The Lit Fuse

So far in this series we’ve established that the United States government is spending a lot more than it gets in revenue. Because of this excess spending, it has borrowed a lot of money. Our government has also promised to pay for certain programs for which it has not set aside money to fund. If things continue on this way, sooner or later the government will be insolvent. What exactly does this mean for our government?

Up until now we’ve been scaling our numbers to create the fictitious example of Joe — a worker who makes $25,000, spends $35,000, has $200,000 in debt, $1 million in unfunded liabilities, and has other financial pressures. Any reasonable person would agree that Joe is already very far down the road to disaster. He will default on his debt, his credit will get shut off, he won’t be able to pay his liabilities, and he’ll most likely end up declaring bankruptcy. Some of his assets will be taken and sold, and without much access to credit he’ll be forced to live within his means all at once. Joe’s comfortable life is about to come crashing down, and his parents are in some serious trouble, since Joe had promised to help support them.

While all of this and more would happen to Joe, this is where our Joe example stops working. The federal government has powers that a private citizen such as Joe does not have, including the power to print more money. With those powers the Federal government can avoid defaulting on its debts — if it chooses to.

The US Constitution gives Congress control over how much money the Federal government can borrow. The limit Congress sets is called the debt ceiling. Since the government owes so much money, each year, when the debt ceiling needs to be raised to avoid default, there is an increasing resistance to doing so. If that resistance gets high enough, and Congress does not agree to raise the debt ceiling, the federal government will be left without enough money available to pay its bills. Even if that did occur, the government could work around that problem in various ways. For example, there has been talk recently of the executive branch having the US Treasury mint platinum $1 trillion dollar coins and then borrowing against their alleged value, to work around any failure of Congress to raise the debt ceiling.

What would happen if the US government chose to default on its debts? If both the legislative and executive branches refused to authorize an increase in money so that there wasn’t enough available, a default could theoretically happen.

The government’s credit rating would be hit hard. Access to additional credit from foreign sources would be reduced dramatically and the cost – meaning interest rates – of borrowing would increase. Foreign investment would also be hit hard, as this willful default would be viewed as a dangerous instability; our government would be viewed as broken. Someone, likely the President, would need to decide what to do with the money we did have, meaning who or what would be paid and who or what wouldn’t be paid. Many government workers could be sent on furloughs – effectively, unpaid vacations. National parks could be closed, some government offices might close for business, and non-essential services could be suspended. There are many arguments that other serious negative consequences would ensue, even if the default was short-lived.

The fallout on the state and local level would be particularly damaging. With the federal government’s credit rating in disarray, and without money to spare, little to no assistance from the federal level would be available. As a group, state and local governments are spending more than they get in revenue, just as the federal government is. Unlike the feds, they cannot print their own money. To borrow, they must rely on money actually being lent, mostly in the form of government bonds – essentially, IOUs that promise to pay back a certain amount at a certain date. Bonds are investments purchased by individuals, companies, and foreign governments. With any investment, there is the risk of default. The less financially solid a bond-issuing entity seems, the more they must offer to pay back in order to make a bond purchase worth the risk. If the risk is viewed as high enough, no one would purchase their bonds at any price.

Imagine what would happen to a local government whose budget was suddenly reduced significantly. Where would they cut? Communities spend most of their money on their schools, public safety such as police and fire, public works including roads, and the salaries and pensions of municipal workers. Schools are already stretched thin in many places, with old textbooks and aged buildings in need to repair. Police in most cities and towns can barely handle the level of crime in existence today, never mind the increases we’ll see if things get worse. Roads and bridges are decaying at an alarming rate already. Salaries and pensions can’t legally be cut in most cases, but in any event cuts to any of these programs would hit hard.

It is unlikely that the US government would allow a default, causing those bad things to happen. Instead, the alternative to default is for the federal government to continue to monetize its debt. Monetizing means that they can print more money, or perform actions that are essentially the same as printing more money. When a debt comes due, they can just claim they borrowed this newly printed money, and pay the debt with it. This is what they do today, and it is very likely this is what they will continue to do, despite all of the arguments against raising the debt ceiling. Because of all the disastrous effects that would come in the short term, politicians may talk tough about our debt but in the end, either they will raise the debt ceiling or some other action such as minting allegedly valuable coins will take place.

