Is the U.S. Government Insolvent?

 

Given the economic situation at hand, the word "insolvent" might be nominated as Word of the Year (2008, 2007). However, given all the attention to that word -- which basically means one is unable to cover financial obligations -- I'm not sure why more people aren't a little more concerned about the idea that our government itself may be, in effect, insolvent, and becoming more so every day.

Consider the trillions committed for economic stimulus and bailout purposes. We already owe trillions (including $1 trillion to China). Recall that private enterprise, real estate, and consumer spending all bring in the tax revenues that the government requires to fund its initiatives if it had a balanced budget. Needless to say, tax income is dwindling as the economy stumbles and teeters on the brink of even more serious damage.

And yet the government is committed to spending even more, which means borrowing more and/or firing up the printing presses, making some decisions that could cripple many businesses and drive some overseas -- not to mention hurt already beleaguered consumers. Anybody who realizes money doesn't grow on trees or get delivered by storks (in the case of trillions, flocks of storks I guess, or maybe Monsanto's (NYSE: MON) working on genetically modified super storks) should be very concerned.

Same economic story, different administration

For what it's worth, expanding government, spending taxpayer money, and digging us into a huge debt hole for defense spending is most certainly not "better" than expanding government, spending taxpayer money, and digging us into a huge debt hole for social programs that likely won't result in real, long-term economic growth. I find war spending far more odious, but neither should come to pass, especially with the kind of fiscal black hole U.S government has been digging with a Keynesian shovel -- although admittedly, even John Maynard Keynes didn't condone governments indulging in deficit spending in supposedly good times like the Bush administration did.

Last year's documentary I.O.U.S.A., which featured well-known people in government and business like Alan Greenspan, Paul Volcker, Ron Paul, and Berkshire Hathaway's  Warren Buffett, pointed to an overburdened and unsustainable situation even before all the bailout madness really picked up steam. The National Debt Clockran out of numbers, folks. That was meant to be a wakeup call: We were already over our heads!

Of course, people can argue all they want about "this guy versus that guy," and why "we shouldn't question this new guy's economic policies because he's so much better than the last guy," or "this political party's my political party so they're OK no matter what," and "gee, do we ever hate those other guys!" Maybe some people find all that team mentality as comforting as six-packs and Monday Night Football, but I think it's all a silly distraction that distracts people from thinking about the real issues. And as far as I can tell, what the real issue is: Where's the money, and where's more of it going to come from?

Beyond the banks
Many people are already well aware of the fears that huge banks like Citigroup Bank of America, and Wells Fargo up to their eyeballs in risky loans that are rapidly defaulting are basically insolvent. Meanwhile, the consumer climate makes dying dinosaurs like General Motors even sicker, and of course its own debt load's nothing to sneeze at.

But all that's child's play when you ponder our government's cash burn and burgeoning obligations.

The $3.6 trillion budget President Obama recently spearheaded includes a near-term deficit of a mind-blowing $1.75 trillion. While he vows that the deficit will be halved later, that seems built upon some rather rosy economic recovery projections coming to pass, and if industries become increasingly beleaguered (and businesses provide jobs and tax revenues, folks), then I think you can see why this might present a problem down the road.

Meanwhile, the National Debt is currently just under $11 trillion and growing. You can't just keep adding debt while GDP declines, and raising taxes will strangle already beleaguered businesses and citizens. The Federal Reserve is firing up the printing presses, but that brings to mind the very real risk of hyperinflation.

Last but not least, I hope nobody missed the fact that last week China expressed concerns about the U.S. being good for its debt to that country. If that doesn't scare you -- and support the thesis that there is major reason for concern -- I don't know what will. Meanwhile, France and Germany balked at spending for their own stimulus plans. Um, hello?

Fasten your seatbelts
Unfortunately, the government's overheated spending, relying on future revenues and of course, that of future generations, reminds me a little too much of the Ponzi scheme mentality. And if entrepreneurship and business suffers, then our economy will be awfully close to a Ponzi scheme, where money is simply handed around without any real productive enterprise going on. Only this time it's going to include ugly side effects like worthless greenbacks resulting from out-of-control inflation. (And the Fed's $1 trillion move yesterday certainly stirs up still more concerns about runaway inflation even if the stock market did rise on the news.)

And of course, things could most certainly get far worse from there.

I know this sounds harsh, but I'm a proponent of trying to recognize the truth instead of fighting to stay in a state of overly optimistic delusion. I'm not stuffing cash in my mattress or giving up on the idea of investing; I try to remind myself that panic is destructive, not constructive, and won't help our current situation.

Yet I do believe there are grave issues at hand that we should contemplate, which could most certainly change the way we invest, not to mention the way we live.

And one of them is, is the U.S. Government insolvent? Feel free to comment in the comment boxes below, but I fear the road to real economic recovery is looking awfully rocky -- fasten your seatbelts, it's going to be a bumpy ride.

Why successful bank rescue is far away?

I am becoming ever more worried. I never expected much from the Europeans or the Japanese. But I did expect the US, under a popular new president, to be more decisive than it has been. Instead, the Congress is indulging in a populist frenzy; and the administration is hoping for the best.

