Anybody who has been lending money to the US federal government by buying T-Bills and its other debt instruments received a brutal one-two punch last week. It was hopefully a sobering experience, causing them to question why they would want to hold any US government paper.
The Washington Post landed the first punch with the following report on March 6th. "WASHINGTON -- Treasury Secretary John Snow notified Congress on Monday that the administration has now taken "all prudent and legal actions," including tapping certain government retirement funds, to keep from hitting the $8.2 trillion national debt limit…Treasury officials, briefing congressional aides last week, said that the government will run out of maneuvering room to keep from exceeding the current limit sometime during the week of March 20."
The second punch was delivered a couple of days later by this Dow Jones Newswires dispatch: "WASHINGTON (Dow Jones) -- The U.S. government ran a monthly budget deficit of $119.20 billion in February, an all-time monthly record that was still slightly less than forecast, according to a Treasury report Friday. The February federal government deficit was 5% greater than a year earlier, according to the Treasury Department's monthly budget statement."
These two reports make clear the dire financial straits the federal government is facing, but its financial position is even worse than it appears. The $8.2 trillion debt limit -- that has proven inadequate to meet the federal government's borrowing needs -- covers only its direct liabilities. In other words, this $8.2 trillion is the total amount of dollars owed to all the holders of US government debt instruments. Excluded from this total debt are all of the federal government's other liabilities, which total another $38 trillion. In "The 2005 Financial Report of the United States Government", US Comptroller General David Walker reported that "the federal government's fiscal exposures now total more than $46 trillion, up from $20 trillion in 2000."
Yes, it's insane. But it's even more insane that people buy the US government's T-Bonds and T-Bills thinking that they are a safe, low-risk investment. Maybe they used to be that, but things change. US government debt instruments are no longer a safe place to park your dollars. To substantiate this assertion, here are some shocking facts to mull over.
1) REVENUE -- Federal revenue peaked at $2.03 trillion in 2000, and then declined for three years, bottoming in 2003 at $1.78 trillion. That's never happened before. Revenue typically declines during a recession, but the most it has ever declined before was two years in a row, during the severe recession of 1958 and 1959. Revenue has rebounded the last two years and reached $2.15 trillion in 2005, but in constant 2000-dollars (i.e., adjusted for inflation), revenue remains 6.3% below that received in 2000.
2) EXPENDITURES -- While the federal government's revenue has been constrained, not so with expenditures, which have continued to soar. They were $2.47 trillion in 2005, an alarming 38.2% above the federal government's expenditures in 2000. Expenditures soared even in constant 2000-dollars, scoring a shocking 21.8% increase over the five years from 2000 to 2005.
3) RELIANCE UPON DEBT -- As a consequence of constrained revenue and uncontrolled spending, the federal government has come to increasingly rely upon debt in order to obtain the dollars it spends with gay abandon. In 2000, 1.1% of the federal government's cash flow (revenue plus the annual increase in debt) came from new debt. This reliance on debt grew to 20.4% in 2005. In other words, for every $100 spent by the federal government in 2005, $20.40 came from borrowed money, compared to only $1.10 in 2000.
4) INTEREST RATES -- Of all the major expenditure categories of the federal government, only one declined from 2000 to 2005 -- interest expense. It paid $361.9 billion in interest in 2000, and its interest expense burden fell to $352.3 billion in 2005. During this period, the federal debt climbed 40.5% from $5.63 trillion to $7.91 trillion. So given this increase in debt, it is obvious that the federal government's interest expense burden declined for only one reason -- interest rates fell. In fact, the average interest rate paid by the federal government on its debt in 2000 was 6.4%; it was only 4.6% in both 2004 and 2005.
5) INTEREST EXPENSE BURDEN -- During the 1990's, 24.0% of the federal government's revenue on average was used to pay interest on its debt. During the Bush administration that burden has declined to only 17.5% on average. The reason is that the 5.2% average interest rate paid by the federal government during the Bush administration so far is significantly less than the 7.2% rate it paid on average in the 1990's. It is clear that the lower interest rates engineered by the Federal Reserve after the 2000 stock market peak have favorably impacted the federal government's budget. Lower interest rates reduced its interest expense burden, thereby making the deficits incurred so far during the Bush administration much smaller than they would have been if higher interest rates prevailed.
The above facts are indeed shocking as they clearly highlight that both the runaway growth in federal spending during the Bush administration and the resulting deterioration in the financial position of the federal government have been cloaked and little noticed because interest rates have been falling in recent years. So the above facts therefore make the immediate future frightening because as we all know, the Federal Reserve has been raising interest rates.
What will happen to the federal government's financial condition now that the Federal Reserve is raising rates in order to try suppressing the growing inflationary pressures in the economy? The federal government faces a potentially toxic mix of constrained revenue, soaring expenditures, ballooning debt and rising interest rates.
The federal government desperately needs strong economic activity in order to generate the highest possible tax revenue to decrease its reliance on debt. But rising interest rates work against this objective. Rising interest rates dampen economic activity. We have already seen what has happened to the housing market since the Federal Reserve began raising interest rates.
