Who Will Buy America’s Trillions In New Debt?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
February 24, 2009

IN THIS ISSUE:

1. Federal Bailouts Surpassing $10 Trillion

2. Government Finance 101

3. Who Will Buy All This New Debt?

4. Bernanke: Crank Up The Printing Presses

5. Real Storm Clouds On The Horizon

6. Conclusions – Not Many I Can Find

Introduction

Over the last two weeks, I have discussed at some length President Obama’s $787 billion stimulus package and Treasury Secretary Geithner’s bank rescue plan that he said would cost $1½-$2 trillion or more. Add to that President Obama’s announcement last week of another potentially $275 billion in a new bailout plan aimed at homeowners and mortgage lenders.

But these latest revelations are only the tip of the iceberg.

Bloomberg has recently discovered that with the passage of the $787 billion stimulus package, the federal government is now on the hook for $9.7 trillion in direct bailouts and associated government guarantees. Add to that Geithner’s $1½-$2 trillion and another $275 billion to help the housing crisis, and you get pretty close to $12 trillion which is staggering.

Where will the government get that kind of money? In the pages that follow, I will discuss how the government normally finances its deficits, and how those sources are beginning to dry up due to the global recession. Unfortunately, it appears that the Federal Reserve will become the “lender of last resort” to fund the massive credit needs of the US government.

There are many serious implications of the historic bailout spending we have seen in the last year, with much more to come, especially if the Fed moves ahead to directly purchase trillions in Treasury debt. Sadly, there are no guarantees that this massive spending will even work. Even worse, we could be facing unprecedented inflation once we come out of this recession, or even before, as I will discuss below.

Federal Bailouts Surpassing $10 Trillion

Following announcement after announcement over the last year, Americans are growing dizzy from the various federal bailout plans. Who knows what the federal government is on the hook for? After filing a federal lawsuit to get the actual information on the bailouts and various bailout guarantees, Bloomberg reported the following on February 9:

“The stimulus package the U.S. Congress is completing would raise the government’s commitment to solving the financial crisis to $9.7 trillion, enough to pay off more than 90 percent of the nation’s home mortgages. The Federal Reserve, Treasury Department and Federal Deposit Insurance Corporation have lent or spent almost $3 trillion over the past two years and pledged to provide up to $5.7 trillion more if needed.

The Senate is to vote early this week on a stimulus package totaling at least $780 billion that President Barack Obama says is needed to avert a deeper recession. That measure would need to be reconciled with an $819 billion plan the House approved last month.

Only the stimulus package to be approved this week, and the $700 billion Troubled Asset Relief Program passed four months ago and $168 billion in tax cuts and rebates approved in 2008 have been voted on by lawmakers. The remaining $8 trillion in commitments are lending programs and guarantees, almost all under the authority of the Fed and the FDIC. The recipients’ names have not been disclosed.” [Emphasis added, GDH.]

As we all know, Obama’s $787 billion stimulus has already been passed. The $9.7 trillion discussed above breaks down as follows. We have not spent it all yet, but it could happen depending on how things go. Bloomberg continues:

“The pledges, amounting to almost two-thirds of the value of everything produced in the U.S. last year, are intended to rescue the financial system after the credit markets seized up about 18 months ago. The promises are composed of about $1 trillion in stimulus packages, around $3 trillion in lending and spending and $5.7 trillion in agreements to provide aid.

The worst financial crisis in two generations has erased $14.5 trillion, or 33 percent, of the value of the world’s companies since Sept. 15; brought down Bear Stearns Cos. and Lehman Brothers Holdings Inc.; and led to the takeover of Merrill Lynch & Co. by Bank of America Corp.

The $9.7 trillion in pledges would be enough to send a $1,430 check to every man, woman and child alive in the world. It’s 13 times what the U.S. has spent so far on wars in Iraq and Afghanistan, according to Congressional Budget Office data, and is almost enough to pay off every home mortgage loan in the U.S., calculated at $10.5 trillion by the Federal Reserve.” [Emphasis added, GDH.]

