How to save the US from bankruptcy, and why it won't happen
Posted: Wed Aug 03, 2011 5:56 pmWhat would it take to save the US from bankruptcy? Here are my proposed answers and a practical way.
The situation
US public finances can be summed up this way (approximate "broad strokes" values):
Static view
- GDP 15,000 B$
- Federal public debt 15,000 B$ (100% of GDP)
- Sub-Federal public debt 3,000 B$ (20% of GDP) -that's State and Municipal
- Financial guarantees to Fannie Mae and Freddy Mac 5,000 B$ -that's not actual debt, but a risk to incurr a debt
- Unfunded obligations 60,000 B$ (400% of GDP) -that's a very rough value, subject to divergent estimates + is not actual debt, but a promise to pay if commitments are not legally altered in the meantime
Dynamic view
- GDP growth for all practical matter has stalled for the last few years, with little prospect for significant upsurge before numerous years -excess of personal indebtment, excess of public indebtment, lack of export competitivity, lack of personal savings, lack of venture financing all stand in the way.
Therefore: Little hope of reducing the debt burden through growth
- Federal deficit stands around 10% of GDP (1,500 B$). Projections of future deficits in the next 10 years show deficits in excess of 1,000 B$ through all the period, this even with optimistic growth assumptions.
Therefore: US public debt-to-GDP ratio set to increase during the whole next decade
- US financial plan adopted by Congress August 2nd 2011, if it is implemented during the whole 10 years period, will result in 2,400 B$ of cuts in planned expenses, a small dent not in actual expenses but in previsions of expense increases.
Therefore: That plan will barely change the dynamic of US federal deficits and debt
- Interest on existing debt stands around 400 B$, thanks to historically low T-Bond rates. Interest could grow by large margin, even two- or three-fold, in case investors came to fear US bankruptcy, which would result in larger Federal deficits, therefore added investor fear, hence interest rate increase and a vicious loop towards bankruptcy: the mechanism which struck Greece, Ireland, Portugal, and threatens Italy and Spain
Therefore: Significant risk of self-feeding interest rate increase leading to much larger deficits
Is this situation a clear and pressing danger?
Size of public debt, decade-long deficit prospects, risks of self-feeding interest rate increases all vouch to call the danger clear and pressing.
Additional comparisons to European sovereign debt situation are useful. In a nutshell, the US situation is significantly more disturbing:
- Total US public debt stands at 120% of GDP.
For comparison: this is similar to Italy, except Italy has much lesser public deficit than the US. Much more than Germany, France, Spain, Portugal, Ireland… Only Greece has more, and Greece is in actual default
- Financial guarantees to Fannie Mae and Freddy Mac to the tune of more than 30% of GDP were emitted in 2008.
For comparison: the recent EFSF European plan entails guarantees by Germany, France, etc. to the tune of less than 5% of GDP, and many German politicians are balking at such risks
- US public financing from November 2010 to June 2011 was ensured more than 50% through direct monetary creation (aka "QE2"), which first is a very dangerous action that risks triggering uncontrollable inflation, then is a sign that investors are wary to add to their US sovereign bond holdings: that wariness is precisely what created the need for QE2
For comparison: no comparable action was taken by the European Central Bank
Remembering that the sovereign bond crisis in Europe is very severe, and potentially fatal for Europe's monetary union, the risks to US public finances can only be described as extremely severe, and very pressing.
Why they have not yet materialized through actual bankruptcy can only be attributed to the US dollar having been for so long a time the international reserve currency –old habits die hard- and the US Federal bank resorting to desperate acts which the ECB has for the time being refused to contemplate.
What would be the consequences of US bankruptcy?
First line of answer is: nobody knows. Never before in human history has the country emitting the fiat currency used as primary reserve by the whole of human race gone bankrupt, no matter whether through default or through hyperinflation. This would be totally unprecedented.
