Approaching the Wall

How Long Before America Hits the Wall?

BY TERRY COXON

Decades of manipulation by the Federal Reserve (through its creation of paper money) and by Congress (through its taxing and spending) have pushed the US economy into a circumstance that can't be sustained but from which there is no graceful exit.

With few exceptions, all of the noble souls who chose a career in "public service" and who've advanced to be voting members of Congress are committed to chronic deficits, though they deny it. For political purposes, deficits work. The people whose wishes come true through the spending side of the deficit are happy and vote to reelect. The people on the borrowing side of the deficit aren't complaining, since they willingly buy the Treasury bonds and Treasury bills that fund the deficit. And taxpayers generally tolerate deficits as a lesser evil than a tax hike.

Deficits are politically convenient for a second reason. They can take a little of the sting out of a recession. That effect is transient, and it's not strong – more like weak tea than Red Bull. But it can be enough to help a struggling politician get past the next election.

Yes, sometimes there's a big turnover in the personnel, such as with the 2010 election, when a platoon of self-styled anti-deficit commandoes parachuted into Congress. As soon as they had taken their seats, they began offering proposals to deal with the government's trillion-dollar revenue shortfall. But none of the proposals were serious. They were merely tokens intended to make politicians wearing anti-deficit uniforms look less ridiculous. Cut a ginormous $2 billion out of this program and a great big $500 million out of that program. Reduce spending by half a trillion dollars... over ten years. Balance the budget to the penny, but later. No one proposed anything close to dealing with the deficit now.

So stay up as late as you like on election night to see who wins, but the deficits aren't going to stop anytime soon. The debt mountain will keep growing. The part of it the government acknowledges is now approaching $16 trillion, which is more than the country's gross domestic product for a year. Obviously, the debt can't keep growing faster than the economy forever, but the people in charge do seem determined to find out just how far they can push things.

Inflation as Savior

At some point, personal and institutional portfolios will be glutted with Treasury securities, and the government will be forced to pay higher and higher rates to induce investors to take more of the paper – and the accelerating interest cost will make the deficits that much bigger. When that happens, the problem will be feeding on itself. The only way for the politicians to buy time will be through price inflation, to reduce the real burden of the debt, and whether they admit it or not, inflation is what they will be praying for.

The Federal Reserve will hear their prayer. It is 100% committed to protecting the value of the dollar, except when it is debasing the dollar in an effort to cure a recession or prevent a depression. It's been doing that important work since 1971, when the dollar slipped the leash of the gold standard. With every downturn in the economy, the Fed speeds up the creation of new cash. Each time, the economy does seem to recover, but the economic distortions that caused the recession are allowed to linger to one degree or another. They accumulate like the grotesqueries in the picture of Dorian Gray and predispose the economy to further and deeper slowdowns.

For the last three years, the Fed has been performing an additional service to help keep the system going. Whether or not you believe that suppressing interest rates with newly conjured dollars stimulates the economy in a healthy way, the practice certainly makes it easier for the Treasury to sell bonds to cover its deficit. And as total debt grows, the Fed will be biased more and more toward printing in order to retard any rise in interest rates. In short, the cost of postponing the bankruptcy of a government engaged in nonstop deficit spending will be progressively higher rates of inflation. There is no inherent stopping point in the process short of hyperinflation and the destruction of the currency.

Will it actually go that far? My guess is that it won't, but that's a guess about politics, not about economics. At some point, perhaps at an inflation rate of 30% or 40%, the turmoil that comes with runaway inflation will become so painful that the public will accept, and the politicians will find it wise to deliver, a balanced budget and a return to a stable currency. But even a year or two of such high inflation rates, while not a Weimar experience, would be a calamity. Most people's savings would be destroyed. Most businesses would be badly damaged, and most investment portfolios would be ruined. It would be like the economy hitting a wall.

But when will the economy reach the wall toward which it is headed? Not soon, I believe, but in the meantime there will be plenty of excitement.

The twin motors driving the economy toward the wall are deficits and money printing. Let's take them in turn and try to foresee their pace.

Danger Zone

When federal debt recently overtook a year's worth of gross domestic product, the US government crossed over into the zone at which, by historical experience, governments can get caught in a debt trap. High debt raises doubt about creditworthiness; doubt raises borrowing costs; higher borrowing costs add to deficits and day by day to the total debt burden; growing debt increases doubt about credit worthiness. Once in the cycle, it is hard to escape.

But Debt = GDP is not a formula for certain doom. It's possible to spend some time in a bad neighborhood without getting shot. Japan's ratio of government debt to GDP, to cite an extreme example, is over 230%. Perhaps the Japanese government is living on borrowed time as well as on borrowed money, but it is still able to find buyers for its debt at low yields.

The US may outdo Japan's ratio before hitting the wall. The capital markets will tolerate an especially high debt-to-GDP ratio for the US for a simple reason – it's safer than most other places. It doesn't get invaded, it doesn't get blown up in wars, it doesn't have revolutions and it hasn't destroyed its currency recently. Still, there is a limit to what the capital markets will tolerate.

How rapidly the US ratio of debt to GDP will grow depends on a list of barely-guessables, including how long the recovery from the recent recession drags on, the time elapsed until the next recession and the level of the public's actual tolerance for deficits. Assuming that the recent level of deficits continues indefinitely, it would take on the order of ten years for the US debt-to-GDP ratio to get where Japan's is now, which would bring us near 2022. After that, the safety factor still should buy the government a few years more.

That adds up to a long time to wait for the end of the world. Fortunately for the impatient, there is the Federal Reserve, and what the Fed will be doing, what the effects will be and when they will be felt all can be anticipated with a bit more clarity than the doings of Congress, although it remains guesswork.

Approaching the Wall

The M1 money supply has grown by 52% since the Federal Reserve opened the spigot in October of 2008. That alone is reason to believe that the current recovery, though painfully slow, is real. It has been held to a snail's pace by the fear of deflation that so many people learned in 2009. Fear of deflation is a reason to hold on to cash, but as 2009 becomes more distant, that fear is waning, and the holders of that 52% are becoming more and more disposed to think of it as excess cash that should be spent on something. That feeds the recovery.

Given the slow pace, it should be perhaps two years until the economy seems more or less normal, but the excess cash will still be at work. Give it one more year, and price inflation will emerge as a noticeable complaint. Then the Federal Reserve will let interest rates rise, but only slowly at first. By the time it tightens in earnest, price inflation will be approaching double-digit rates. It will look like the 1970s. And despite all the statistics it publishes, the Fed will only be feeling its way in the dark, since there is no reliable, real-time indicator of how much excess cash there is in the system. So inflation will keep rising, and the Fed will keep tightening until it produces a rerun of 2008-2009, with crashing investment markets announcing a new recession.

But there will be two important differences vis-à-vis 2008-2009. First, it will be happening with the US government far deeper in debt than it was when the last recession began. In the tightening phase, the government's interest expense will move above $1 trillion per year, and the budget deficit will jump to new record highs. Second, it will be happening with the rate of price inflation already at a troubling level. Another round of the monetary therapy the Fed applied to cure the last recession would push price inflation to levels beyond those reached in the 1970s. They'll do it anyway.

This gets us to 2016 or 2017 with the system in turmoil but still functioning. No wall yet, and there will be room for at least one more cycle of reflation. But it will be a fast cycle, since in an environment of already high inflation, people will be quick to spend the newly created cash. That means a quick recovery from the 2017 recession and a catapult into the 20% plus range for price inflation. Then the wall may be in sight.