Actually, the various bailouts and guarantees are even larger than Bloomberg outlined above. The day after this article was published on February 9, Treasury Secretary Geithner announced a new financial rescue package aimed at not only banks but also consumers, which will total another $1½-$2 trillion. That puts the total up to $11.7 trillion in bailouts and guarantees.

Then on February 19, President Obama announced his “Homeowner Affordability and Stability Plan” that will spend up to $275 billion for “refinancing loans for millions of families in traditional mortgages who are underwater or close to it, by modifying loans for families stuck in subprime mortgages they can't afford as a result of skyrocketing interest rates or personal misfortune, and by taking broader steps to keep mortgage rates low so that families can secure loans with affordable monthly payments.” That puts us close to $12 trillion in bailouts and guarantees, and we’re probably not done yet.

I could spend the rest of this E-Letter discussing the implications of spending this unheard of amount of money trying to bail this economy out of recession and unfreeze the credit markets. But a more basic question comes to mind: Where is the US going to get all this money?

Government Finance 101

Now that we know the real numbers, the question then becomes how the federal government intends to pay for all of these programs. Remember, the federal budget deficit is already scheduled to exceed $1 trillion this fiscal year, so where is all of this money going to come from?

That’s a very good question. The answer may appear to be very basic, but please bear with me as it leads into more important matters below. The US government essentially has three ways to deal with budgetary issues. First, it can reduce spending on other programs in order to fund the bailouts. Of course, we all know that politicians will never cut spending, so there’s no use in even entertaining this option.

Next, the federal government can increase revenues by raising taxes. President Obama has already indicated that he wants to raise taxes on those making over $200,000 to $250,000 a year, but has also lowered taxes (or increased giveaways, as the case may be) to those with lower incomes. To fund the bailouts, however, would require a massive tax increase that may even be more than liberals could bear.

Consider this: the total amount of personal income tax revenue received by the federal government in 2006 (latest data available) was just over $1 trillion. With trillions of dollars of bailouts either enacted or proposed, a tax increase in an amount to cover these expenditures would likely be dead on arrival in Congress, and certainly would make the economy even worse.

Numerous studies have shown that as you tax income at higher and higher rates, there is less of an incentive to take the risks necessary to invest in new businesses. This, in turn, can lead to reduced economic activity. In other words, higher income tax rates could stall the very economic recovery the bailouts seek to bring about. This is just another reason that increasing income taxes to fund the bailouts is not a good idea.

A final way to fund the activities of our federal government is through the issuance of debt securities. Accordingly, the Treasury Department issues a variety of T-bills, notes and bonds to finance budget shortfalls. Currently, the total debt incurred by the federal government (the “national debt”) is just over $10 trillion. That amounts to over $32,000 for every man, woman and child in America based on the Census Bureau’s population clock. The annual interest on this debt amounted to over $454 billion in 2008, including interest accrued by bonds held by the government itself.

As you might expect, Treasury Department officials have indicated that money to pay for past and future bailouts and stimulus legislation will be funded by borrowing through the issuance of additional Treasury securities. That being the case, it might be interesting to see who currently purchases these debt instruments, and whether they have appetites for more.

By far, the single largest entity holding Treasury securities is the federal government itself. According to the recent Government Account Office’s Schedules of Federal Debt, as of September 30, 2008 over $4.2 trillion of government debt is categorized as “Intragovernmental Debt Holdings.” Of course, the largest among this group is the Social Security Administration, but this category also includes various federal retirement funds, health care funds and agency trust funds.

The remaining $5.8 trillion of government debt held by the public is spread among a variety of holders, including Federal Reserve Banks, state and local governments, foreign governments and central banks, pension plans, trusts and many individual investors. By far, the greatest percentage of publicly held debt is owned by foreign interests, reaching a total of $2.8 trillion as of September 30, 2008. China has recently become the largest foreign holder of US debt, followed by Japan, the United Kingdom and a host of other countries owning smaller amounts.

