We have $16 trillion in debt. Looked at more closely, however, it's more like $76 trillion, including unfunded entitlement promises like Social Security, Medicare and Medicaid. What this means for our nation's future well being is the question we'll address herein.
As we begin the discussion, we'll look to what Bill Gross, perhaps the world's biggest, wisest, most outspoken and best known bond manager, has to say about what must be done and how soon, too.
Gross has just published a timely and penetrating analysis of our fiscal problems and the big steps that must be taken to successfully address them and get our financial house back in order. It won't be easy.
To make a long story short, Gross reasons that we need to raise tax receipts and cut government spending from current levels by an average of $1.6 trillion each year. That's at least four times more than anything being discussed by our politicians today and $1.6 trillion compared to $400 billion makes it a completely different ball game.
So let's see what he has to say in the current Pimco Investment Outlook:
- The U.S. has federal debt/GDP less than 100%, Aaa/AA+ credit ratings, and the benefit of being the world’s reserve currency.
- Studies by the CBO, IMF and BIS (when averaged) suggest that we need to cut spending or raise taxes by 11% of GDP and rather quickly over the next five to 10 years.
- Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow, and the dollar would inevitably decline. . . .
The ring of fire
In last month’s Investment Outlook I promised to write about damage of a financial kind – the potential debt peril – the long-term fiscal cliff that waits in the shadows of a New Normal U.S. economy which many claim is not doing that badly. After all, despite approaching the edge of 2012’s fiscal cliff with our 8% of GDP deficit, the U.S. is still considered the world’s “cleanest dirty shirt.” It has federal debt/GDP less than 100%, Aaa/AA+ credit ratings, and the benefit of being the world’s reserve currency – which means that most global financial transactions are denominated in dollars and that our interest rates are structurally lower than other Aaa countries because of it. We have world-class universities, a still relatively mobile labor force and apparently remain the beacon of technology – just witness the never-ending saga of Microsoft, Google and now Apple. Obviously there are concerns, especially during election years, but are we still not sitting in the global economy’s catbird seat? How could the U.S. still not be the first destination of global capital in search of safe (although historically low) prospective returns?
Well, Armageddon is not around the corner. I don’t believe in the imminent demise of the U.S. economy and its financial markets. But I’m afraid for them. Apparently so are many others, among them the IMF (International Monetary Fund), the CBO (Congressional Budget Office) and the BIS (Bank of International Settlements). I hold on my lap as I write this September afternoon the recently published annual reports for each of these authoritative and mainly non-political organizations which describe the financial balance sheets and prospective budgets of a plethora of developed and developing nations. The CBO of course is perhaps closest to our domestic ground in heralding the possibility of a fiscal train wreck over the next decade, but the IMF and BIS are no amateur oracles – they lend money and monitor financial transactions in the trillions. When all of them speak, we should listen and in the latest year they’re all speaking in unison. What they’re saying is that when it comes to debt and to the prospects for future debt, the U.S. is no “clean dirty shirt.” The U.S., in fact, is a serial offender, an addict whose habit extends beyond weed or cocaine and who frequently pleasures itself with budgetary crystal meth. Uncle Sam’s habit, say these respected agencies, will be a hard (and dangerous) one to break.
What standards or guidelines do their reports use and how best to explain them? Well, the three of them all try to compute what is called a “fiscal gap,” a deficit that must be closed either with spending cuts, tax hikes or a combination of both which keeps a country’s debt/GDP ratio under control. The fiscal gap differs from the “deficit” in that it includes future estimated entitlements such as Social Security, Medicare and Medicaid which may not show up in current expenditures. Each of the three reports target different debt/GDP ratios over varying periods of time and each has different assumptions as to a country’s real growth rate and real interest rate in future years. A reader can get confused trying to conflate the three of them into a homogeneous “fiscal gap” number. The important thing, though, from the standpoint of assessing the fiscal “damage” and a country’s relative addiction, is to view the U.S. in comparison to other countries, to view its apparently clean dirty shirt in the absence of its reserve currency status and its current financial advantages, and to point to a more distant future 10-20 years down the road at which time its debt addiction may be life, or certainly debt, threatening.
I’ve compiled all three studies into a picture chart perhaps familiar to many Investment Outlook readers. Several years ago I compared and contrasted countries from the standpoint of PIMCO’s “Ring of Fire.” It was a well-received Outlook if only because of the red flames and a reference to an old Johnny Cash song – “I fell into a burning ring of fire –I went down, down, down and the flames went higher.” Melodramatic, of course, but instructive nonetheless – perhaps prophetic. What the updated IMF, CBO and BIS “Ring” concludes is that the U.S. balance sheet, its deficit (y-axis) and its “fiscal gap” (x-axis), is in flames and that its fire department is apparently asleep at the station house.
To keep our debt/GDP ratio below the metaphorical combustion point of 212 degrees Fahrenheit, these studies (when averaged) suggest that we need to cut spending or raise taxes by 11% of GDP and rather quickly over the next five to 10 years. An 11% “fiscal gap” in terms of today’s economy speaks to a combination of spending cuts and taxes of $1.6 trillion per year! To put that into perspective, CBO has calculated that the expiration of the Bush tax cuts and other provisions would only reduce the deficit by a little more than $200 billion. As well, the failed attempt at a budget compromise by Congress and the President – the so-called Super Committee “Grand Bargain”– was a $4 trillion battle plan over 10 years worth $400 billion a year. These studies, and the updated chart “Ring of Fire – Part 2!” suggests close to four times that amount in order to douse the inferno.