If anybody doubts the dangers, they need only read the latest analysis from the International Monetary Fund.* It expects world output to shrink by between 0.5 per cent and 1 per cent this year and the economies of the advanced countries to shrink by between 3 and 3.5 per cent. This is unquestionably the worst global economic crisis since the 1930s.

One must judge plans for stimulating demand and rescuing banking systems against this grim background. Inevitably, the focus is on the US, epicentre of the crisis and the world’s largest economy. But here explosive hostility to the financial sector has emerged. Congress is discussing penal retrospective taxation of bonuses not just for the sinking insurance giant, AIG, but for all recipients of government money under the troubled assets relief programme (Tarp) and Andrew Cuomo, New York State attorney-general, seeks to name recipients of bonuses at assisted companies. This, of course, is an invitation to a lynching.

Yet it is clear why this is happening: the crisis has broken the American social contract: people were free to succeed and to fail, unassisted. Now, in the name of systemic risk, bail-outs have poured staggering sums into the failed institutions that brought the economy down. The congressional response is a disaster. If enacted these ideas would lead to an exodus of qualified employees from US banks, undermine willingness to expand credit, destroy confidence in deals struck with the government and threaten the rule of law. I presume legislators expect the president to save them from their folly. That such ideas can even be entertained is a clear sign of the rage that exists.

This is also the background for the “public/private partnership investment programme” announced on Monday by the US Treasury secretary, Tim Geithner. In the Treasury’s words, “using $75bn to $100bn in Tarp capital and capital from private investors, the public/private investment programme will generate $500bn in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time”. Under the scheme, the government provides virtually all the finance and bears almost all the risk, but it uses the private sector to price the assets. In return, private investors obtain rewards – perhaps generous rewards – based on their performance, via equity participation, alongside the Treasury.

I think of this as the “vulture fund relief scheme”. But will it work? That depends on what one means by “work”. This is not a true market mechanism, because the government is subsidising the risk-bearing. Prices may not prove low enough to entice buyers or high enough to satisfy sellers. Yet the scheme may improve the dire state of banks’ trading books. This cannot be a bad thing, can it? Well, yes, it can, if it gets in the way of more fundamental solutions, because almost nobody – certainly not the Treasury – thinks this scheme will end the chronic under-capitalisation of US finance. Indeed, it might make clearer how much further the assets held on longer-term banking books need to be written down.

Why might this scheme get in the way of the necessary recapitalisation? There are two reasons: first, Congress may decide this scheme makes recapitalisation less important; second and more important, this scheme is likely to make recapitalisation by government even more unpopular.

If this scheme works, a number of the fund managers are going to make vast returns. I fear this is going to convince ordinary Americans that their government is a racket run for the benefit of Wall Street. Now imagine what happens if, after “stress tests” of the country’s biggest banks are completed, the government concludes – surprise, surprise! – that it needs to provide more capital. How will it persuade Congress to pay up?

The danger is that this scheme will, at best, achieve something not particularly important – making past loans more liquid – at the cost of making harder something that is essential – recapitalising banks.

This matters because the government has ruled out the only way of restructuring the banks’ finances that would not cost any extra government money: debt for equity swaps, or a true bankruptcy. Economists I respect – Willem Buiter, for example – condemn this reluctance out of hand. There is no doubt that the decision to make whole the creditors of all systemically significant financial institutions creates concerns for the future: something will have to be done about the “too important to fail” problem this creates. Against this, the Treasury insists that a wave of bankruptcies now would undermine trust in past government promises and generate huge new uncertainties. Alas, this view is not crazy.

I fear, however, that the alternative – adequate public sector recapitalisation – is also going to prove impossible. Provision of public money to banks is unacceptable to an increasingly enraged public, while government ownership of recapitalised banks is unacceptable to the still influential bankers. This seems to be an impasse. The one way out, on which the success of Monday’s plan might be judged, is if the greater transparency offered by the new funds allowed the big banks to raise enough capital from private markets. If that were achieved on the requisite scale – and we are talking many hundreds of billions of dollars, if not trillions – the new scheme would be a huge success. But I do not believe that pricing legacy assets and loans, even if achieved, is going to be enough to secure this aim. In the context of a global slump, will investors be willing to put up the vast sums required by huge and complex financial institutions, with a proven record of mismanagement? Trust, once destroyed, cannot so swiftly return.

The conclusion, alas, is depressing. Nobody can be confident that the US yet has a workable solution to its banking disaster. On the contrary, with the public enraged, Congress on the war-path, the president timid and a policy that depends on the government’s ability to pour public money into undercapitalised institutions, the US is at an impasse.

It is up to Barack Obama to find a way through. When he meets his group of 20 counterparts in London next week, he will be unable to state he has already done so. If this is not frightening, I do not know what is.

The root cause of the financial crisis: a demand-side view- Photis Lysandrou

The financial sector is widely blamed for the financial crisis, with banks and their investment vehicles considered responsible for the products at its epicentre.