Who Will Buy All This New Debt?

In light of having to fund additional expenditures related to the bailouts, I did some thinking about who among the various buyers of US debt might be able to expand their appetite for Treasury securities just ahead. While I’m not an economist or an expert in Treasury securities, the future does not look bright in my opinion.

Given that we’re in a global economic recession, will the same foreign purchasers of US debt be able to continue to buy Treasuries at their previous pace, much less take on more? Let’s take a closer look at just a few of the major sources of debt financing for the federal government.

Federal Government – As noted above, the single largest holder of Treasury securities is the US government itself, most of which is held in the trust funds for entitlement programs such as Social Security and Medicare. However, it is not likely that these trust funds can be counted upon to increase their purchases since the amounts they buy are determined by the excess of tax revenues over expenditures. Here are some things we know about these trust funds:

In 2004, the Medicare Hospital Insurance expenditures began to exceed tax revenues. This means that the Medicare Trust Fund is now in the process of cashing in bonds, not buying new ones.
The Social Security Trust Fund will actually be purchasing less and less government debt as the Baby Boom generation begins to retire and claim benefits. As more workers retire, tax revenues go down and expenditures go up. It is generally agreed that the Social Security benefit expenditures will outpace tax revenues in the year 2018 (if not sooner). This is hardly a scenario for a source of increased Treasury purchases.
Let’s take this one step further. As the expenditures outpace tax revenues, trustees of these funds will have to start transferring money back into these programs to cover the shortfall. Where do you think they will get the money? That’s right, they’ll cash in some of their Treasury bonds. But wait, where will the government get the money to redeem the bonds? Well, they’ll either have to borrow from another source or print the money, much as they plan to do to finance the bailout. So, in reality, the $787 billion “stimulus” and the $1½-$2 trillion bank rescue package Geithner announced two weeks ago may be just a dress rehearsal for an even greater expansion of the money supply starting in 2018 (or sooner).

Of course, the Federal Reserve can also purchase Treasury Securities, but must generally print the money to do so. I’ll discuss this option and its possible negative consequences in more detail later on.

State and Local Governments – These sources of debt financing are now on the receiving end of the recent stimulus bill, and are not likely to be making new investments to the same extent they have in the past, and may actually have a net reduction in their Treasury securities holdings as states and cities seek cash to maintain their services.

Individual Investors – Treasury securities got a boost late last year as investors joined in a flight to safety. However, some observers see this as a one-time event as investors moved to the sidelines and out of equities. Future purchases by investors may be hampered by low rates on these securities.

Americans have been spending less and saving more over the last year or so. Most economists expect this trend to continue for some time yet. That may well be, but one estimate I ran across said that even if Americans got back to their historical average savings rate of 8%, this would mean only about $830 billion of new Treasury purchases - and that’s IF the public chooses to invest its increased savings in Treasuries. Personally, I expect some new money from individual investors to continue to flow into Treasury securities as they seek a safe harbor in uncertain times, but this is almost certainly a temporary phenomenon. Who knows, to encourage private investment to help finance the bailouts, the government may even dust off some of the old bond promotions that they used back in World War II to encourage the public to buy war bonds.

Pension Plans, Endowments, Etc. – Many institutional investors got creamed in the recent bear market, with some losing half or more of their asset values. To the extent new contributions are made to these entities, they may continue to be a source of funding for the government. Plan trustees and investment managers have been burned, and may choose to buy safe Treasury securities until they feel better about the equity and bond markets, as well as the economy as a whole. But here, too, this is likely a temporary phenomenon.

Foreign Governments – Many foreign governments have bought Treasuries because they have been flush with US dollars from exporting goods to us. As the recession deepens and Americans cut down more on spending, fewer dollars will be flowing offshore, and this could affect the ability of foreign entities to purchase even the same amount of Treasuries, much less increase their buying activities. Plus, if we factor in the latest protectionist legislation like the “Buy American First” piece of the $787 billion stimulus bill, it might be hard to make a case to foreign nations for investing more in US Treasury securities.

