The Problem with Debt

The economy is recovering. The areas that seem to show the most life are those sectors that have had sufficient debt relief so as to be able to move forward. The big banks are moving out in a very robust fashion, just how robust we will begin to hear this week. The auto industry seems to be moving ahead, albeit a little more slowly than the big banks. And, there are other areas that show signs of moving forward, the health industry and firms in the information technology industry.

The big cloud hanging over all of this is the debt that still is outstanding in many sectors of the economy. The problem with debt is that it just won’t go away. Regardless of any adjustments made to who owes what to whom, if there is debt outstanding, someone has to pay for it in some fashion.

The big banks were saved, but who picked up the tab for the bailout? The taxpayer did, or, at least the taxpayer has footed the bill pending a potential Obama tax on the banks to “recover” some of the bailout monies.

Who saved the auto industry and subsequently holds the IOU for the rescue? A large part of the financial restructuring came at the expense of those that had provided credit or equity funds to the car companies. And, the federal government also paid a share.

If homeowners got relief from their mortgage and consumer debt, who would pay the bill? Shareholders of the bank, holders of mortgage-backed securities, and the federal government. (You might check out this little piece by Peter Eavis in today’s Wall Street Journal: http://online.wsj.com/article/SB20001424052748704081704574652660161217386.html#mod=todays_us_money_and_investing.)

And, what about the debt that is related to commercial real estate lending? Shareholders of banks, holders of commercial mortgage vehicles, and the federal government.

Then we move to the financial problems of the states. Recent information points to the fact that 36 states in the United States are having financial problems and these could lead to deficits in the state budgets of around $350 billion this year and next. Where is the money going to come to pay for these shortfalls? States have already attempted to sell off properties, outsource functions to the private sector, and even turn some things over to the federal government.

Part of the problem here is that the tax base in most states has collapsed as unemployment and under-employment have risen, as property values have fallen, and as business earnings have collapsed. Rating agencies have begun to lower credit ratings on some states. The best guess is that ratings will drop on many other states before the year is over.

And, what about local and municipal governments? Same problems.

And, then, what about the federal government? Without totaling up the bill for the problems mentioned above, let alone the escalation of wars here and there all over the world, health care reform, and some kind of energy bill, many expect federal deficits over the next ten years to total $15 to $18 trillion!

Who is going to purchase all or almost all of this debt? China?

What I find scary is that our “friends” are voicing concern in different ways. For example, the Financial Times this morning carries the opinion piece of Gideon Rachman titled “Bankruptcy Could Be Good for America”: http://www.ft.com/cms/s/0/a8486284-fee9-11de-a677-00144feab49a.html. The point Rachman makes is that the Brics, Brazil, Russia, India, and China all went through economic reform before they “broke out” into their current ascendency. Brazil’s reform came in the 1990s, Russia defaulted in the late 1990s, India embraced economic reform in 1991, and China moved to a new mindset in the early 1990s. “Those much discussed emerging powers, the Brics, all needed a fiscal crisis to set them on the road to economic reform and national resurgence. America may one day be lucky enough to experience its very own national fiscal crisis.”

Even if we print money to pay for the federal debt, as the Federal Reserve has done over the last year or so, (the monetary base rose 23% from December 2008 to December 2009, and rose by 101% over the previous 12 months) someone, somewhere will pay this debt in terms of a reduction in purchasing power.

Need I mention that since January 1961 the purchasing power of one dollar has dropped to roughly $0.15. Inflating the United States government out of its debts has a long, post-World War II history.

Might this process of “printing money” continue?

Seems like a lot of people believe that it will. For one there is the problem of rising long term interest rates. More and more worry is being expressed about the expected increases. Why? Well most analysts believe that the Federal Reserve has helped to keep long term interest rates lower than they would have been in order to provide liquidity to the financial markets and to support the mortgage market. On January 6, 2010, the Fed held on their balance sheet $777 billion in U. S. Treasury securities, $160 billion in Federal Agency debt securities, and $909 billion in Mortgage-backed securities.

This totals $1.846 trillion in securities held by the central bank! The concern is that in the last week of August, 2008, the Fed had provided only $741 billion in funds to the banking system through some kind of market or auction based transaction.

How much affect these purchases have had on keeping long term interest rates lower than they would have been is currently being debated. What is not in question is that, sooner or later, interest rates are going to begin to rise, first because the Fed’s artificial support will be removed, but rates will rise as the economy begins to improve, further pressure will be put on rates as issuers of bonds race to place debt before the rise takes place (See “Rate Rise Fears Spark Rush to Issue Bonds: http://www.ft.com/cms/s/0/6f46f226-fef2-11de-a677-00144feab49a.html), and as inflationary expectations are incorporated into bond yields.

How fast will the Fed allow interest rates to rise because rising interest rates will slow down economic recovery. Also, the Fed has created another problem by keeping short term interest rates so low. Not only have these low rates created arbitrage possibilities for domestic investment, borrow short term money in the 35 to 65 basis point range and invest in 10-year government bonds at 3.50% to 3.80% but also for the international carry trade. It is argued that the Fed cannot allow rates to go up too fast or big financial institutions and other investors will get trapped in losses that will not help the economic recovery.

The point of all this discussion is that any “exit” strategy that the Fed is planning to reduce the securities held on its balance sheet from current levels to even a level of $1.0 trillion, let alone the $741 billion mentioned above, is already in jeopardy. And, many are arguing that in the face of such overwhelming future deficits, the Fed will be forced to print even more money than it has over the last 17 months.

The problem with debt is that debt, once issued, really does not go away. Someone has to pay for it!