreaking book, This Time is Different: Eight Centuries of Financial Folly, Reinhart and Rogoff show that, historically, once a country’s debt exceeds 90% of its GDP, either default or a rapid inflation usually occur.  The debt/GDP ratio in the U.S. is now approaching 100%, and it is clear that the debt will continue to grow at much faster rates than the GDP.  Investors would be foolish to believe that “this time is different”!

Robert Barone, Ph.D.

March 23, 2011

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

This writing discusses the possibility of future events and outcomes based on a limited number of circumstances.  Ancora West makes no guarantee these future events or outcomes may occur to due other future circumstances that could not be considered in preparing this writing.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

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