By contrast, investors who bought these products are seen as having played a largely passive role. In fact, demand-side pressures were the main driving force behind the growth of these products. As a result, governments will be unable to prevent crises if they restrict themselves to changing the global financial architecture.

The scale of demand for securities (see appendix, table1) helps to explain the fall in treasury yields and the tightening of yield spreads after 2001. Psychological factors are typically invoked to account for these developments: infected by the atmosphere of optimism and confidence in the real economy, investors also became over-confident and hence overly willing to accept lower risk premiums. However, it is more likely that yields fell after 2001 mainly because governments and large corporations were unable to supply securities with a sufficient wealth storage capacity to accommodate the surplus capital pools.

Without any one of the main components of the global demand for securities, yields would not have fallen as far as they did; nor would the ‘search for yield’ phenomenon have become as pronounced as it did.

The question is: which demand component can we subtract? That exercised by the institutional investors? Or by the banks? Or by governments? In each case, there is justification or plausible explanation for the size of the demand for securities that was exercised.

However, this hardly applies to the high net worth individuals, of whom there were 9.5m in 2006. HNWIs may have had little or no direct involvement in the collateralised debt obligations market, but their indirect involvement was substantial in that they were the leading providers of finance to hedge funds (see appendix, figure 1). These hedge funds were in turn the leading buyers of CDOs (see appendix, figure 2).

This last fact is easily explained. The basic task of hedge funds is to generate above average returns for their clients, for which these clients pay above average fees. This task became increasingly difficult in the low-yield environment of the early to mid- 2000s. The problem was that no matter how sophisticated were the investment strategies used to generate yield, there were limits to how much could be squeezed out of the securities and other available asset classes. So the hedge funds found themselves in a dilemma: on the one hand, more and more assets were placed under their management because other investors were finding it difficult to generate yield; on the other hand, the hedge funds were themselves finding it difficult to generate yield.

It was hedge funds’ need to resolve this dilemma that led them to the search for alternative financial products that could give higher yields, and, when finding that the CDOs fitted this description, led the demand for them. Hedge funds pressured suppliers into providing these products at an ever-increasing rate. As Gerald Corrigan, a managing director of Goldman Sachs, told British MPs recently: “To a significant degree it has been the reach for yield on the part of institutional investors in particular that goes a considerable distance in explaining this very rapid growth of structured credit products”.

Financial crises will not be avoided merely by reforming the financial system. Regulators can make the system as transparent and accountable as they like, but as long as there remain external pressures on it to create products or to indulge in harmful practices, such products and practices will continue to be introduced and financial crises will continue.

Only a significant re-distribution of wealth will remove these external pressures. This requires globally coordinated action in three areas of tax policy:

(1) Tax havens: these need to be closed to prevent trillions of dollars from disappearing off governments’ radar screens;

(2) Tax structures: these need to be harmonised to prevent mobile sections of global capital from encouraging a tax competition ‘race to the bottom’ with the result that domestic tax burdens fall on those who cannot operate across borders;

(3) Tax rates: these need to be re-aligned so that the tax burden is again distributed on a progressive rather than regressive basis.

A globalised version of Keynesianism is needed to help to prevent future crises and to help finance the resolution to the present one. As governments pile more claims on their future revenues through bond issuance, the lower will be their credit ratings and the higher will be the risk-adjusted returns that investors will demand.

From where will these returns come? Since there are limits to how much can be raised from average income households, small businesses and other immobile taxable units, there will have to be, in the absence of serious tax reforms, deep cuts in many areas of government expenditure.

It will be difficult for governments to institute the necessary tax reforms, and thus prevent them from making those cuts, given the pressure exercised by the very wealthy.

However, it can be done providing strong countervailing pressure is brought to bear on governments. If ever there was occasion and opportunity to exercise that countervailing pressure, it is now.

Photis Lysandrou is professor of global political economy, London Metropolitan Business School, London Metropolitan University

Appendix: Table 1

Major Holders of Securities, 2006 (US $Trillions)	Total Assets	Securities	Alternative Investments (inc. Hedge funds)	Other Assets (cash, real estate, etc.)
1. Institutional Investors
(a) PFs	21.6	17.3	1.3	3
(b) MFsÂ	19.3	17.4	0.8	1.1
(c) IC's	18.5	14.8	1.1	2.6
2. Banks	74.4	37.2
3. Governments
(a) Reserves	5.4	4.9	0	0.5
(b) SWFs	1.9	1.5	0.2	0.2
4. HNWIs	37.2	19.3	3.7	14.1

References

Bank of England (2008), Financial Stability Report, October
Capgemini (2007), 11th World Wealth Report, June
Conference Board (2008), Institutional Investment Report, September
House of Commons (2008), Treasury Committee, Report on Financial Stability and Transparency, 26th February, 2008,
International Monetary Fund (2008), Global Financial Stability Report, April
McKinsey Global Institute (2008), Mapping Global Capital Markets: Fourth Annual Report, January
Sovereign Wealth Fund Institute (2008), Asset Comparison -Investor Classes and Asset Classifications, August