A few points of concern (not limitative list):
- Since the dollar is by far the most widely used reserve currency, and the US T-Bond market is by far the largest and most liquid bond market, conceivably every financial institution the world over may go bankrupt. This would be compounded by CDS and other financial insurance mechanisms "distributing" risks the world over
While some institutions would probably be salvaged through emergency action by those countries financially solid enough to do so, all would risk sudden death. "Not all of them died, but all of them were wounded"
- Large number of financial institution bankruptcies, even with partial bailout of some others, would result in much of the world's savings being wiped out, therefore extensive capital destruction and middle classes collapse in many countries
- Since financial payments are necessary for every and all market transactions, means of payment being unavailable could result in "sudden stroke" trade suspension the world over –a process that was beginning but didn't go to completion in September 2008. Resumption of international trade may well be slow and disorderly given the lack of immediate alternative to the US dollar –Euro or Yen not much more attractive, Yuan not convertible, Swiss Franc not deep enough a market, Gold not yet directly used for international trade which would take time…
- Long and protracted trade resumption would have consequences on production of all advanced industrial goods, because of internationalization of logistical chains and just-in-time principles (little stocks). Conceivably, much of advanced industrial production could be stopped for a long time because of lack of specific parts, with all consequences in term of widespred unemployment and destruction of companies. Interruption of (inter-Soviet Republic) logistical chains and destruction of (publicly owned) companies is basically what happened in the former Soviet Union 1992 and resulted in several years of widespred misery
- Long and protracted trade resumption would have further consequences if oil and gas trade is temporarily interrupted or severely disrupted, given that oil is crucial for logistical chains the world over. Further risks of logistical disruption could entail
- Most ominously, interruption of international food trade could have extremely severe human consequences. During a few days in September 2008, many food-exporting countries announced total interruption of their exports, only to resume exports shortly afterwards as it had become clear the crisis was contained. An extended interruption of food commerce would potentially create a human disaster of unprecedented scale among food-importing countries
- Extended poverty resulting from economic collapses has historically be correlated with scapegoating of ethnic/religious groups and rise of imperialistic regimes. The risk of repeats should not be underestimated, no more than the risk in the longer term of new totalitarian Communist ideologies rising on the ashes of international capitalism's reputation
In short, the most pessimistic –but not at all irrealist- view of possible consequences would be an economic collapse mirroring the Soviet Union's, except that it would be extended to the whole world.
Is the situation desperate, is bankruptcy unavoidable?
Most probably NO.
Here is a practical 9-decisions plan to save the US from bankruptcy. I'm not saying it's the only possible one, what I am saying is that it's one that would work. The existence of at least one escape path proves that it's not desperate –yet.
1. Balancing the US Federal budget
1a. Realistic assumptions
- GDP will not grow during the next decade. No growth at all. If any growth does happen, added fiscal inlays will go towards debt repayment
- Interest on existing debt will double during the next years because of return to average interest rates and investors' nervosity "testing" US solvency. Therefore, 400 B$ more deficit need to be balanced
- Spending cuts will initially have a depressing effect on US economy –smooth effect, nothing compared to collapse resulting from bankruptcy- with 10% reduction on fiscal inlays. Therefore, 300 B$ more need to be balanced
Result of these assumptions: 1,500 + 400 + 300 = 2,200 B$ of deficit need to be balanced urgently
1b. Spending cuts
1b1. Health care
US health care expenses amount to 17% of US GDP. Even with these expenses, US health performances –life expectancy, infant mortality, health insurance coverage- are no more than mediocre compared to all OECD nations. They are much worse than the better performers. But these best performers have health care expenses in the vicinity of 9% GDP (Canada), 11% GDP for the worst managed (France)!
Decision 1: The US will send study missions to Canada to copycat the Canadian health system; complete including legislation. No "adaptation to US context": it will be pure and simple copycat enabling accelerated implementation.
Realistic objective: health care expenses down to "worst managed, US excluded" (France) rather than "best" (Canada), within a 2-year timeframe.
Important remark: part of this transformation will be spending cuts, part will be tax increases, this by virtue of the Canadian health system being more skewed towards a public system than the US health system
Deficit reduction: 6 points of GDP, that is 900 B$ from the 3rd year
1b2. Defense
US defense expenses –total including ongoing Wars but without Homeland Security– are 900 B$ (6% of GDP)
US defense expenses were 3.5% of GDP in year 2000. America can moreover contribute less to defense of its allies –South Korea, Japan and Germany come to mind therefore repatriate some of the troops which were deployed overseas year 2000.
Decision 2: The US will totally discontinue ongoing Wars within a few months timeframe. Defense expenses will be henceforth limited to 3% of GDP, within the next two years.
Important remark: the US empire will basically be preserved with dominance of Sea, Air and Space maintained. This is not an "empire dismantlement" decision.
Deficit reduction: 3 points of GDP, that is 450 B$ from the 3rd year
1b3. Other
Decision 3: An overall 10% reduction will be applied to all non-Defense non-Health care outlays, within the next two years.