The problem with all of the above sources of debt financing is that they may require concessions on the part of the Treasury to continue to buy its debt securities. Should the US be seen as unable to perform on these notes, investors may require a higher rate of interest to compensate for the added risk.

Foreign purchasers who have so reliably gobbled up our Treasury securities in the past are already balking. China recently demanded guarantees on the $690-plus-billion of Treasury securities it owns, which is not likely to happen soon but it is nonetheless a troubling development. Plus, in light of the global recession (or worse), our trading partners will likely have fewer dollars with which to buy our debt.

Bernanke: Crank Up The Printing Presses

In light of the above difficulties, there is little surprise that Chairman Bernanke recently announced that the Fed would be the purchaser of last resort of the potentially trillions of dollars of Treasury securities being issued to pay for the bailouts. I first brought this to your attention in my December 9, 2008 E-Letter. In a speech delivered in Austin on December 1, Bernanke first announced that the Fed was considering very large direct purchases of Treasury securities.

Speaking to the Austin Chamber of Commerce, Bernanke said, “Although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest-rate policies to support the economy is obviously limited.”

Another option he offered was: “The Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand.” Bond prices soared on this news and yields fell to record lows.

This should not have come as a surprise. As the discussion above points out, the government has only limited ways to finance its deficits, and the global recession is serving to reduce some of those sources. Moreover, the Fed had already expanded its balance sheet by close to $2 trillion over the last year by buying up troubled assets. Even before Obama’s $787 billion “stimulus” package became law, the Fed announced it would make up to $1 trillion available for consumer loans.

The problem with the Fed buying trillions of dollars worth of Treasury and other debt is that it has to print the money to pay for them. Most experts agree that we could be facing significantly higher inflation whenever the economy comes out of this recession, if the Fed monetizes trillions in federal debt by buying Treasuries.

Even when the economy and the securities markets are weak, the Fed’s financing of big federal deficits can be inflationary. We learned that in the late 1970s when the Fed’s deficit financing sent the CPI up to an annual rate of almost 15%. That confounded the Keynesian theorists who believed then, as now, that federal spending “stimulus” would restore economic health.

Inflation is the product of the demand for money as well as of the supply. And if the Fed finances trillions in federal deficits and more bailouts in this recession, it could create more money than the economy can use. The result could be the return of “stagflation,” a term coined to describe the 1970s experience when the economy slowed but prices rose anyway. As the global economy slows and Congress relies more on the Fed to finance a huge deficit, there is a very real danger of a return of stagflation.

These concerns, however, are not at the top of Bernanke’s worry list (or Obama’s or Geithner’s). Remember that Bernanke is a student of the Great Depression, and he believes that the government waited too long and did too little to head off the economic and financial crisis of that period. As I have noted frequently of late, Bernanke is worried about deflation, not inflation. Here are some excerpts from the Fed’s last policy meeting on January 28:

“In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term [read: deflation].

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee’s policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve’s balance sheet at a high level.

The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility [up to $1 trillion] to facilitate the extension of credit to households and small businesses.”

So it is clear that the Federal Reserve is prepared to purchase however many trillions of Treasury paper that are required to fund the massive bailouts President Obama is asking for. The implications of this massive monetization of government debt are far from clear, especially as they relate to possible inflation down the road. Ironically, there are no guarantees that any of this will work.

Real Storm Clouds On The Horizon

Ever since the end of the 1980-82 recession, I have been a consistent optimist regarding the US economy. For the last 25+ years, I have believed that the technology and productivity-led US economy would surprise on the upside, not without a brief recession or two along the way. I was correct. As long-time readers will attest, I have condemned the “gloom-and-doom” crowd countless times in my newsletter and in recent years in this weekly E-Letter.

