Dienstag, April 20, 2010

Debt, Aging, Despair And...

This has been making the rounds of those who care about things like debt and sustainability. It's not a particularly hard thing to read, but it is a very depressing thing to read.

Not ecological sustainability, but economic sustainability. More on that later.

To summarize what is said: we all are in a world of hurt right now. The financial crisis - regardless of who you are, what you do, who you voted for, where you live (and yes, I'm including the Third World as well - is going to have real effects on the world's economy.

First and foremost: there is a fundamental weakness in all advanced economies.

Unfunded pensions with an aging demographic.

This is going to sound boring: it is anything but that.

The reason for long-term fiscal imbalances, imbalances that threaten the well-being of the world's financial system, is that there is rising and largely unfunded age-related spending that is driving government spending into a corner, slowly but surely. Why? Because systems of social security, including health insurance during the most expensive years of care, are unfunded and have to be paid out of current income.

It really is as simple as that.

While you can analyze all of this from a short-term perspective, the real problem is the long-term perspective. Ignore this at your peril: the paper linked to above tells the basic story.

For the US to meet the unfunded liabilities due to an aging population, it needs to improve their budget balance to a more or less permanent 7% surplus, instead of the 9% deficit that the US currently (2010) runs. I've rounded these numbers, as it makes no functional difference to the argument to do so.

That's right: for the US to cover future aging-related expenses, the budget deficit has to move no less than 16%, i.e. 1600 basis points: right now, it is expected to improve by 100 basis points (i.e. 1%) next year.

One might think that the US US is actually fairly well off, all things considered: the aging effects are fairly minimal over the next 30 years compared to countries like Japan, Germany, and even China. The problem for the US is that the aging population continues to expand, while Japan and Germany will see their aging populations shrink as their overall declining populations reduce the number of elderly significantly over time.

The effect that this has on government debt is devastating, and if left unchecked would be grounds for despair.

Why? Because the massive amounts of fiscal debt taken on in the wake of the financial crisis have brought up the day of reckoning that much closer to today. The dirty little secret of social security systems that are unfunded is that they all function today, but there is certainty that they cannot always function the same way. China will be particularly hard hit: with 4-2-1 in place (one-child policy, which results in four grandparents, two parents and one child) the Chinese will, sometime in the latter half of the 21st century, have to abandon its pension scheme for literally hundreds of millions of people, as you cannot expect tens of millions to support hundreds of millions without realizing that it doesn't make sense to work when the government takes it all away.

Hence the aftermath of the financial crisis is that it has brought structural imbalances forward into today, rather than leaving these problems to the next generation.

There are two ways of dealing with fiscal debt: becoming frugal and working at paying it off, or finding an accommodation with debt servicing that carries the debt forward in perpetuity. Fiscal restraint, as the authors of the BIS paper put it, delivers stable debt, but rarely debt reduction.

Right now, this is all fairly sustainable - here in the economic sense, of actually being a process that can be continued over very long periods of time - as long as interest rates remain low.

The problem is that the massive levels of debt acquired over the last several years is set to drive interest rates higher, rather than allowing them to remain low, setting up, effectively, the perfect storm for financial catastrophe.

It's popular to say that we are all Keynesians now, that we've all come to accept that the government sometimes needs to intervene in the economy to save us all from collapse, destruction and despair.

The problem? How to pay for it. Looking at the historical record, one thing comes out: three years after a typical banking crisis, the absolute level of public debt is around 86% higher, on average, than it was before the crisis. Countries hit hard by such crises tend to add more debt: in the current crisis, Ireland increased its debt by 98% and the UK by 111%, with the US posting an increase of 75% and Spain by 78%. These are structural increases, not cycle-related, and represent what would have otherwise been lost.

Because of these increases in debt, employment and growth will not be returning to pre-crisis levels: there is a permanent loss of potential output caused by the crisis, which will further lower government revenues and worsen the general picture.

Now, this, together with the effects of an unfunded social security system, means that long-term growth in the United States (and, of course, elsewhere with similar systems) is simply, as it is today, unsustainable.

What does unsustainable mean here?