The United States will become insolvent, and little notice will be taken of it. In fact, many people will argue and disagree, saying that the United States is not insolvent, regardless of how much financial and numeric proof is given that we are.

If so few will notice, why should anyone care? Because the financial misconduct of monetizing debt has far more devastating long term effects. Each time more money is printed, the currency is diluted: existing dollars such as the ones you hold in your savings account drop in value. It’s a lot like a company issuing new stock shares without raising the value of the company – existing shares drop in value because the total worth of all the shares is the same before and after the new shares are issued. The difference is that this is far less obvious when our government does it, especially since they have so many different ways of doing it, each with their own name. You will find many that argue, for example, that “quantitative easing is non-inflationary”, even though it absolutely is, because we haven’t felt the effects yet.

Countries that continue to monetize their debt on a large scale have always ended up with a currency crisis. As the value of a currency becomes more and more diluted, no one wants to hold on to it. Governments, people, and businesses holding the currency sell or exchange it, or purchase things with it, to get rid of it. This significantly increases inflation, and as it increases, more and more currency is dumped. When the currency drops enough, or inflation rises high enough, everyone gets rid of the currency at once. Runs on banks collapse the banking system and hyperinflation sets in.

While defaulting on our debt would be bad, hyperinflation is far worse. Imagine inflation of 100% a year. After just 2 years, your savings would be reduced in value by 75%. Now imagine inflation of 100% a day – the same thing would occur in only two days. Hyperinflation is a complex subject, and will be covered in a later series of posts, but in history the damage from it has been horrific. The collapse of a country’s currency is true national insolvency.

Those who are trying to point out that we are headed for a currency crisis are often ridiculed as if they were “Chicken Little” misinterpreting the data and being alarmist. There is a bizarre lack of general agreement about the government’s spending and revenue patterns that can only be a form of cognitive dissonance*. Propaganda is being written to soothe our fears and get us to continue on the same way as we are now that many are choosing to believe. We can’t even rely on our government to tell us the truth. For example, the federal government calculates an inflation rate that excludes the things that are rising in price the most, calling them “volatile”. This means that the inflation rate they publish is much lower than the real inflation rate – they are hiding the real inflation rate from us. 
* Cognitive dissonance is the name given to the process the human mind goes through in manipulating its own beliefs when presented with conflicting (dissonant) beliefs, such as information that requires an unpleasant change in behavior.

It isn’t enough to watch the debt and deficit if the federal government is going to print more money to avoid default. We need to watch the new money being created in so many sneaky ways, and the real inflation rate that results.

In our previous posts in this series, we’ve established that the United States government is spending about $1 trillion more than they get in revenues, has accumulated somewhere around $20 trillion in debt of various kinds, and has unfunded liabilities so high that they would need perhaps as much as $100 trillion in the bank right now to cover the future expense.

Why is this debt a serious problem?

It is a problem for the same reason that high personal debt is a problem. Debt has to be repaid, and while it is being repaid, it has to be serviced – meaning, the interest has to be paid. The higher the debt goes, the higher the cost to service it goes, and the higher the cost to repay it goes.

How much interest did the US government pay on its debt in 2012? Close to $360 billion, according to the US treasury. Let’s go back to our fictional example of Joe, who makes $25,000 a year, spends $35,000 a year, owes $200,000 in borrowed money, and needs $1 million in the bank to keep his promise to his parents to support their retirement. The government’s debt interest scaled to Joe’s world represents a payment of $3,600 a year, or about 14% of what Joe makes in a year. While this doesn’t sound too bad, it’s only this low a payment because Joe has borrowed his money at a very low interest rate: from 1% to 2.5% depending on the lender. Also, Joe is paying interest only and not paying any principal, so the debt is only being serviced and not repaid. To approximate Joe’s $3,600 a year in payments, we’d use a blended interest rate of 1.8%: $200,000 times 1.8% is $3,600.

