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September 23, 2008

Trillion Dollar Treasury Deficits: Truth and Consequences
by Richard Benson

One of my recent articles explained why the US Treasury deficit, without financial bailouts or government stimulus, was heading towards $600 billion a year. Another one forecasted that the bill for the financial bailouts would also be huge. This week, the cost of the bailout was confirmed with the nationalization of Fannie, Freddie, and AIG, added to the failure of Lehman Brothers, and the new massive $700 billion plus Treasury "Taxpayer Cash for Wall Street Trash" legislation. The total bill for this legislation plus existing bailouts will cost taxpayers more than a trillion dollars paid out over the next three years.

It's important to realize that this bailout plan adds nothing to economic growth and was necessary to prevent a worldwide global collapse of the financial system. The proposal will shift hundreds of billions of taxpayer dollars to purchase rotten financial assets from Wall Street institutions and banks for more than they are worth. This is all happening as our economy has been weakened by higher unemployment and non-financial corporate failures, and we're bracing for a worldwide recession that is unfolding in never-ending newspaper headlines. Even now, before America has a newly-elected President and a fresh Congress in office, legislators in Congress have already started discussions to launch another stimulus package. My bet is that the stimulus needed will total at least $500 billion. Trillion dollar federal deficits for the next few years are now inevitable and as this truth sinks in, the consequences will be enormous. Here are the reasons (see chart below):

The $4.2 Trillion of Intragovernmental Holdings is the "fictional borrowing" from Social Security and Medicare accounts. This fictional borrowing consists of social security taxes collected in excess of benefits paid out since the program began. In the past, the federal government profited nicely from excess social security taxes, but now the excess taxes have been spent on government projects like the war in Iraq, earmarks, etc. In a few short years when the Baby Boomers start to retire, the Social Security benefits paid out will exceed the taxes collected. When that happens, this fictional borrowing will flip back into real borrowing from the public. This means the government borrowing will be real, not fictional.

Of the $5.5 Trillion to date that has been borrowed from the public by the Treasury, $3 trillion of it is Treasury debt owned by foreign central banks. It turns out that the Chinese and other Asian countries (along with the Gulf Arabs and many other governments) have been generous and ready lenders to the US Treasury. The question remains whether they will continue to be. It took our fine republic a few hundred years to run up $5.2 trillion in debt, but over the next three years Treasury borrowing could exceed $8 trillion, a staggering 60 percent increase in the real national debt. Is it rational to believe that foreigners will double their holdings of US Treasury debt from $3 Trillion to $6 Trillion in the next three years? Yes, indeed! Where else would they get that amount of money?

The US Treasury will be facing major funding problems when they attempt to borrow the next three trillion dollars. The last few trillion they borrowed was a piece of cake despite the fact that Americans have no savings and, therefore, bought little of the new Treasury debt. Borrowing from foreign governments was also easy because of the way it was done (see below):

First, Americans would borrow dollars using their credit cards and homes (home equity loans), and then send them to the Asians and Gulf Arabs in exchange for manufactured goods and oil. That gave the foreigners lots of dollars to buy Treasury debt and other US financial assets, such as the debt of Fannie & Freddie. Notice the cause and effect: First, the foreigners got the dollars then they invested them in US Treasuries. Americans used a massive dollar-trade deficit to finance the Treasury's dollar-budget deficit. This paradigm is now over. America's trade deficit is falling and the US is in recession.

Our country's ability to buy goods and services from abroad is diminishing and Santa is not coming this Christmas (just look around and you'll see Christmas decorations already in some stores - how desperate is that?) Foreign manufacturers are going to be scratching their heads over the holidays wondering where the dollars that used to come from America suddenly went.

The financial markets are going to slowly realize that the only reason foreign central banks bought Treasuries is because the US bought their goods first! China, as one example, realizes our money is not that good and will take an interest in holding dollars only because we are buying goods and services from them. Foreign countries have no reason to buy massive amounts of Treasury debt unless we buy something from them first.

So here we are now with the Treasury deficit that will quickly zoom past the trade deficit by several hundred billion dollars; the Treasury debt still can't be sold to American savers because America doesn't have savers; and, we are no longer buying enough goods from foreigners and sending them our dollars to finance the Treasury deficit.

What are the obvious consequences of Trillion dollar Treasury deficits? One such consequence is called "Crowding Out". Crowding Out is the phenomenon that occurs when the US Treasury sells debt in a world where foreigners and Americans are no longer flush with dollars. That means that the dollars to buy the debt must be squeezed out of the financial system and interest rates are forced up. Trillion dollar deficits aren't chump change! However, squeezing a trillion dollars out of the money markets of the world is clearly impossible and the only remaining option to fund the US Treasury's insatiable appetite is through "monetization". Monetization means that the Federal Reserve would step in and print up new money out of thin air and buy the Treasury debt. If that occurs, monetary growth rates would soar and, in turn, create very high inflation as too many dollars start chasing too few goods. Rising inflation forces interest rates up, and rising interest rates always have devastating consequences for the prices of financial assets such as stocks and bonds.

So, how will we all be affected? First, start reading about what life has been like in the Banana Republic and in countries like Argentina, where the inflation rate in 2002 rose to 20 percent following the devaluation of the country's currency, the peso. Brace yourself for several years of rising inflation and interest rates and, by all means, protect your portfolio. Remember, cash is king again.

My investment plan remains the same. I expect real assets will greatly out-perform financial assets. First, I want to buy gold and silver in physical form whenever I can. In the world of inflation, while cash is king, gold is the emperor! Second, I look to accumulate real assets if they are quality assets and the prices have crashed down. So, I do believe that in a few years even real estate will again be a great inflation hedge!

Richard Benson
Benson's Economic & Market Trends
Specialty Finance Group, LLC

Prior to founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980's and started in the securitization business in 1983 at Bear Stearns, and helped build the early securitization businesses at Citibank and E.F. Hutton.

Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. Mr. Benson is a member of the Harvard Club of New York and Palm Beach.

The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.

Copyright © 2004-2008 Richard Benson

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