Paying Off The Piper
"I place economy among the first and most important of republican virtues, and public debt as the greatest of dangers to be feared." - Thomas Jefferson
The majority of stock and bond investors are facing a dire future. The only thing higher than tensions in the Middle East is the price of crude oil. Meanwhile, the popular press openly questions whether the president has the leadership skills to warrant re-election. I am referring to 1979, but the parallels to 2004 are undeniable.
President George W. Bush is certainly cut from a different cloth than President Jimmy Carter, yet the problems America faced in the late 1970s - rising debt, slow growth and an explosive Middle East - have returned in droves.
Those of us with a few gray hairs remember the '70s, not just for the outlandish clothes and mindless music, but also for the long lines of cars snaking from gas stations during the Arab oil embargo. And who could forget the decade-long bear market in stocks and bonds?
In the 1970s, the concept of perpetual government debt was still a relatively new idea in the United States. In fact, at the dawn of that decade, the United States was the world's largest creditor. Since then, however, successive presidents and Congresses have refused to let a large deflationary period occur on their watch. Big companies like Chrysler near bankruptcy? No problem - taxpayer money will bail them out. The same solution was used for reviving both the banking and thrift industries during the S&L crisis of the 1980s.
It seems as if there is no problem that Washington cannot wash away with taxpayer money. But just as there are limits to how much oil we can draw from the Earth, there are limits to how much money Uncle Sam can borrow without triggering an economic crisis. After all, our government does not earn money. It can only fill its coffers in two ways: taxation and borrowing. But borrowing has become an albatross around the government's neck.
Currently, the federal government is spending half a trillion dollars more than it collects. Even in the face of this troubling fact, the president and Congress continue to contract new obligations. There is the $100 billion - and growing - tab for our involvement in Iraq and the $14 billion conscripted for the war on terrorism. That is even before we spend a nickel on traditional social and defense spending. In the midst of this, our president is determined to cut taxes to revive a mature economy. And then there are the interest costs on all this debt.
The financial obligation is so big that it is hard to fathom. One way to look at it is to consider the fact that America's annual deficit almost matches the total value of goods and services that Canada produces in a single year.
U.S. federal debt was relatively flat until the mid-'70s. But from then on, it has been on an almost uninterrupted upward trajectory.
We have reached a point where federal debt stands at a level so that each American owes roughly $25,000. A bit of arithmetic shows that a family of four is on the hook for $100,000 in federal IOUs.
Most shocking is that half of this debt - some $3.5 trillion - has been borrowed since 1990! That is amazing when you consider that since the creation of our nation until the mid-1970s - a span of 200 years that included two world wars - our federal government had accumulated a debt of less than $1 trillion.
Now fast forward to 2004. Washington's guns-and-butter course of action will result in a debt of $1 trillion a year by the end of this decade.
Not that long ago economists argued that federal debt was of little consequence, since it was money we owed to ourselves. That is no longer the case today. Of the $3 trillion in Treasury debt outstanding, foreigners hold more than half of it.
In other words, the rest of the world - much of it envious of the American way of life - is financing America's social spending, the government's interest payments and even our defense spending.
Today the United States no longer faces the threat of Soviet aggression, but the country now faces a much more subtle threat - mass selling of Treasury bonds by foreigners. The results of any rush for the exits by our foreign creditors would make the stock market crash of October 1929 look like an inconvenience. The fact is that the greenback is vulnerable to a sudden and devastating vote of no-confidence.
The divestment of Treasury debt by foreigners would send the dollar reeling and wreck havoc in the bond markets. America has made itself so dependent on the lending of foreign interests - most notably foreign central banks - that it wouldn't know how to survive without.
In military terms, the United States' power is unparalleled; but it is nevertheless vulnerable to the economic whims of foreigners, who own $8 trillion of U.S. financial assets, including 13% of all stocks and 24% of corporate bonds. And foreigners have the ability to slowly but surely divest themselves out of dollars. In fact, I believe this is exactly what has been happening over the past year.
But keeping foreign nations committed to U.S. dollars and Treasurys is becoming tougher by the day as the value of the dollar slides and America keeps spending money it doesn't have. The United States must try to manage a delicate balancing act between borrowing heavily from foreigners and keeping rates low for the folks at home.
To keep the economy out of the ditch, the Fed must not only keep rates low to make government borrowing affordable, but also they must create an atmosphere where the vast majority of Americans can afford to spend now and pay later. Just how long this loop can continue remains to be seen, but if the government has its way, the payments promised in the future will exact a lot less pain than most anticipate.
One thing seems certain - with a total debt load now measuring four times America's GDP, the nation's ability to pay back what it borrowed is next to impossible. It is probably safe to say that no empire has faced such a startling predicament since Rome.
America's debt bubble has grown so big that there is only one way out - inflate the dollar and reducing the real cost of its payments. In order to do this the Fed will not be able to raise interest rates.
It wouldn't take much in the way of interest rate hikes to collapse this debt-laden economy. The last time the Fed raised rates (1999 to 2000), it brought about a collapse in the stock market and a subsequent recession. Today the economy is far more dependent on asset inflation in real estate, stocks, bonds and mortgages. Therefore, a sharp rise in rates would bring about severe asset deflation in paper assets.
The long and short of it is that credit will continue to be expanded in this country until no more borrowers can be found. Then, when borrowing dries up, the government will become the borrower-of-last-resort, the Fed monetizing all the government's excess borrowing or budget deficits. This monetary inflation virtually guarantees a bull market in gold, silver and commodities.
Keep printing, Dr. Greenspan, keep printing...