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The Next Signal to Watch

Wednesday, March 1, 2017 11:49
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This post The Next Signal to Watch appeared first on Daily Reckoning.

Trump advisors believe they can avoid a debt crisis through higher than average growth. This is mathematically possible but extremely unlikely.

A debt-to-GDP ratio is the product of two parts — a numerator consisting of nominal debt and a denominator consisting of nominal GDP. In this issue, we have focused on the numerator in the form of massively expanding government debt. Yet, mathematically it is true that if the denominator grows faster than the numerator, the debt ratio will decline.

The Trump team hopes for nominal deficits of about 3% of gross domestic product (GDP) and nominal GDP growth of about 6% consisting of 4% real growth and 2% inflation. If that happens, the debt-to-GDP ratio will decline and a crisis might be averted.

This outcome is extremely unlikely. As shown in the chart below, deficits are already over 3% of GDP and are projected by CBO to go higher. We are past the demographic sweet spot that Obama used to his budget advantage in 2012–2016 (As I noted HERE – Obama Has Tied Trump’s Hands).

Total Deficits and Surplus

The Congressional Budget Office, CBO, estimates that inflation and real GDP will each grow at about 2% per year in the coming ten years. This means that nominal GDP, which is the sum of real GDP plus inflation, will grow at about 4% per year. Since debt is incurred and paid in nominal terms, nominal GDP growth is the critical measure of the sustainability of U.S. debt.

The Fiscal Budget

The Congressional Budget Office, CBO, estimates that inflation and real GDP will each grow at about 2% per year in the coming ten years. This means that nominal GDP, which is the sum of real GDP plus inflation, will grow at about 4% per year. Since debt is incurred and paid in nominal terms, nominal GDP growth is the critical measure of the sustainability of U.S. debt.

From now on, retiring Baby Boomers will make demands on social security, Medicare, Medicaid, Disability payments, Veterans benefits and other programs that will drive deficits higher.

The CBO projections show that deficits will increase to 5% of GDP in the years ahead, substantially higher than the hoped for 3% in the Trump team formula.

As for growth, we are now in the eighth year of an expansion — quite long by historical standards. This does not mean a recession occurs tomorrow, but no one should be surprised if it does.

Official CBO projections, shown in the chart below, expect approximately 2% growth and 2% inflation for the next ten years. That would yield 4% nominal growth, not enough to match the deficit projections. The debt-to-GDP ratio is projected to soar even under these rosy scenarios.

Growth of Real GDP

Inflation

The Congressional Budget Office, CBO, estimates that inflation and real GDP will each grow at about 2% per year in the coming ten years. This means that nominal GDP, which is the sum of real GDP plus inflation, will grow at about 4% per year. Since debt is incurred and paid in nominal terms, nominal GDP growth is the critical measure of the sustainability of U.S. debt.

There are numerous problems with the CBO projections. They make no allowance for a recession in the next ten years. That is highly unrealistic considering that the current expansion is already one of the longest in history. A recession will demolish the growth projections and blow-up the deficits at the same time.

CBO also makes no allowance for substantially higher interest rates. With $20 trillion in debt, most of it short-term, a 2% increase in interest rates would quickly add $400 billion per year to the deficit in the form of increased interest expense in addition to any currently project spending (as was noted prior on the Unencumbered Interest Rate Policy – CLICK HERE).

The Impact Signal of Debt on Growth

Finally, CBO fails to consider the ground-breaking research of Kenneth Rogoff and Carmen Reinhart on the impact of debt on growth. We have discussed the 60% debt ratio danger threshold in this article. But there is an even more dangerous threshold of 90% debt-to-GDP revealed in the Rogoff-Reinhart research. At that 90% level, debt itself causes reduced confidence in growth prospects — partly due to fear of higher taxes or inflation — which results in a material decline in growth relative to long-term trends.

These headwinds practically insure that the Trump growth projections are wholly unrealistic. With higher than expected deficits, and lower than projected real growth, there is one and only one way for the Trump administration to reduce the debt ratio — inflation.

If inflation is allowed to rip to 4% and Fed financial repression can keep a lid on interest rates at around 2.5%, then it is possible to achieve 6% nominal growth with 5% deficits, which would be just enough to keep the debt ratio under control and even reduce it slightly.

Can Trump pull-off this finesse? Are his advisors even analyzing the problem along these lines?

We will know soon. As we’ll discuss in upcoming issues, Trump will have the chance to make an unprecedented five appointments to the Fed board of governors in the next 16 months, including a new chair and two vice chairs.

If he appoints doves, that will be the signal that inflation in the form of helicopter money and financial repression is on the way. That will also be the signal to move out of cash and increase our allocation to gold beyond the current 10% level.

If Trump appoints hawks to the board, that will be a signal that his team does not understand the problem and is relying on overoptimistic growth assumptions. In that case, we could expect a recession, possible debt crisis and strong deflation. That is a signal to keep our 10% gold allocation as a safe haven, but also buy Treasury notes in expectation of lower nominal rates.

We are watching for a signal on Trump’s nominations to the Fed board. The first three should be announced soon. Once the names and their views are known, the die will be cast.

Regards,

Jim Rickards
for The Daily Reckoning

The post The Next Signal to Watch appeared first on Daily Reckoning.

This story originally appeared in the Daily Reckoning . The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today’s markets. Its been called “the most entertaining read of the day.



Source: https://dailyreckoning.com/next-signal-watch/

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