What happens when we borrow trillions to pay interest?
Will T-bills become Risky?
by Fred E. Foldvary, Senior EditorThe human tendency to procrastinate unpleasant things becomes toxic when corporate and government chiefs do it. For example, corporations and governments promised pension plans to their workers but did not fund them adequately. Big pension costs have now ruined the US automobile companies and have imposed higher taxes and services cutbacks in cities.
The US government has set itself up as the guarantor of all things bad, the lender of last resort, and the great insurer against all calamities. In the downward side of the business cycle, the government is bailing out homeowners, lenders, and speculators. Taxpayer are gifted with government “rebate” checks. All this is done with borrowed money, while billions are also borrowed to wage war.
The US government can spend lavishly with borrowed funds because the USA’s debt has been considered maximally safe. United States treasury bonds are the benchmark of safety; all risks are relative to T-bonds. The US federal government thus enjoys a zero risk premium on its debt, in contrast to corporations that must pay extra to get buyers to hold corporate bonds rather than federal debt.
Even while the federal budget is currently suffering large deficits, the federal government is incurring colossal unfunded liabilities. Twenty years from now, Social Security taxes will be insufficient to pay the transfers to retired folks. Medicare expenses are scheduled to escalate way beyond the tax revenue that funds it. The government has promises to keep, and not many miles before the leap; meanwhile the public is asleep.
The day of reckoning will come around 18 years from now, during the next major economic downturn. In 2008 the 18-year real estate cycle marched right on schedule, with a downturn 18 years after the last real-estate recession of 1990. If no great disaster interferes, the economy will recover and the next expansion will again become a speculative boom. Recent and coming legislation to reign in the speculative excesses are only treating the effects, not the cause of the boom-bust cycle. Counting 18 years after 2008 brings us to 2026.
Who will pay for the ever greater Social Security, Medicare, pensions, and other unfunded liabilities of governments? Corporations such as General Motors can shrink when confronted with large unfunded costs -- the value of the shares of stock plunges, and the company sells off its assets and lays off workers. Governments cannot loot shareholders, and political pressure keeps them from reducing benefits such as medical care. Political pressure also limits income tax increases as enterprise and wealth flee to more welcoming locations.
The political line of least resistance is to borrow funds, especially since US has top credit ratings. By 2020, the federal government may well be borrowing two trillion dollars per year, including one trillion to pay the interest on a $20 trillion debt. There will be strong temptation for the Federal Reserve to monetize the debt, to buy treasury bonds. The vast increase in the money supply will offset the higher interest rates caused by the huge diversion of investment funds to US debt, but will then spark much higher price inflation. The US government will also sell its gold to raise funds.
The huge expansion of US debt will finally call into question whether the government can continue to pay the interest. With trillions of dollars of T-bonds already held worldwide, in order to sell more bonds, the US government will have to offer higher “interest,” which will really be a risk premium. Bidders will not buy ever more bonds unless the return is higher. US bonds will no longer be super safe. The bills for past profligacy will be due.
But in the financial crisis of 2026, the US government will again be bailing out the financial system, mortgage lenders and borrowers, and giving money to the army of the unemployed. The risk and inflation premiums on T-bonds will become so high that the line of least resistance will be to declare a temporary postponement of the interest payments. This will then segue into a default. Most of the bondholders will be foreigners, and they don’t vote.
It will be a financial earthquake in the global financial system that will bring on a world-wide economic crash. The next Great Depression will most likely not be this time around but in the next downturn 18 years hence, when the unfunded liabilities come due. Many are warning about the coming liability calamity, but the incentive of politicians is to keep pushing the problem to the future, when the government chief has retired and is receiving his unfunded government pension.
-- Fred Foldvary
Copyright 2008 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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