Likewise, over those same 25+ years, I have predicted that the US stock markets would also surprise on the upside, and they did with the greatest bull market in history, which the gloom-and-doom crowd totally missed. I encouraged clients and readers to remain fully invested in US stocks, but with a significant allocation to strategies that had the flexibility to move to cash (or more recently hedge long positions) during periodic stock market downturns.

I also predicted since 1982 that inflation, which had reached 15% in the late 1970s, would be brought under control, thanks in large part to former Fed chairman Paul Volcker. Inflation has not been a major threat since then, despite non-stop warnings from the gloom-and-doom crowd and the gold bugs to the contrary.

My optimism over the last 25+ years was well placed, and hopefully allowed my clients and readers to take advantage of the greatest bull market in stocks and bonds ever. But I must admit that my optimism is fading fast. While I am not remotely in the gloom-and-doom camp today, I am not optimistic about America’s future, especially in light of the discussion above.

Our nation is in the process of borrowing nearly $12 trillion in an effort to bail us out of the current financial crisis. As noted above, there is no assurance that this plan will work. And most importantly, there is no plan for how this money will be paid back.

So the government will be incurring the most massive federal debt ever at arguably the worst possible time in our nation’s history. This fact is highlighted by the reality that tens of millions of Baby Boomers will be entering retirement (if they are lucky) over the next 10-15 years.

We have all seen reports of the strains this will put on Social Security over the next 10-20 years, which will mean even more government borrowing to shore up our nation’s entitlement programs. If you believe the numbers, Social Security outlays will begin to outstrip inflows by 2018. I will not be surprised if it happens even sooner.

My confidence in the massive bailouts discussed above was never much, and is fading rapidly. Frankly, I am not sure what the best course of action is at this point. But I do not believe that putting the government into the largest net debtor position in our nation’s history is where we should go. Likewise, I do not believe that the government should nationalize our largest banks, but it may very well do so in the months ahead.

Not to end on a political note, but I have warned repeatedly that President Obama comes from a political persuasion which believes that government ownership of the private sector is just fine. I hope not, but we are seeing this evolve after only just over a month of his presidency. It remains to be seen what we should expect next.

Conclusions – Not Many I Can Find

The financial crisis is far from over, and the government is planning to borrow and spend several trillions more over the next couple of years or longer. The Federal Reserve is pledged to be the “lender of last resort,” which could lead to a big rise in inflation in the coming years, or stagflation depending on how the economy does going forward.

The stock markets are devastated, with many people’s retirement accounts down by half or more. There is little sentiment that a recovery to new highs will occur anytime soon, for good reason. Millions of Baby Boomers have nowhere near enough to retire into the lifestyles they previously envisioned. As the latest massive bailouts have been announced, stock market prices have consistently tumbled over the last few months to new lows. Does the Obama administration get the point? Obviously not.

At the end of the day, the question is: Will all of these bailouts work? Or are we just delaying the inevitable (as suggested last week in the article by Nouriel Roubini). The main point is that we could have just let banks, brokerage firms and other businesses fail, but this possibly would have created a global depression. However, are we still headed for that fate, only $10 to $20 trillion deeper in debt? Only time will tell.

President Obama is scheduled to speak before Congress tonight (Tuesday), at which time he is expected to present “a road map for how we get to a better day,” a senior adviser said on Monday. Then later this week, Treasury Secretary Geithner is expected to unveil more details on the massive bank rescue plan. It should be another very interesting week.

Best regards in troubling times,

Gary D. Halbert

SPECIAL ARTICLES:

Obama’s Stimulus: A Colossal Waste (Read this!)
http://www.realclearpolitics.com/articles/2009/02/obamas_stunted_economic_stimul.html

Obama’s Failing Leadership
http://www.humanevents.com/article.php?id=30804

How the GOP Should Approach TARP 2.0
http://online.wsj.com/article/SB123534958659044761.html

Obama should rebuke Attorney General Eric Holder
http://www.forbes.com/2009/02/22/obama-eric-holder-racism-america-cowards-opinions-columnists_attorney_general.html