Sunday, August 16, 2009

Bill Gross on the Deficit

Bill Gross on the Deficit.

"We are reaping the consequences of that long period of overconsumption and undersavings encouraged by the belief that lower and lower taxes would cure all.

The current annual deficit of $1.5 trillion does not even address the “pig in the python,” baby boomer, demographic squeeze on resources that looms straight ahead. Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure – a number that resembles Latin American economies such as Argentina and Brazil over the past century.

So the rather conservative U.S. government debt ratio shown in Table 1 will likely be anything but in less than a decade’s time. The immediate question is who is going to buy all of this debt? Estimates suggest gross Treasury issuance of up to $3 trillion this calendar year and net offerings close to $2 trillion – almost four times last year’s supply. Prior to 2009, it was enough to count on the recycling of the U.S. trade/current account deficit to fund Treasury borrowing requirements. Now, however, with that amount approximating only $500 billion, it is obvious that the Chinese and other surplus nations cannot fund the deficit even if they were fully on board – which they are not. Someone else has got to write checks for up to $1.5 trillion additional Treasury notes and bonds. Well, you’ve got the banks and even individual investors to sponge up some of the excess, but a huge, difficult to estimate marginal supply will have to be bought. The concern is that this can be accomplished in only two ways – both of which have serious consequences for U.S. and global financial markets. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure it puts on mortgage and corporate rates represents a serious threat to the fragile “greenshoots” recovery now underway. Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its publically announced and near daily purchases of Treasuries and Agencies at a $400 billion annual rate. That in combination with a buy ticket for over $1 trillion of Agency mortgages has been the primary reason why capital markets – both corporate bonds and stocks – are behaving so well. But the Fed must tread carefully here. These purchases result in an expansion of the Fed’s balance sheet, which ultimately could have inflationary implications. In turn, nervous holders of dollar obligations are beginning to look for diversification in other currencies, selling Treasury bonds in the process.

The obvious solution to both dollar weakness and higher yields is to move quickly towards a more balanced budget once a sustained recovery is assured, but don’t count on the former or the latter. It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect “new normal” GDP growth rates of 1%-2% not 3%+ as we used to have."

What's my take on this?

Generally, he's right. The US federal budget is out of control. It needs to get in line, or the future of this country will be a much bleaker one than the past. Taxes will hit socialism levels, unemployment will skyrocket, output will collapse, intelligent people will leave for areas of greater opportunity, social services will become unaffordable and the country will be a shell of its former self. I don't think that's a huge exaggeration.

There is one point on which he is mistaken, I believe. I agree with him that US interest rates will rise, consuming ever more of the federal budget, but his point that corporate and mortgage interest rates will rise substantially as US interest rates rise assumes that US government bonds will continue to be treated as riskless. Mortgage and corporate debt is often priced at US interest rates plus some additional number to incorporate the added risk. While it is true that the law of opportunity cost (few would buy a 10% bond with a 10% chance of default if you can buy a 5% government bond with a 1% chance of default) means that higher US interest rates mean higher corporate and mortgage rates, it likely wouldn't be as substantial a raise as he expects, simply because the risk of holding US treasuries will incorporate much of the increase (in the above example, if the 5% bond goes from a 1% chance to a 5% chance, then you start getting to a point where more investors would be interested without having to raise the 10% rate).

However, I do agree with him that the twin deficits need to drop.

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