Saturday, July 23, 2011

How high can loons fly anyway? (Part II)

There is another way of reducing debt than devaluating the currency. Think about your mortgage payments and your personal debt/asset ratio? If you take a mortgage on your house, over time your house increases in value and thus your debt/asset ratio improves. But also, your income, by means of salary increases, will grow and your mortgage payments will become smaller as a percentage of your income. The same is true for economies. The economy usually grows and this is expressed as 'real GDP growth' or GDP growth after inflation. Western Developed economies are doing just fine at an annual GDP growth rate of 3%.
Figure 2 Assuming nominal GDP growth of 5% per year, a Debt/GDP ratio of 60% decreases over 25 years to 19% provided no new debt is taken on.
Including current inflation at 2-3%, nominally such an economy would grow at around 5% per year. Thus any debt as a percentage of GDP decreases every year by a few percentage points. You may think this is trivial, but that is not right. Figure 2 shows that over a 25 year period, starting at a debt/GDP ratio of 60% (current U.S. debt load), this ratio would shrink (without further debt additions) to 19%. Now add to that the devaluation of the U.S. dollar over the last decade or so!

The debt ceiling issue may be scary, but really, the discussion is not about how much more debt to take on; rather it is about the way to reduce the U.S. budget deficit. When drilling down further it is in fact about cash flow. You need cash to spend on projects that you want to realize and if you have not enough cash to spend on the things you want to do, then you can't do them. When government debt gets too high (as a percentage of GDP) then government has to pay too much of its money towards interest and it has not enough money to spend on projects such as roads, healthcare, etc.

The other thing you may have picked up from this story is that no government, including that of the U.S., is planning to ever pay back a penny of its debt to its creditors. In the worst case, it will borrow money from other creditors to pay for expiring debt. So, the Chinese will never see a penny of the money they're owed by the U.S. Neither does any other investor in government debt.

Debt is an asset for the creditor that creates cash flow in the form of interest. You can see it with the mortgage on your house. You pay interest every month to your mortgage holder and sometimes you pay off a bit of your debt, but really that paying down of principal is just smoke and mirrors. The bank would prefer you never pay off your mortgage because how else are they going to make money of you? If you pay off your mortgage the bank has to find someone else to whom to lend the money you paid back.

So for lender as well as for creditor it is about assets that create cash flow. The only creature that does not use assets to create cash flow is the consumer. It consumes assets! Now you may better understand how insidious government debt is but we are not quite there yet!

Lending your savings (assets) to governments creates cash flow for you and provides money for the government to execute a capital project or roll over expiring debt. So let's look at the cash flow your government bond asset produces. Your cash flow is the interest payment based on the bond's coupon rate. Say currently you get on short term treasury bills, or 'T-bills, 0.5% interest and 3.75% on a 5 year government bond. In Alberta current inflation is at 3.1% and money invested in T-bills over a period of one year at 0.5% results in a loss of 2.6% (0.5 – 3.1%) in terms of purchasing power. Your 5 year bond would result in a 3.75 – 3.1 = 0.65% increase in purchasing power.

Oh… Not so fast, we did not consider taxes. In Alberta you pay 38.6% (top margin) taxes on your interest income. So the T-Bill interest after taxes is 0.5-0.386x0.5= 0.307% minus inflation of 3.1% is a loss of 2.793% in purchasing power. And the 5 year bond would be 3.75 – 0.386x3.75 – inflation is a loss of 0.79% in purchasing power each year.

So no matter what, you always lose! No wonder that the government is in a panic when we're getting deflation because then the story would completely change! Governments like to have zero percent interest or very low interest even when everybody is up in arms about the 'security' of the government debt in many countries. Because especially when interest rates are below inflation governments win and you lose! So if you're thinking that you support government only by paying taxes, you better think again.

U.S. government corporate tax policy taxes profits coming in from foreign subsidiaries that are brought back into the U.S. to their parent companies. Companies like Microsoft may have stashed away billions in cash overseas that they can never pay out to their shareholders or that can be brought into the U.S. economy without triggering a lot of taxes. So if the U.S. government was really so concerned about their foreign debt and their current account deficit you would think they would make it easier to bring all this money into the U.S. But 'au contraire', they discourage it. So do you still feel so smart about investing in government bonds?

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