The US Government’s Debt Spiral

Following on from my previous post on the impending US municipal bond crisis, I want to provide a brief overview of the debt time bomb facing the US Federal Government.

Karl Denninger at Market Ticker has provided a nice analysis of the US Treasury’s 1 February presentation to the Borrowing Advisory Committee (Hat tip Bernard Hickey for the link).

Denninger notes that the Federal Government’s debt has skyrocketed, rising almost exponentially in nominal terms since the 1980s. Here’s the chart that tells the tail:

According to the chart, the Treasury projects Federal Government debt to stabilise at around 80% of GDP by 2020.

And here’s an overall picture of US debt-to-GDP ratios (both public and private) as at early 2010, courtesy of Steve Keen:

As noted by Denninger:

Welcome to compound function hell…How many times do you think we can do this [continually increase debt]?

We hit the wall in 2007, which was why the recession happened. What makes you think we can keep borrowing and spending and not run into that wall again?

The really awful news is in here, interest payments rise according to OMB projections, from about $180 billion to over $800 billion in 2020 [see below chart].

 

No way. The budget is about $3.7 trillion.  Of that we take in about $2 trillion in taxes.  The rest is being borrowed at present.  There’s no way we can possibly put more than 20% of federal revenue toward interest, and this presumes a 3% interest rate on that debt, which is insanely optimistic after we manage to pile on another double.  If we get a “Greece” style response and rates shoot upward, well, you can forget about it.

We won’t get there folks.  It’s not possible.  The market won’t allow it and The Fed can’t control it.

According to the Treasury, around half of the Federal Government’s debt is owned by foreigners (see below chart).  And the acceleration of foreign ownership coincided with the 50% Chinese devaluation of the Yuan against the USD in early 1994 (denoted by the black vertical line).

The Chinese Government achieved this devaluation by ‘sterilising’ its trade surpluses via selling the Chinese yuan and buying USD denominated assets, including Treasury Bonds. Not surprisingly, then, China’s share of foreign Treasury holdings has risen from around 5% in 1994 to around 28% as at end-2009, in the process becoming the US’ single largest creditor (see below chart).

So does the US’ high indebtedness to China place both nations on a political and economic collision course? Denninger seems to think so.

We’re not at war.  But in the future we’re damn-near certain to wind up in one with this chart, and the bad news is that it will come about as a consequence of that foreign ownership and their reaction when the reality strikes – that we cannot pay.   

Denninger is maybe being a little melodramatic in suggesting that the US and China will end up at war over this issue. However, in being so reliant on financing from China to help promote growth and fund its budget deficits, the US is handing China considerable political leverage.    

There is also the risk that China might increasingly view the US as a bad credit risk and decide to offload a large share of its Treasury holdings, which could, other things equal, lead to a sharp depreciation of the USD and force the US to raise interest rates in order to attract capital from other investors. 

However, the likelihood of this scenario playing out is probably slim since a large sell-off by China could:

  1. decrease the value of China’s remaining dollar-denominated assets, leading to large investment losses;
  2. diminish US demand for Chinese imports, either through a rise in the value of the yuan against the USD or a reduction in US economic growth via higher interest rates; or
  3. provoke protectionist measures in the US against China.

Either way, it will be near impossible for the US to repay its debts. With its dependency ratio on the rise following the retirement of the baby boomer generation, the Federal Government is likely to get hit hard by falling taxation revenues, arising from the shrinking workforce, along with rising social security and health care spending related to the ageing population.

Instead, the Federal Reserve will likely continue to ‘print’ (issue) currency in order to monetise its debts. However, by continually increasing the money supply, inflation will ultimately rise precipitously, in turn erroding the wealth of anyone holding USD denominated assets.

Talk about being caught between a rock and a hard place.

Cheers Leith

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Leith van Onselen

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.

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Comments

  1. Business Spectator had some commentary on this earlier today — http://www.businessspectator.com.au/bs.nsf/Article/Confident-of-the-next-crash-pd20110216-E4SPC

    There are some interesting parallels between the US and Japan — although at least the Japanese have a culture of saving, with domestic investors buying up their own Government’s debt (in spite of ridiculously low interest rates) for decades. Even then, Japan’s ageing population needs to start drawing down on their savings to fund retirement, hence rising interest rates are expected to put their crippled economy out of its misery before too long.

    No doubt the same will happen in the US, albeit perhaps even sooner?!

  2. Thankyou Leith

    You have ruled out all of the conventional, responsible, predictable and logical responses to the circumstances you have described so eloquently; thus the ‘re-action’ will most likely come from the currently un-discussed. The Chinese people. The American people.

    Strikes and protests. Perhaps concerted debt nonpayment by large numbers of people. Or one of a million less likely corners.

    The catelyst(s) of change is lurking everywhere.

  3. I’m just interested to hear what Delusional Economics thinks about this, going on what he has previously posted about modern monetary systems.