Deficit reduction: 150 B$ from the 3rd year (1 point of GDP)
1c. Tax increases
Total of all deficit reduction decisions in 1b. is 1,500 B$, short of the 2,200 B$ objective by 700 B$ (less than 5% of GDP)
Decision 4: A total of 700 B$ tax increases will be applied, with immediate effect.
2. Walking out of dangerous and irrealistic financial commitments
2a. Fannie Mae and Freddie Mac
Decision 5: Discontinue the Fed guarantee on them
2b. State and Municipal debt
Decision 6: Issue an explicit statement that no Federal guarantee whatsoever is attached to this form of debt
2c. Unfunded obligations
That burden will be significantly eased by reduction in Health system cost –refer to point 1b1. However, not enough, by a large margin.
Decision 7: Start 3-year long negotiations with all interested parties on reduction of Federal obligations towards a level which is fully fundable in the long term. Negotiations will be completed on 3rd year, when extent of savings resulting from health care reform can be assessed. In case no global agreement is reached on the 3rd year, Federal obligations will be lowered uniformly so that they are fully fundable.
3. Securing the dollar and limiting systemic risk
3a. Securing the dollar
The Federal bank cannot be allowed to bailout banks nor public finances through creation of new US dollars. Therefore:
Decision 8: By law, the Federal bank is forbidden to increase its balance sheet above its mid-2011 level –approximately 2,900 B$.
3b. Limiting the consequences of bank defaults
Discontinuing guarantees or implied guarantees (refer to 2a. and 2b.) will result in several forms of debt being valued to the market rather than to their facial value, hence in severe losses for many banks, many of them going to full bankruptcy. Systemic consequences of such bankruptcies need to be contained.
Decision 9: By law, bank defaults result in immediate debt-to-equity swaps for all unsecured creditors of these banks. By law, priority creditors are those holding current accounts at these banks.
Will this plan, or any similar one, be applied?
What is financially, legally and technically possible is not always politically possible.
The answer is most probably NO.
The only even dimly politically realistic path to implement a serious anti-bankruptcy plan is for Ronald Paul –or a similar politician, but there doesn't seem to be any- to be elected US president in November 2012.
In addition to the small probability of such election, the fact remains that we're 15 months from that date. And that is an awfully long time given the instability of US public finances right now.
We will have the opportunity to tell our grandchildren about our experience of that unprecedented event of the country emitting the fiat currency used as primary reserve by the whole of human race going bankrupt, and what resulted.
Those of us who will live to see our grandchildren, that is.
The situation
US public finances can be summed up this way (approximate "broad strokes" values):
Static view
- GDP 15,000 B$
- Federal public debt 15,000 B$ (100% of GDP)
- Sub-Federal public debt 3,000 B$ (20% of GDP) -that's State and Municipal
- Financial guarantees to Fannie Mae and Freddy Mac 5,000 B$ -that's not actual debt, but a risk to incurr a debt
- Unfunded obligations 60,000 B$ (400% of GDP) -that's a very rough value, subject to divergent estimates + is not actual debt, but a promise to pay if commitments are not legally altered in the meantime
Dynamic view
- GDP growth for all practical matter has stalled for the last few years, with little prospect for significant upsurge before numerous years -excess of personal indebtment, excess of public indebtment, lack of export competitivity, lack of personal savings, lack of venture financing all stand in the way.
Therefore: Little hope of reducing the debt burden through growth
- Federal deficit stands around 10% of GDP (1,500 B$). Projections of future deficits in the next 10 years show deficits in excess of 1,000 B$ through all the period, this even with optimistic growth assumptions.
Therefore: US public debt-to-GDP ratio set to increase during the whole next decade
- US financial plan adopted by Congress August 2nd 2011, if it is implemented during the whole 10 years period, will result in 2,400 B$ of cuts in planned expenses, a small dent not in actual expenses but in previsions of expense increases.
Therefore: That plan will barely change the dynamic of US federal deficits and debt
- Interest on existing debt stands around 400 B$, thanks to historically low T-Bond rates. Interest could grow by large margin, even two- or three-fold, in case investors came to fear US bankruptcy, which would result in larger Federal deficits, therefore added investor fear, hence interest rate increase and a vicious loop towards bankruptcy: the mechanism which struck Greece, Ireland, Portugal, and threatens Italy and Spain
Therefore: Significant risk of self-feeding interest rate increase leading to much larger deficits
Is this situation a clear and pressing danger?
Size of public debt, decade-long deficit prospects, risks of self-feeding interest rate increases all vouch to call the danger clear and pressing.
Additional comparisons to European sovereign debt situation are useful. In a nutshell, the US situation is significantly more disturbing:
- Total US public debt stands at 120% of GDP.
