Monday, October 19, 2009

Retiring to a Banana Republic, without leaving home

The figures, [NH Senator Judd] Gregg told [CNN's John] King, “mean we’re basically on the path to a banana-republic-type of financial situation in this country. And you just can’t do that. You can’t keep running these [federal] programs out [into the future] and not paying for them. And you can’t keep throwing debt on top of debt.” CNN

Retiring to a tropical paradise is a very common aspiration. Who knew all Americans of all income levels would get a chance to do so- if one considers a Banana Republic a tropical paradise.

What does Senator Gregg mean by the phrase "banana republic"? He is referring to the stereotype of a tropical country that borrows so much money it eventually finds its interest expense exceeds its receipts. Once that point is reached, no amount of primary (non-interest) budget restraint can fix the problem and default becomes the only option.

So long, however, as the US$, as currently defined, remains the world's reserve currency of choice the US cannot default in the classical sense. As Alan Greenspan noted a few years ago, We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power.

Of course, the world has increasingly been looking to shift away from the US$ as world's reserve currency- the exorbitant privilege, to which Greenspan refers, is being revoked- thus the US may indeed risk a classical default.

That day, however, has not yet arrived, but it seems to be rapidly approaching. According to the FY2009 report, Federal Interest expenses came to $383B (admittedly higher than any annual deficit prior to 2004) which compares to receipts of $2,105B. On the surface, it seems the US has a lot of wriggle room.

Underneath the surface, however, the wriggle room is rapidly shrinking.

1) The interest charges on the rapidly growing stock of debt are at historically low levels. In the event the US$ needed to be supported by a substantial increase in interest rates (the, thus far, only sure fire method of putting a floor under a currency), particularly given the short duration of the debt stock, it wouldn't be long before interest charges alone exceeded the $1,000B level, assuming no increase in the debt.

2) The debt, however, is not projected to remain stable. Rather, it is projected (by some) to rise by $1,000B per year for the next 10 years. Given the current stock of Federal Public Debt of $7,530B, a $10,000B increase at 12.5% interest would lead to interest charges in excess of last year's receipts. Admittedly, receipts might rise as well over the decade, but we might also find that the 12.5% interest might be too low. Alternatively, especially if economic policy retains its multi-decade "trickle-down" approach of financial system support to pull the real economy behind, receipts might continue their current decline (FY2009 receipts were $400B less than those of FY2007). The higher unemployment becomes, the higher the deficit will be, particularly given the aging demographics of the US population.  Gotta love multi-variable analysis.

Of course, long before the classic banana republic type default point is reached, cleverer people than I would have run their spreadsheets (as I have) and stopped buying new debt (unless the price was right, a much higher interest rate). Budget constraints, thanks to the large and growing stock of external debt, would be imposed from without and the painful choices, long pushed into the future would need to be addressed.

The question is one of wriggle room. Currently, low interest charges create the illusion that the US can continue to run trillion $ deficits for years. Yet, the US$, as I argued in yesterday's The Fed vs. Gold, is no longer nearly as good as gold. In the not too distant future the Fed will need to defend the value of the $. This rise in interest rates will, other things equal, further hinder the real sector, and, far more ominously, as I argued in From Black-Scholes to Black Holes, push the big banks closer to insolvency.

The time is soon approaching for the government to prioritize its goals. It seems clear to me that the US cannot wage wars, honor its commitments to its population, and support the speculative elements in its financial system from default, all at the same time. Choices need to be made or Senator Gregg will be correct.

Full Disclosure: Long Gold and Silver