  4. Goodness….the Federal deficit is merely a reflection of the state of the private economy. The deficit rises first due to automatic stabilisers, then discretionary (stimulus) spending, which has not even been sufficient to arrest the almighty unemployment problem. Just have a look at the output gap and any measure of unemployment (as one example) to get an idea of why the deficit is so large. Of course, if the government wasn’t around to plug holes in deficient aggregate demand, a very different set of outcomes would be in play right now. How you can have an external deficit and a retrenching domestic sector, then decide that the public sector has no role to play, or that reefing more spending out of the economy can be done with impunity, is beyond me. There is no differentiation between private debt and public debt, no serious examination of the topic at hand. Just a complete “F”.

    And China dump Treasuries? Please. Unless they are going to float their currency, then they are going to hold copious amounts of US currency/financial assets of one type or another, whether cash, bonds, or other. If they were really worried about the USD, they wouldn’t even hold cash.

  5. I have trouble reading the legends on your excelent graphs.

    Could you make the graphs larger (at the same resolution)?

    thankyou

    • Hi Part Time. The key with the graphs is to double-click them twice – once in the post and then again in the graph screen. They should then enlarge to a readable format. I am not sure why WordPress makes readers click on the charts twice in order to enlarge them. It’s a little annoying.

  6. Thanks Leith. I’m enjoying your blogs and I’m impressed by their quality.

    Couple of queries/comments on this one.

    One, I’d like to see you engage with the Modern Monetary Theory perspective represented in Oz by Bill Mitchell. Bill is sanguine about govts creating money, and in fact advises it when productive resources are being greatly underutilised. He doesn’t see hyperinflation as an inevitable consequence of monetisation.

    Steve Keen has pointed out that the deflationary impact of reduced credit creation currently greatly outweighs the inflationary impact of increased govt money creation. Down the road, if borrowers are already tapped out (ie just can’t take on more debt), then where is the credit-creation (and hence hyperinflationary) impulse going to come from?

    Two, I’d be amazed if the Chinese expect to be paid back in full. But they have very strong incentives to keep their currency down by buying US denominated assets including Treasuries, while at the same time making public comments aimed at making it harder for the US to devalue.

    The Chinese are effectively subsidising their exports by buying US denominated assets. I expect they will continue to pay that price for as long as the US market matters to their exporters (ie for a long time yet).

    Of course this is undermining US competitiveness. The big unknown is what is the US politically capable of doing about it.

    I suppose one response might be “let’s slap tariffs on Chinese imports.” Another might be ‘let’s bomb Chinese exporters.” Both of these run up against the fact that US corporations have a major stake in China. But anything is possible given the way politics works in the US.

  7. http://www.businessinsider.com/as-chinese-exporters-go-down-western-importers-are-ambushed-guest-post-2011-2#comments

    I think the Chinese are going to do this to themselves with inflation. Let them keep the currency low while the inflation monster goobles up their economy. I dont think there will need to be any tariffs. There are trickles of jobs coming back to the US due to higher costs and then fuel prices uncertainty. I believe jobs will start to come back in waves sooner rather than later. I also think these companies who kept there operations in the US, Australia etc will benefit from these companies who went the China route. Interesting times. I wonder if jobs are starting to trickle back to Australia from China have read anything about that.

  8. What if the Fed keeps buying back Treasury bonds from the Chinese with their money printing m/c called QE1,QE2.. QEn ?

    The Chinese can then keep on buying US treasury bonds with the newly minted paper money from the Fed.

    Some thing’s gotta give way in this ponzi scheme though 🙂

  9. Another interesting link on this topic: http://www.economist.com/economics/by-invitation/guest-contributions/america_bankrupt

    According to Laurence Kotlikoff:

    “The present value of all [the US’s] future spending (including servicing its official debt) less all its future taxes of $202 trillion—almost 14 times GDP. Greece, by comparison, has a fiscal gap of about 11 times GDP. To close the US fiscal gap would require raising all federal taxes, immediately and permanently by almost two thirds!”

    Jeebus?!!

  10. I see DE wouldn’t be drawn into commenting on this thread topic.

    I agree with the posters who have put forward the MMT position – it makes a great deal of sense to me.

    The fact that fiat monetary systems have replaced gold-standard type ones in many countries renders many of the old arguments null and void, kind of like arguing about all the things that could go wrong with the carburettor on a 2010 model holden when the fact is that 2010 model holdens no longer have carburettors – they have computer controlled fuel injection systems.

    We need to start from the point of how monetary systems actually function today, not how they used to function decades ago.

    The public almost universally accepts that a sovereign government budget functions just like a big household budget, a belief that is inherently false however sensible it may seem. Policy makers have little choice but to pander to this misconception or face rejection by the electorate.

    A widespread belief that government must always seek to return the budget to an ever-growing surplus is the biggest worry as I see it, since the electorate do not understand that if they now collectively wish to be in surplus, the government budget must be in deficit as a matter of accounting. The political need to be seen to “fix” the deficit, regardless of why the budget might be in deficit is likely the biggest risk to economies and jobs.

  11. see ‘the 7 deadly innocent frauds of economic policy’ at

    http://www.moslereconomics.com/?p=8662/

    In a nutshell, the US govt pays back tsy secs at maturity by debiting securities account balances at the fed (that’s all tsy secs are) and crediting reserve account balances at the fed. it does this every week for the ten’s of billions continuously maturing. no grandchildren’s checks are involved.