For comparison: this is similar to Italy, except Italy has much lesser public deficit than the US. Much more than Germany, France, Spain, Portugal, Ireland… Only Greece has more, and Greece is in actual default
- Financial guarantees to Fannie Mae and Freddy Mac to the tune of more than 30% of GDP were emitted in 2008.
For comparison: the recent EFSF European plan entails guarantees by Germany, France, etc. to the tune of less than 5% of GDP, and many German politicians are balking at such risks
- US public financing from November 2010 to June 2011 was ensured more than 50% through direct monetary creation (aka "QE2"), which first is a very dangerous action that risks triggering uncontrollable inflation, then is a sign that investors are wary to add to their US sovereign bond holdings: that wariness is precisely what created the need for QE2
For comparison: no comparable action was taken by the European Central Bank
Remembering that the sovereign bond crisis in Europe is very severe, and potentially fatal for Europe's monetary union, the risks to US public finances can only be described as extremely severe, and very pressing.
Why they have not yet materialized through actual bankruptcy can only be attributed to the US dollar having been for so long a time the international reserve currency –old habits die hard- and the US Federal bank resorting to desperate acts which the ECB has for the time being refused to contemplate.
What would be the consequences of US bankruptcy?
First line of answer is: nobody knows. Never before in human history has the country emitting the fiat currency used as primary reserve by the whole of human race gone bankrupt, no matter whether through default or through hyperinflation. This would be totally unprecedented.
A few points of concern (not limitative list):
- Since the dollar is by far the most widely used reserve currency, and the US T-Bond market is by far the largest and most liquid bond market, conceivably every financial institution the world over may go bankrupt. This would be compounded by CDS and other financial insurance mechanisms "distributing" risks the world over
While some institutions would probably be salvaged through emergency action by those countries financially solid enough to do so, all would risk sudden death. "Not all of them died, but all of them were wounded"
- Large number of financial institution bankruptcies, even with partial bailout of some others, would result in much of the world's savings being wiped out, therefore extensive capital destruction and middle classes collapse in many countries
- Since financial payments are necessary for every and all market transactions, means of payment being unavailable could result in "sudden stroke" trade suspension the world over –a process that was beginning but didn't go to completion in September 2008. Resumption of international trade may well be slow and disorderly given the lack of immediate alternative to the US dollar –Euro or Yen not much more attractive, Yuan not convertible, Swiss Franc not deep enough a market, Gold not yet directly used for international trade which would take time…
- Long and protracted trade resumption would have consequences on production of all advanced industrial goods, because of internationalization of logistical chains and just-in-time principles (little stocks). Conceivably, much of advanced industrial production could be stopped for a long time because of lack of specific parts, with all consequences in term of widespred unemployment and destruction of companies. Interruption of (inter-Soviet Republic) logistical chains and destruction of (publicly owned) companies is basically what happened in the former Soviet Union 1992 and resulted in several years of widespred misery
- Long and protracted trade resumption would have further consequences if oil and gas trade is temporarily interrupted or severely disrupted, given that oil is crucial for logistical chains the world over. Further risks of logistical disruption could entail
- Most ominously, interruption of international food trade could have extremely severe human consequences. During a few days in September 2008, many food-exporting countries announced total interruption of their exports, only to resume exports shortly afterwards as it had become clear the crisis was contained. An extended interruption of food commerce would potentially create a human disaster of unprecedented scale among food-importing countries
- Extended poverty resulting from economic collapses has historically be correlated with scapegoating of ethnic/religious groups and rise of imperialistic regimes. The risk of repeats should not be underestimated, no more than the risk in the longer term of new totalitarian Communist ideologies rising on the ashes of international capitalism's reputation
In short, the most pessimistic –but not at all irrealist- view of possible consequences would be an economic collapse mirroring the Soviet Union's, except that it would be extended to the whole world.
Is the situation desperate, is bankruptcy unavoidable?
Most probably NO.
Here is a practical 9-decisions plan to save the US from bankruptcy. I'm not saying it's the only possible one, what I am saying is that it's one that would work. The existence of at least one escape path proves that it's not desperate –yet.