Credit in the world is a limited commodity, at least until governments start printing fiat currency*. What happens to any limited commodity as it is bought up? It gets more expensive. In addition, as the fiscal weakness of the United States becomes more and more obvious, lenders see the increased risk, so the cost of credit rises. The cost of credit is expressed in its terms, which usually means the interest rate. Let’s say Joe goes on another five years without changing his ways. At the start he’s spending $10,000 a year more than he makes, and now, his parents’ expenses add somewhere around $13,333 a year. He has to service the debt as it rises, so his deficit rises and debt grows from $200,000 to $340,000. The extra $140,000 would have made his annual debt payment grow to $6,120 if he had been able to borrow at the original interest rates, but Joe’s creditors are getting wary of his debt and income level, and have now raised his rates to 3.6% on the newly borrowed funds – still a fairly low rate, but now, Joe’s annual debt service costs him $8,640. This is 2.4 times what it used to cost, and raises his annual spending from $35,000 to about $40,000 a year. His debt service has gone from about 14% of what he makes to more than 34%. If Joe continues on in this way, eventually the cost of servicing his debt will be higher than what he makes. While Joe might succeed using tricks such as borrowing more money to pay the existing debt’s interest, eventually he will become insolvent by defaulting on his debt service. 
* Fiat currency means the government pays their bills by printing up new money that isn’t backed by anything. Printing fiat currency in large amounts causes existing money to lose value, triggers severe inflation, and often causes a currency crisis. This will be covered in a later post.

Now let’s look at the option of Joe attempting to repay his debt before this happens. What might Joe do, given his $10,000 overspending, $200,000 in debt at 1.8% annual interest, and $1 million in unfunded liabilities which averages about $13,333 a year in additional spending?

• Joe would immediately have to lower all his spending so that it did not total more than he makes, meaning his deficit would have to go to zero.
• If Joe were to attempt to repay his debt over 30 years, like a standard mortgage, it would take $8,632 a year in both interest and principal — much more than the $3,600 he’s paying now.
• Joe is still committed to paying his parents’ retirement bills, which is projected to require $13,333 a year.
• To cover just the obligations of his debt payment and unfunded liabilities, Joe would have to spend $21,965 a year – leaving Joe with just $3,035 a year, or about $250 a month to pay all of his own bills.
• Currently, Joe is spending about $31,400 a year on his own bills — $35,000 minus the $3,600 debt service.

So, to maintain the same life he had, and meet all of his obligations, Joe would need to increase his income from $25,000 a year to $53,365 – more than double what he makes now. Since this is unlikely to be possible, he’s going to have to figure out some combination increasing income, not meeting on his obligations, and/or extreme cost-cutting in his lifestyle to make the numbers work. Worst of all, this is the picture now. If Joe goes on 5 years and owes $340,000 instead of $200,000, with a higher blended interest rate, the picture is far more bleak. The annual payment on the additional $140,000 at 3.6% would be $7,638 – meaning just to make his debt payment and obligations would cost Joe $29,603 a year, more than he makes without even spending a penny on his rent or other bills.

If we scale all of these numbers up to our government’s revenue, spending, and debt, it means that just like with Joe’s income, taxes on individuals and businesses would have to more than double for the government to have the revenue they would need to pay off our debt in 30 years and meet their obligations – except that history has shown that raising tax rates does not significantly raise the amount of taxes collected*. So there would have to be some combination of tax increases, spending cuts, and/or lowering of the cost of obligations like Social Security and Medicare would be required – often referred to as austerity measures — and again, worst of all, this would have to happen right now. Every day we don’t do these things means we accumulate up more debt, and the choices become more and more painful. 
See "Hauser’s Law" reference in post on Progressive Taxation for more information.

If our government gets into debt deeply enough, just as with Joe and his fictional financial woes, insolvency will become unavoidable. I believe it already is unavoidable.

In the next post we will examine the possible effects of government insolvency.