Sovereign Debt - Default and the Economic Fallout

The question of how we will navigate the sovereign debt mess is one which occupies my thoughts, and is becoming more of a mainstream topic in the media and financial press. I start off todays blog with a thesis, supposedly from George W Bush, our ex president, about how our government needs to be made smaller, so that the people paying taxes are also the ones who determine how the government is spending its money. Otherwise, the situation is not sustainable. I then go on to discuss the contents of a recent Morgan Stanley research piece which is entitled: “Ask Not Whether Governments Will Default, but How”.


* Yesterday I discussed the concept that we might somehow muddle through the current malaise, without any catastrophe occurring. In my discussions, I raised the point that the tea party movement has the potential to throw the economy into a tailspin by virtue of their fiscal responsibility creed. On the other side of the ledger, President Obama, while he pays lip service to fiscal responsibility, has no problem running trillions of dollars of deficits, while inflicting additional taxes, (in the form of the passed health care bill, and carbon taxes which has only passed one part of Congress so far). My discussion is not on the merits of health care or the carbon tax, as I do believe in the concept of universal health care, but rather on the sustain-ability of our government, with such a large burden which our welfare state entails.


A reader raised the concept of right-sizing the government to match the contributions of its constituents, which was espoused by ex-President, George W Bush, (GWB), in a recent interview. I could not find that interview on the internet, so instead, I will pass along the reader’s summary. In short, GWB made the point that the government will not be sustainable, if the people who receive benefits from the government do not contribute to the running of the government. According to various sources, including an article in todays WSJ, approximately half of this country pays no taxes, and receives entitlement payments from the government. And a very small amount of taxpayers pay the burden of taxes which benefits so many. In other words, the burden of government needs to be distributed, so that all people contribute to the government’s budget, and accordingly, should have a vested stake in how the government runs. When so many people contribute nothing, and just receive benefits, then we have created an environment where the recipients will just demand more, without being accountable to using their tax payments in an efficient and effective manner. And when so few contribute the bulk of the government’s budget, then they will not have a voice in the running of the government, since their voices will be drowned out by those looking to take more of the pie to which they did not contribute.


According to my reader, GWB extended the discussion to the idea that in order for the government to be aligned with the contributions (taxes) of its constituents, then the government can only be so big, because, otherwise, there will not be enough money to support the government, with a tax structure that draws revenues from all income categories. All this sounds simple enough, but in order to right-size the government, the government needs to be made smaller, and provide less services/entitlements. The concern of those with this point of view is that if you tax the wealthy too much, then the government will force people to figure out ways to skip out on taxes. You cannot even quantify this, because those who figure out ways to avoid taxes will do so in a fashion that cannot be counted. I do remember seeing a graph showing the percentage of GDP going to pay taxes to the government. With the exception of WW2, this ratio was somewhere in the 17-18% range, going into the 20s% in WW2, despite the fact that the US has had high and low tax rates over the last 100 years. If anyone has that graph, I would love to see a copy of it. In other words, no matter what the tax rate, there are natural limits on what the government can collect from its citizens. This concept further supports the idea that the current US government, and for that matter, governments around the world, cannot continue spending money at the current rate.


* Along the lines of how we might muddle through the current mess, as opposed to facing a calamity, Morgan Stanley put out an interesting piece, which was forwarded by John Mauldin last night, titled: “Ask Not Whether Governments Will Default, but How”. The Morgan Stanley article assumes that there will be some form of default. Just how this default happens will determine the nature of the upcoming financial landscape. To quote this article:


“some or all of its stakeholders must suffer a loss: either taxpayers (through a higher tax burden), or beneficiaries of public services (through lower expenditure) or bond holders (through some form of default).”


“The question is not whether the (government) will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take. From the perspective of sovereign debt holders, this translates in two questions:


*    Does their claim on governments rank senior enough relative to other claims to fully shelter them from losses?


