Dienstag, Juli 07, 2009

Debt, Deficits and the Dismal Science...

Two articles got me started on this one.

But first this: debt is, in and of itself, not a bad thing. There are reasons for getting and going into debt, usually because of time constraints on large-ticket purchases. If you want to buy a house, you can save for 30 years and then pay cash, but given the finite lifetimes of people and the need for shelter - and of course the desire to have a house that fits one's lifestyle and inclinations - it's more convenient (but not cheaper) to take out a mortgage and go into debt.

The same is true for companies: many, if not most, leverage their cash flow above and beyond their fixed costs plus an operative reserve in order to purchase machinery and plant that can add to their capacity. Sure, they can finance these ex post facto after profits come in, but given technological imperatives and life cycles, it's usually a more sensible business idea to finance these things, buying them now with future revenue streams for a cost.

Now, government is both the same and yet different.

There's two kinds of government debt. There's the debt taken on to build infrastructure, to pay for the common defense, to fight wars. That's the "good" debt: it's part and parcel of what governments are "supposed" to do.

But then there's the debt that is incurred in order to pay for social programs, ones that are delivered in order to win votes or to take care of "desperately needed social programs". This is generally not investment, but rather consumption.

Why this distinction?

Because of risks involved. Banks lend money to both private and corporate customers, but also do risk analysis to quantify, as far as it is possible, the risk that a consumer or a company won't pay back the debt that has been incurred. This results, for poor risks, in banks either choosing not to lend at all or charging very high rates for lending; for good risks, the banks will give you preferential rates.

As they should.

Now, when income exceeds outlays, everyone is happy. Private consumers live within their means; companies have a solid cash flow that allows for profits and dividends, and governments don't need to "enhance revenues", i.e. raise taxes.

When outlays exceeds income, however, ahhh: problem city. Private consumers, living beyond their means, go bankrupt; companies do as well.

Governments? That's another story.

There's a lot of way of quantifying the likelihood of insolvency, both private and corporate.

Private insolvency is simply a function of how rapidly savings are depleted by the negative cash flow, as well as the ability of their cash flow to consolidate short-term debt into long-term debt. Once both limits are reached (i.e. no more savings and their cash flow, beyond minimum physical survival, is fully leveraged, leaving no further leeway), the individual files bankruptcy, with all the trials and tribulations that includes.

Corporate insolvency is more difficult, as there are more variables involved. Basically, though, there is an empirical formula (Googel Z-Score) that says that if this score declines for two years, the companies involved usually go bankrupt within two years, as "healthy" companies tend to have positive scores. As an indicator, it's been empirically verified (meaning that it actually works) with a pretty high accuracy rate (70%+).

The key point I'm laboriously trying to make here is that it's not so much debt that is the killer, but much more negative cash flows, i.e. deficits.

This is where the risk to governments comes in.

In this first article, Richard Berner of Morgan Stanley in New York puts it bluntly:

America's long-awaited fiscal train wreck is now underway.  Depending on policy actions taken now and over the next few years, federal deficits will likely average as much as 6% of GDP through 2019, contributing to a jump in debt held by the public to as high as 82% of GDP by then - a doubling over the next decade.  Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP.  Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth.  And soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service.  Not only will those factors steadily lower our standard of living, but they will imperil economic and financial stability.

As the saying goes, read the whole thing. The point that Berner makes is important: the way things are shaking up under the Obama Administration and the 111th Congress, the US deficit - outlays exceeding income - will dramatically worsen, even without the chimera of universal health care. Fundamentally, the deficit is not only not going to go away, it is going to worsen significantly, and the additional debt burden that this deficit implies is going to become onerous at the least and downright restrictive at worst.

Now the second link underscores this:

The key to understanding why it is critical to get the deficit under control is this: anyone who has a negative cash flow can do two things to get that cash flow under control. One is to get a better job, inherit or marry exceedingly well; the other is to consume less.

The latter is the only thing that is an absolute necessity. Raising revenues is at best a short-term solution, as tax avoidance is the reaction to increased taxes. By not restraining the deficit - in other words, to cease digging when you realize you are in a hole - you make things worse, and markets will react to this: according to the Fed itself, long-term interest rates, given a deficit now programmed, will result in interest rates doubling.

Doubling. As in not going up 20-30 basis points, but rather 3500 basis points from the current 3.5% for long-term US government bonds to around 7%.

While that will be great for investors searching absolute returns, it means one basic and hideous fact: it means that interest rate growth and the resulting debt service will, necessarily, reduce consumption. Reducing consumption means, for the US, in the economy continuing to shrink, rather than expand.

The timing couldn't be worse: the way things look, the recession will move from long U form to a W-form, i.e. the stimulus package, which may (or may not be) showing some positive results, will fail to re-ignite the economy, leading to an extension of the recession.

Which, of course, would lead to a renewed spiral of debt-taxes-reduced growth.

This outlook, at best, is dismal.

If the Obama Administration and the 111th Congress continue to ignore the dismal science and further ratchet up the deficit and hence the debt, there'll be market reactions to this world-wide that will make things significantly worse; if the Obama Administration and the 111th Congress continue to ignore the dismal science and further distort markets in the name of political opportunism, there'll be market reactions to this world-wide that will make things significantly worse.

At best, the Obama Administration and the 111th Congress can stabilize the economy.

But that would mean abandoning their policies and rolling back their current initiatives. The Obama Administration and the 111th Congress are showing absolutely no signs of this whatsoever, and, by not listening to the dismal science, are bringing the country onto a path that will be dismal at best.

The upside? The US system of representative democracy within a federalist structure generally does allow the voters to vote the bastards out.

The year 2010 can't come soon enough.

Right now, the legacy of the Obama Administration and the 111th Congress will be one of crushing debt acquired for political consumption, of receivership, of local spending frozen basically forever, of stagnation and, if it were not a sin, despair.

The year 2010 can't come soon enough.

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