It means that even without financial crisis, war, man-made and natural catastrophes, that at some point the economy will start to grow slower and slower because it is being choked by government spending on the aged and servicing the debt alone.

This will happen sooner, rather than later: the mere existence of the debt brings with it the seeds of doom. Right now, there is effectively a zero interest rate through most of the world, if not indeed, in real terms, negative interest rates. This is the only thing that is preventing a fairly huge sovereign debt melt-down. But the current situation is unstable: at some point, investors, those who buy the debt, will want higher returns as sovereign risks become apparent (the core risk, of course, is that a government will default on sovereign debt), which will then accelerate in a massive downward spiral for bond prices, effectively raising interest rates significantly and initiating what the Germans would call a GAU (größte anzunehmenden Unfall, aka worst conceivable accident, used by the anti-nuclear energy folks to insist that no nuclear plant can ever be safe unless it takes a core melt-down into account).

Basically, an increase of government debt by 100 basis points, empirically, results in a risk premium of between 120 and 160 basis points: this means increasing levels of government debt acts as a multiplier to any sort of upwards interest rates pressure. While central banks have, so far, avoided raising interest rates, it will become increasingly more difficult to place additional debt unless interest rates rise.

The GAU would be that sovereign debt would climb to levels that leave virtually no alternative to sustained and comprehensive defaults on sovereign debt, effectively ruining the world's bond markets and wiping out any government's ability to raise money outside of taxes. That would push the world's economy not into a severe recession, but into outright collapse.

We're talking here of unsustainable debt levels that would reach 300%, 400%, 600% and more of GDP, and not of some tin-hatted wacko dictatorship in the darkest corner of Africa, Asia or South America, but rather in the OECD countries.

That is how bad things are right now: this is not speculation, but rather go read that paper linked to above, from the Bank For International Settlements, the BIS, the central bank for central bankers.

Let's go back to what governments must do in order to get their finances in order: for the US, the average primary balance (i.e. government budget surplus), according to the BIS paper, needs to be +8% for the next five years, +4% for the next 10 years, and +2% for the next 20 years: right now, it's -7%.

That is how deep the hole is.

Now, raising taxes is one option, but, economically speaking, a poor one: taxes distort resource allocation, slowing growth, as investors act to reduce their tax burden (and yes, they are allowed to do that). Add to this the crowding-out effect of productive private capital, you can see how growth becomes slower: weakened investments, as the newest capital is always more productive than older capital, results in weaker growth.

It also ties the Keynesian hands of governments heading into the next crisis: we may have weathered this crisis, but there cupboards are bare and a hard, hard winter is coming.

Don't think this is a problem? Recent increases in risk premiums on long-term bond issues show that the markets do not consider sovereign debt to be low risk any more.

The authors of the BIS paper point out one fundamental fact: that regardless of what will be done, any program that fail to reduce future unfunded liabilities add to the problem, rather than helping solve the problem.

While the authors of the BIS paper do not offer advice how to solve the problems, I see no such constraint.

The solution is based on economic necessity and the cold, hard facts: government spending must be reduced drastically - basically eliminating all discretionary spending and instituting zero-based budgeting at a minimum in order to start generating the surpluses needed to stabilize and then slowly retire the debt - and taxes will have to go up. Government must become smaller (and hence more efficient) without any additional revenues, and the US savings rate will not only have to increase significantly - over 15% of disposable income - but will also have to be largely "invested" in US government bonds at virtually no interest (effectively giving the government a zero-interest loan), earmarked for paying off existing government debt that does generate interest.

Regardless of your political bent, this is unavoidable. Any other solution is economic folly.

Folks, the US government has dug us a huge hole that we can't otherwise get out of. I don't like this one bit, but pretending it can be otherwise is sheer folly.

Continuing to vote for those who got us into this is as much folly: any politician proposing unfunded future spending should be voted out of office and made to work for a living.

There is only one institution that is to blame: the US Congress. They are the only ones who can legally spend US government money.

There is no reason for despair: despair is a sin. But the longer the problem goes on, the worst the infestation.

Thanks to those who promised us the future, we've lost the present.

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