The Impossible Math of US Government Obligations

Who will get stiffed when the US can't pay...?

INCLUDING the promises made to old people, the US government owes $86trn – five times annual output. And US debt is increasing 21 times faster than increases in GDP, writes Daily Reckoning founder Bill Bonner.

No one knows exactly what will happen. But this much is sure: hearts will be broken. Not everyone will get what has been promised to him. It's not mathematically possible.

Who will get stiffed? In a recent Financial Times piece, Robert Jenkins argued that the US may need a bail-out from the IMF. Why?

Each percentage point rise in interest rates adds (over time) $160bn to annual debt financing. Thus a 5 per cent rate rise adds $800bn to the budget deficit and, given compounding, more than $8tn per decade to the national debt.

The second factor is that more than 45 per cent of tradable US debt is held by foreigners. The Japanese are in hock to the Japanese people. The US is in hock to – among others, the Japanese.

Third: sovereign bonds are no longer presumed to be risk-free. Indeed, there is now general awareness that at some level of financing costs, government debt becomes unsustainable.

Five years ago, posing the question: 'At what interest rate does Italy or Spain's deficit financing become untenable?' to analysts, economists or journalists would have elicited a shuffling of the feet or a shrug of the shoulders. Ask today and the quick reply will be: 'Why 7 per cent of course.' We have been educated.

Fourth: globally, there are some $20tn of funded pension assets, $60tn of professionally run assets under management and $600tn of various derivatives. The pricing of the related liabilities, expected returns and valuations is tied directly or indirectly to the yield on US Treasuries – all on the assumption that US paper represents a risk-free rate of return. Remove that assumption and we are in a financial world without gravity.

[Another] factor concerns the 'ugly sister syndrome'. Ever wonder why the Euro has been so strong against the US Dollar? That the Euro has not tanked may say more about the global search for an alternative to the Dollar than it does about confidence in Europe's determination to save the single currency.

So it is worth considering the degree to which progress on the Euro might trigger a crisis in the greenback. When the spotlight shifts from Europe, where will it light?

And yesterday's Wall Street Journal told us that the 'fiscal cliff' hasn't gone away either.

Fiscal Cliff Talks at Stalemate

The White House and congressional Republicans remained at loggerheads-in both public and private-over how to design a deficit-reduction package, with just a few weeks remaining before the nation hits the fiscal cliff.

Leading figures on both sides doubled down on their positions in interviews that aired Sunday, and they blamed each other for the current standoff, reflecting the talks that House Speaker John Boehner (R., Ohio) told "Fox News Sunday" have gone "nowhere."

Senate Minority Leader Mitch McConnell (R., Kentucky.) has said a deal could include raising the eligibility age for Medicare above 65...

The smart money is betting that the feds will make a gesture towards reducing deficits... and then spend, spend, spend. The US debt will grow, not shrink.

Then, they will try to 'inflate their way out', raising prices over a period of years rather than defaulting outright, so that most people won't know what hits them. Creditors – including millions of old people – will be confused...frustrated...and angry. They'll be poorer too. But they won't be wiser.

But hold on. Creating consumer price inflation (CPI) is harder than it looks. Sometimes prices go down faster than they go up – even when the feds are printing billions of Dollars. And sometimes, prices can shoot up a lot faster than the feds would like. So, just because the feds want moderately higher rates of consumer price inflation doesn't mean they'll get them.

But there's another problem. Federal benefits are indexed for inflation. The feds don't get as much gain as you might think – at least not from moderately higher rates of inflation. Hyperinflation, on the other hand, pays off quickly. Benefits are adjusted, but not fast enough to protect the old folks.

Bondholders can be ripped off easily too. A few percentage points of increase in the CPI and trillions of Dollars worth of US financial obligations disappear.

What will happen? Darned if we know, but it is almost sure to be thrilling.

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Bill Bonner is founder and owner of Agora Inc., one of America's largest consumer newsletter publishers. Best-selling author and globe-trotting correspondent since 1999 for the Daily Reckoning email, he is chairman of family-wealth advisory Bonner & Partners, and co-author with his son Will of Family Fortunes: How to Build Family Wealth and Hold Onto It for 100 Years (Wiley, 2012).

See full archive of Bill Bonner articles

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