Financing Massive deficits. Also, John Mauld

Author: David Kotok, Post Date: July 12, 2009

John Mauldin has put together a thought-provoking piece on the growing global debt burden and how it must be financed.  In five minutes you can read the entire essay, graphs included. 

Find it on Barry Ritholtz’s website: .    Also, it’s found at, where you can sign up for a free subscription to John’s weekly Thoughts from the Frontline and Outside the Box e-letters.

First excerpt: “Over the last ten years, the government (Japan) has seen the level of debt-to-GDP rise from 99% to over 170%, not including local governments. They ran those deficits to try and pull themselves out of the doldrums of their Lost Decade of the ’90s, following the crash of their real estate and stock markets, starting in 1989. They built bridges and roads to nowhere, all sorts of programs, quantitative easing, etc. Sound familiar?”

Second excerpt: “The government kept borrowing, and rates stayed in the area of 1%. Today, a ten-year bond yields 1.3% in Japan, so they could run up a very large debt and the interest-rate cost was not a big factor in the budget.”

Third excerpt: “Interest-rate expense is now about 18% of the Japanese government budget. What if rates went to a lofty 2%? That would over time double the interest-rate expense. And the Japanese are borrowing between 30-40% of their annual budget.”

John segues to the US: “The graph shows the US will need to issue $3 trillion in debt. ‘Wait,’ I asked, “I thought it was only 1.85.’  The answer is that the number has grown to almost $2 trillion. Then you need to add in off-budget items like TARP, state and municipal debt, etc. Pretty soon it adds up to another trillion.”

Readers may see the rest of the details about the global need for savings in order to finance the sovereign borrowing.  We congratulate John Mauldin, who put together a straightforward depiction of the issues.

We will add a few comments about the United States.  For about a half-century our federal deficits ranged between 0% and 4% of GDP.  Our economy grew; thus, we have been able to handle the rising interest burden.  Over the last thirty years, nominal interest rates declined as inflation expectations were reduced.  Lower interest rates meant ease of financing for new borrowings and of refinancing maturing government debt.  Meanwhile, state and local governments operated with balanced budgets.

The Bush deficits broke this pattern.  The Obama deficits have sent this curve into a parabolic form.  Meanwhile, state and local budgets are deteriorating rapidly, and mayors and governors are clamoring for federal aid.  They are succeeding and many new programs are structured to be an indirect form of federal assistance to the states and to local governments.  At Cumberland, we do not expect states to default.  Instead the Obama Administration is advancing a larger governmental structure.  That also means states will be raising taxes and not reducing programs.

So the United States will combine its on-budget borrowing with its off-budget borrowing and access the global credit markets for an estimated $3 trillion, according to Mauldin.  Cumberland’s estimate is a few hundred billion smaller, but the exact number is not relevant to this analysis.  Fact: We are in uncharted waters on governmental debt issuance for a large economy that is hugely financing its consumption during a peacetime period.

The US will be able to succeed with this financing, because the world is in an economic slowdown and private-sector demand for credit is tepid.  And because savings rates around the world are rising as households and firms borrow less and spend less and hence provide marginal-money balances that can be used to buy this debt.  Also because the world’s central banks have taken short-term interest rates to or near zero.

This is the benign period of the debt explosion.  We enjoy a “free lunch” by consuming now and dealing with the debt later.  Once the economy levels out and resumes an upward path, the chickens come home to roost with a vengeance. 

Then the result is either a much higher level of taxation to restore budgets to some balance, or a monetary policy that allows inflation to cheapen the “real” burden of the debt.  Or it is a repudiation of the debt burden, with all the consequences ensuing therefrom.  As Joe Mason reminds us in a recent essay, states did default in the early part of the 19th century.  Sovereigns also default and repudiate; witness Argentina a few years ago and Ecuador recently.  Taxation, inflation, repudiation or variations of them — that is what happens when debt gets out of control.

But will the US follow this path?  Not likely in the near term.  More likely the adjustment will come in the value of the US dollar relative to the other major currencies.  Some food for thought: The total government debt burden being financed in the current year in the Eurozone, in relation to its GDP, is about one-third of that in the US.  The European Central Bank has an inflation target, a clear policy, a transparent process, and its central bank status is protected by a treaty.  We have written several times about the risk to the US central bank that is being debated in Congress, in the form of changing the Fed’s role and decision-making construction.  

Longer-term strategy at Cumberland is oriented toward a weaker US dollar.  We must not be misled by short-term swings in relative dollar strength when market volatility rises and there is a temporary trading-based flight to quality.  We saw that in the last three weeks.  The dollar strengthens and the Treasuries market rallies (prices rise and yields fall).  Barclay’s David Woo has done some excellent work on dissecting this trading phenomenon out of the longer-term trend in foreign-exchange rates.  See our website for references, .

Massive structural change is occurring in global government finance.  Central banks are in uncharted areas of policy making.  Look for the changes to reflect first-hand and violently in currency relationships.

In the Cumberland Global Multi Asset Class model, the US now is a minority position.  The fixed-income portfolios are biased toward taxable and tax-free municipal bonds of high quality and issued by state and local governments, with backing by general-obligation pledges or liens on essential-service revenues.  Sometimes the revenue bond is a superior structure to the G.O.  We have sold Treasuries and are taking advantage of the spread areas in fixed income.

Meanwhile, the heavier lifting with financing the Obama deficits will unfold in the second half of this year.  Stay tuned.

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