In addition to adversely impacting revenue, rising interest rates also have an unfavorable impact on expenditures. This impact is purely mathematical. A 6% average interest rate on $8.2 trillion of debt results in a higher interest expense burden than a 4.6% rate.
Thus, higher interest rates restrain tax revenue while increasing the level of expenditures. Together these factors worsen the budget deficit, which then causes the federal government to borrow even more money. The resulting higher level of debt leads to a greater interest expense burden, further worsening the deficit. Consequently, the federal government is rapidly moving to the point where its borrowing becomes an increasingly important source of the dollars that it needs to meet its interest expense obligations.
It is clear that these circumstances create a vicious circle where the federal government borrows money to obtain the dollars needed to meet its debt obligations. This condition is not sustainable, and it will end in one of two alternatives -- either the dollar is saved or it isn't. If the vicious circle is not addressed and corrected, it will turn into a death spiral in which the dollar is destroyed.
To explain this point, the federal government will never default on its debt. With the ever-helping hand of the Federal Reserve and the banking system, the federal government will always come up with the dollars it needs to meet its interest expense and other debt obligations. But if the vicious circle described above is not addressed, the federal government will repay its debt obligations with dollars that are worth less and less until they become worthless when the death spiral occurs.
The vicious circle does two things. First, it increases the supply of dollars by creating 'out of thin air' the dollars needed by the federal government to meet its debt obligations. The second point is less obvious but just as pernicious. The vicious circle lessens the demand for the dollar as people over time come to understand the ruinous, underlying dynamics of what's happening to the currency. Higher supply and lower demand mean only one thing -- the purchasing power of the dollar is being inflated away.
These circumstances are not new. They are experienced by every fiat currency sooner or later when the discipline of the gold standard is removed. The discipline of the gold standard is needed to constrain government spending. In the absence of that discipline, a fiat currency inevitably reaches the vicious circle. In fact, it's even happened before with the dollar.
The dollar was in a vicious circle during the waning years of the Carter administration. Paul Volcker was appointed Federal Reserve chairman to break the vicious circle, and he did it by raising interest rates. He kept raising interest rates until real rates (nominal interest rates less the inflation rate) soared to greater than 6%, historically a phenomenally high rate. It was not surprising therefore that the demand for the dollar started rising, thereby breaking the vicious circle and saving the dollar from a death spiral. But Mr. Volcker had an advantage not available today to Mr. Bernanke.
Back then the federal debt was not the burden it is today. Recall that the US was the largest creditor nation in the world back then. The total level of dollar debt was not only much less, but manageable in the environment of rapidly rising interest rates and the high real interest rates ushered in by Mr. Volcker.
Today the US is the world's largest debtor. The US savings rate is negative. American home owners have consumed most of the equity in their houses. In short, the federal government and many consumers are borrowing just to try keeping their head above water. What's worse, there is all the uncertainty arising from trillions of dollars of outstanding financial derivatives, essentially none of which existed during Mr. Volcker's era.
In short, Mr. Bernanke cannot raise interest rates the way Volcker did, which I believe is well understood by both Mr. Bernanke and Mr. Greenspan. After all, look at what happened during the last year of so of Mr. Greenspan's tenure at the Fed. He raised interest rates, but throughout this period, real interest rates remained close to zero and at times were negative, which is a condition that creates a highly inflationary framework for the dollar. In other words, there was a lot of jawboning from Mr. Greenspan to save the dollar from inflation by raising interest rates, but he did not even come close to following in the footsteps of Mr. Volcker. Mr. Bernanke won't either.
Today's monetary system is not only broken, it's completely crazy. For this reason I found the following quote in the current issue of Barron's to be of interest. It's by Richard Daughty, from the March 8th issue of his newsletter, The Mogambo Guru ( 9241 54th St. N., Pinellas Park, Fla. 33782): "What a scam! The week [before last], the Fed snaps its fingers and creates $2.2 billion, and then uses it to buy $2.2 billion in government debt! What in the hell can you do but laugh at the sheer audacity! Somehow, a government creating more and more money and spending it is not, for the first time in history, going to turn out to be a bad thing? And especially one where the money is just paper and computer blips that they can create on a whim? Of course, I sigh wearily as I note that the banks themselves are in on the scam, and they bought up another $13 billion in government debt [the week before last]. Foreign central banks continue to soak up government debt, and they swallowed another $7.6 billion [that] week, too. The government sells debt to get money to spend on its deficits, and the bank creates the money to buy the debt. Debt and money supply both expand, and it expands to create a bigger and more expensive government! And higher prices. This is economic suicide!"
Indeed, it truly is "economic suicide", but it's even worse than that. It's also monetary homicide. The dollar as we know it is being killed, poisoned by debt from the hand of the federal government with its accomplices in the Federal Reserve and the banking system. So far it's been a slow death, with few people watching, but that's about to change. With the horrific new amounts of debt being injected into the dollar's weary remains, its death is not far off.