And to draw, dear reader, what I think are critical relative comparisons, look at who’s in that ring of fire alongside the U.S. There’s Japan, Greece, the U.K., Spain and France, sort of a rogues’ gallery of debtors. Look as well at which countries have their budgets and fiscal gaps under relative control – Canada, Italy, Brazil, Mexico, China and a host of other developing (many not shown) as opposed to developed countries. As a rule of thumb, developing countries have less debt and more underdeveloped financial systems. The U.S. and its fellow serial abusers have been inhaling debt’s methamphetamine crystals for some time now, and kicking the habit looks incredibly difficult.
As one of the “Ring” leaders, America’s abusive tendencies can be described in more ways than an 11% fiscal gap and a $1.6 trillion current dollar hole which needs to be filled. It’s well publicized that the U.S. has $16 trillion of outstanding debt, but its future liabilities in terms of Social Security, Medicare, and Medicaid are less tangible and therefore more difficult to comprehend. Suppose, though, that when paying payroll or income taxes for any of the above benefits, American citizens were issued a bond that they could cash in when required to pay those future bills. The bond would be worth more than the taxes paid because the benefits are increasing faster than inflation. The fact is that those bonds today would total nearly $60 trillion, a disparity that is four times our publicized number of outstanding debt. We owe, in other words, not only $16 trillion in outstanding, Treasury bonds and bills, but $60 trillion more. In my example, it just so happens that the $60 trillion comes not in the form of promises to pay bonds or bills at maturity, but the present value of future Social Security benefits, Medicaid expenses and expected costs for Medicare. Altogether, that’s a whopping total of 500% of GDP, dear reader, and I’m not making it up. Kindly consult the IMF and the CBO for verification. Kindly wonder, as well, how we’re going to get out of this mess.
So I posed the question earlier: How can the U.S. not be considered the first destination of global capital in search of safe (although historically low) returns? Easy answer: It will not be if we continue down the current road and don’t address our “fiscal gap.” IF we continue to close our eyes to existing 8% of GDP deficits, which when including Social Security, Medicaid and Medicare liabilities compose an average estimated 11% annual “fiscal gap,” then we will begin to resemble Greece before the turn of the next decade. Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow and the dollar would inevitably decline. Bonds would be burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive within the “Ring of Fire.”
If that be the case, the U.S. would no longer be in the catbird’s seat of global finance and there would be damage aplenty, not just to the U.S. but to the global financial system itself, a system which for 40 years has depended on the U.S. economy as the world’s consummate consumer and the dollar as the global medium of exchange. If the fiscal gap isn’t closed even ever so gradually over the next few years, then rating services, dollar reserve holding nations and bond managers embarrassed into being reborn as vigilantes may together force a resolution that ends in tears. It would be a scenario for the storybooks, that’s for sure, but one which in this instance, investors would want to forget. The damage would likely be beyond repair.
William H. Gross
SUMMARY FOLLOWS ON SAME SUBJECT
If that's too much to contemplate in depth and all at once, the article Bill Gross: Bonds Could Be 'Burned to a Crisp' sets forth his sobering views in a slightly different manner:
"Bill Gross, the manager of the world's biggest bond fund, warned that bonds could be "burned to a crisp" if the U.S. doesn't tackle its debt problems, even as his fund took in $2.8 billion in new cash last month. . . .
In his October investment outlook, also released Tuesday, Mr. Gross, the founder and co-chief investment officer at Pacific Investment Management Co. unleashed another stern warning on how the U.S. fiscal woes may dethrone Treasury bonds' status as the world's go-to safe haven, and the dollar's role as the world's premier reserve currency. Mr. Gross has argued over the past months that the growing share of U.S. public debt in the economic output is worrisome and that the U.S. will struggle to kick its debt habit.
"If the fiscal gap isn't closed even ever so gradually over the next few years, then rating services, dollar reserve-holding nations and bond managers embarrassed into being reborn as vigilantes may together force a resolution that ends in tears," he said in the report. . . .
Analysts say the U.S. needs to find a balance between boosting growth in the short term and cutting spending that could hurt the economy in the short term but boost its longer-term fiscal health.
Without efforts to shrink the rising ratio of debt to gross domestic product, the Federal Reserve would print more money, which could lead to inflation that hurt values of both the dollar and longer-dated Treasury bonds, he said.
"Bonds would be burned to a crisp and stocks would certainly be singed," he added. "Only gold and real assets would thrive in the 'ring of fire'."
We continuously are hearing about the fiscal cliff. Now Bill Gross has introduced us to what he labels as the fiscal gap.
What this does in simple terms is include the impact of making required contributions to fund our entitlement promises so we'll be able to pay Social Security, Medicare and Medicaid benefits in the future. In other words, if we based our financial projections on all of our very real obligations, instead of just the officially recognized $16 trillion, our indebtedness would increase by another $60 trillion. As a result of that truth telling, our government's annual funding obligations would be dramatically higher than acknowledged today.
In sum, our national debt issues are enormous and much worse than most of We the People believe them to be. As a result of a lack of public pressure from a relatively uninformed citizenry, Gross believes that our politicians may not have the necessary courage to develop and implement a credible plan for dealing with these issues effectively in the near future. He's right about that!
And should that be the case, disaster awaits We the People. But even should that not be the case, higher tax receipts, reduced entitlements and ACTUAL REAL WORLD reduced government spending will be required to right the ship.
As I see it, private sector led economic growth is an absolute necessity if we are to arrive at a genuinely viable solution to our nation's financial problems.
Although what Gross has to say about the U.S. "fiscal gap" is not happy reading, it's worthwhile reading for all Americans.
What he says is absolutely true but not something we're likely to hear much about anytime soon from the "leadership" of either political party.