*    If it does not, what form will this loss take?” (end of  MS excerpt)


The reality is that the US government will be forced to cut back on promised benefits to its people. You can count on that. As this reality sinks in, people will start saving more for their retirement, and less for current consumption. Forcing people to save more for retirement/health expenses will put a long term crimp on the economy. The tax is coming, what it is has yet to be determined. It has to be in the form of reduced benefits, because any progressive tax scheme will fail to raise the necessary revenues, as history has proven.


Another option which the MS article cites is that the government can devalue the currency it is paying its debt backs with. As I have said about the US in the post WW2 experience, in which we had 2 years of 12.5% inflation. This reduced the value of the debt owed by the US, and according to the MS article, in England and France as well, in the post WW2 period. Despite the Fed’s best efforts to re-flate the economy, inflation remains subdued. My contention is that until the surplus countries start spending their dollar hoards in the US, that inflation will remain subdued in the US. Eventually, all the Fed’s efforts to push inflation will result in a lower dollar. Not only are the prices of imports low because wages in trade surplus countries are much lower than in the US, but also because those countries are currently keeping their currency exchange values artificially low. In other words, we can print an endless amount of money and run trade deficits to the sky, which we are doing, yet inflation only shows up in the trade surplus countries. This seems pretty stupid to me, but this is what is going on.


So how are we going to create enough inflation so the surplus countries IOUs get paid back with a lower valued dollar? I do not know. China is desperately trying to buy natural resources, and I would bet a buck that they are behind the increase in the share offering of Petrobas, which is supposed to come this Thursday. I guess so long as they accumulate dollars and purchase US treasuries, then there is nothing to worry about, except for the fact that the size of the snowball on the top of the cliff keeps getting bigger, and will appear more ominous, the bigger it gets.


All of this still does not answer the question on how we are going to solve our deficit problem, but the evidence does suggest that some combination of reduced benefits, attempts to raise taxes, (which will fail), and some action from our overseas trading partners to spend money over here, will solve some of the problem. And for my part, I do not have a neat answer to share with you, except to place you in the middle of the conversation.


For more on the dilemma about entitlements, check out this story in todays WSJ:

 

Story HERE

* A reader writes in with this, in reaction to yesterday’s blog:


“You know that scene from old movies (maybe even the Batman and Robin TV series) where the hero is tied to a table and there is a huge penduluming saw blade swinging back and forth and little by little the blade gets lower and lower until (in theory) it cuts its victim in half?  That’s our economy in action.  We are all tied to the table and you, Rick, see that the blade keeps getting closer and closer and you are consequently telling us all that we’re going to die as it gets closer and closer.  The nay-sayers are saying that that blade has been swinging for a long time and nothing bad has happened yet.  And you point out that the blade is closer now and they say that doesn’t mean anything.  Then there are the ones that think the blade is getting closer, but that some miracle will happen like always and we will be saved.  That’s how I view allot of this discussion.  It’s not as simple to see what is happening in the economy and what the end result will be as it is with the swinging blade, but same idea.


   I can see Batman and Robin now, strapped to the table, swinging blade closing in.  And Batman says, “We are going to be killed if we don’t get ourselves out of these ropes”, to which Robin replies, “I am getting tired of listening to all of your negativity”.” (end of readers comment)


All I can say is that in 10 years, when the dust settles, we are going to look at each other and say, I cannot believe what the last 15 years were like. Batman might escape the swinging blade and then get hit by a car. A firestorm, in one fashion or another is coming, and the consequences will not be pretty.


* I had this dialogue yesterday with another reader:


From yesterday’s blog: In fact, we could stop paying interest on external debt in an effort to get those surplus countries to spend the money over here.  


Reader: “Uh, not a great idea Rick.  Who’s going to buy Treasuries to fund our debt if we don’t pay interest to foreigners?”


Rick: The Fed


Reader: “You’re probably right.  Fasten your seat-belt.”


I think by the time this party is over, the Fed will emerge as the treasury buyer of last, and possibly first, resort.