1. Balancing the US Federal budget
1a. Realistic assumptions
- GDP will not grow during the next decade. No growth at all. If any growth does happen, added fiscal inlays will go towards debt repayment
- Interest on existing debt will double during the next years because of return to average interest rates and investors' nervosity "testing" US solvency. Therefore, 400 B$ more deficit need to be balanced
- Spending cuts will initially have a depressing effect on US economy –smooth effect, nothing compared to collapse resulting from bankruptcy- with 10% reduction on fiscal inlays. Therefore, 300 B$ more need to be balanced
Result of these assumptions: 1,500 + 400 + 300 = 2,200 B$ of deficit need to be balanced urgently
1b. Spending cuts
1b1. Health care
US health care expenses amount to 17% of US GDP. Even with these expenses, US health performances –life expectancy, infant mortality, health insurance coverage- are no more than mediocre compared to all OECD nations. They are much worse than the better performers. But these best performers have health care expenses in the vicinity of 9% GDP (Canada), 11% GDP for the worst managed (France)!
Decision 1: The US will send study missions to Canada to copycat the Canadian health system; complete including legislation. No "adaptation to US context": it will be pure and simple copycat enabling accelerated implementation.
Realistic objective: health care expenses down to "worst managed, US excluded" (France) rather than "best" (Canada), within a 2-year timeframe.
Important remark: part of this transformation will be spending cuts, part will be tax increases, this by virtue of the Canadian health system being more skewed towards a public system than the US health system
Deficit reduction: 6 points of GDP, that is 900 B$ from the 3rd year
1b2. Defense
US defense expenses –total including ongoing Wars but without Homeland Security– are 900 B$ (6% of GDP)
US defense expenses were 3.5% of GDP in year 2000. America can moreover contribute less to defense of its allies –South Korea, Japan and Germany come to mind therefore repatriate some of the troops which were deployed overseas year 2000.
Decision 2: The US will totally discontinue ongoing Wars within a few months timeframe. Defense expenses will be henceforth limited to 3% of GDP, within the next two years.
Important remark: the US empire will basically be preserved with dominance of Sea, Air and Space maintained. This is not an "empire dismantlement" decision.
Deficit reduction: 3 points of GDP, that is 450 B$ from the 3rd year
1b3. Other
Decision 3: An overall 10% reduction will be applied to all non-Defense non-Health care outlays, within the next two years.
Deficit reduction: 150 B$ from the 3rd year (1 point of GDP)
1c. Tax increases
Total of all deficit reduction decisions in 1b. is 1,500 B$, short of the 2,200 B$ objective by 700 B$ (less than 5% of GDP)
Decision 4: A total of 700 B$ tax increases will be applied, with immediate effect.
2. Walking out of dangerous and irrealistic financial commitments
2a. Fannie Mae and Freddie Mac
Decision 5: Discontinue the Fed guarantee on them
2b. State and Municipal debt
Decision 6: Issue an explicit statement that no Federal guarantee whatsoever is attached to this form of debt
2c. Unfunded obligations
That burden will be significantly eased by reduction in Health system cost –refer to point 1b1. However, not enough, by a large margin.
Decision 7: Start 3-year long negotiations with all interested parties on reduction of Federal obligations towards a level which is fully fundable in the long term. Negotiations will be completed on 3rd year, when extent of savings resulting from health care reform can be assessed. In case no global agreement is reached on the 3rd year, Federal obligations will be lowered uniformly so that they are fully fundable.
3. Securing the dollar and limiting systemic risk
3a. Securing the dollar
The Federal bank cannot be allowed to bailout banks nor public finances through creation of new US dollars. Therefore:
Decision 8: By law, the Federal bank is forbidden to increase its balance sheet above its mid-2011 level –approximately 2,900 B$.
3b. Limiting the consequences of bank defaults
Discontinuing guarantees or implied guarantees (refer to 2a. and 2b.) will result in several forms of debt being valued to the market rather than to their facial value, hence in severe losses for many banks, many of them going to full bankruptcy. Systemic consequences of such bankruptcies need to be contained.
Decision 9: By law, bank defaults result in immediate debt-to-equity swaps for all unsecured creditors of these banks. By law, priority creditors are those holding current accounts at these banks.
Will this plan, or any similar one, be applied?
What is financially, legally and technically possible is not always politically possible.
The answer is most probably NO.
The only even dimly politically realistic path to implement a serious anti-bankruptcy plan is for Ronald Paul –or a similar politician, but there doesn't seem to be any- to be elected US president in November 2012.
In addition to the small probability of such election, the fact remains that we're 15 months from that date. And that is an awfully long time given the instability of US public finances right now.
We will have the opportunity to tell our grandchildren about our experience of that unprecedented event of the country emitting the fiat currency used as primary reserve by the whole of human race going bankrupt, and what resulted.
Those of us who will live to see our grandchildren, that is.