Debt Ceiling Battle’s Predictable Outcome

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 10, 2011

IN THIS ISSUE:

1.  The Economic Recovery Remains Soft

2.  What is the National Debt?

3.  A Brief History of the National Debt

4.  What is the National Debt Ceiling?

5.  The Republicans Have No Leverage

6.  What Happens When the Bond Market “Blows Up”?

Introduction

As this is written, the US national debt that is subject to the “debt limit” stands at apprx. $14.27 trillion.  The current statutory debt limit is $14.3 trillion. With a projected budget deficit of $1.65 trillion for this year, we are set to hit the debt ceiling sometime in the next few weeks. A battle is brewing in Washington over how much to raise the debt ceiling. 

Congress has raised the debt ceiling limit many, many times before, and there is no doubt that it will be raised again… and again and again.  Yet every time we face an impending increase in the debt limit, the media makes it out to be a dangerous and potentially apocalyptic battle.  Nothing could be further from the truth.

The business-as-usual Republicans will hold out for more spending cuts to win their votes to increase the debt ceiling.  The business-as-usual Democrats will scream that the Republicans want to put old people out on the streets.  What else is new?  We’ve all seen this movie several times before, after all.  How short do they think our memories are?  Or maybe better put, how stupid do they think we are?  I think the operative answer to that question is VERY.

Yet the reality is that after a theatrical (as in fake) battle over whether or not to raise the debt ceiling, with the lapdog media warning of a looming disaster, an increase in the debt ceiling limit will predictably get done just in the nick of time.  I predict the Republicans will get close to zero in actual spending cuts on this one, because virtually no one wants to see the government shut down – more on this as we go along.

In order to address the debt ceiling problem, we will take a brief look at how our national debt is soaring out of control and what may be done about it.  Sadly, I don’t expect anything material to be done about our out-of-control spending until after the 2012 election, and then only if President Obama is defeated.  The Republicans in the House have lost their leverage, in my opinion.  I’ll explain why later on.

Before I get into the national debt and debt ceiling issues, let’s first take a brief look at a few recent economic reports and the latest data from Blue Chip Economic Indicators.

The Economic Recovery Remains Soft

The May issue of Blue Chip Economic Indicators (BCEI) arrived Monday morning.  This is a monthly survey of 50 leading economists and market analysts.  As expected, the consensus estimate for GDP growth in 2011 fell in light of recent disappointing reports, in particular the latest GDP estimate of only 1.8% (annual rate) in the 1Q.  In the latest BCEI, the consensus is for growth of only 2.7% (annual rate) for all of 2011, down from 2.9% last month.   The consensus expects GDP growth to rise above 3% in the 2Q, 3Q and 4Q.  The consensus predicts growth of 3.15% for all of 2012.

News on the unemployment front was also disappointing.  The official unemployment rate rose from 8.8% in March to 9.0% in April, largely because more people who had given up are now looking for work.  The report noted that 268,000 new jobs were created in April, a bit better than expected.  However, the number of people who filed for new unemployment benefits in the last week of April rose to 474,000, well above expectations.  In fact, initial claims were above 400,000 every week in April, obviously not a good sign.

What is the National Debt?

As the debt limit battle heats up, let’s begin this week’s discussion with a brief explanation of what the debt ceiling limit is and how it got started in the first place.  The US public debt is a frequently reported measure of the obligations of the United States federal government and is presented by the Treasury Department in two components and one total:

  • Debt Held by the Public, representing all federal securities held by institutions or individuals outside the United States Government;
  • Intragovernmental Holdings, representing US Treasury securities held in accounts which are administered by the United States Government, such as the OASI Trust fund administered by the Social Security Administration; and
  • Total Public Debt Outstanding, which is the sum of the above components.

As of February 2011, the debt held by the public was $9.6 trillion and the intra-governmental debt was $4.6 trillion, for a total of $14.2 trillion. 

As of March 25, 2011, the Total Public Debt Outstanding of the United States was $14.26 trillion which was 97.3% of calendar year 2010’s annual Gross Domestic Product (GDP) of $14.66 trillion.  Using 2010 figures, our national debt as expressed as a percentage of our GDP ranked 12th highest against other nations.

The national debt of $14.26 trillion is largely the net accumulation of our annual federal budget deficits and surpluses since our nation was founded.  This does not include other unfunded government obligations such as Social Security, Medicare and unfunded pensions.  If we were to include all government payment obligations, our national debt is, in reality, north of $50 trillion.  But for purposes of this discussion, we will consider only the federal budget deficit national debt.

The national debt should not be confused with the trade deficit, which is the difference between net imports and net exports.  Also, it should be noted that state and local government securities (those issued by state and local governments) are not part of the United States national debt.

A Brief History of the National Debt

This may surprise you, but the United States has had public debt since its inception. Federal deficits began during the American Revolutionary War in the year of 1791. The first dramatic growth spurt of the debt occurred because of the War of 1812. Yet in the 20 years following the War of 1812, the US paid off 99.97% of its debt.

The second dramatic growth spurt of the debt occurred because of the Civil War.  The national debt was just $65 million in 1860, but passed $1 billion in 1863 and had reached $2.7 billion following the war.  In the following 47 years, America returned to the practice of running surpluses during times of peace, experiencing 36 surpluses and only 11 deficits. During this period, 55% of the US national debt was paid off.

The next period of major growth in debt came during WWI, with the national debt reaching $25.5 billion at the War’s conclusion.  It was followed by 11 straight surpluses and saw the debt reduced by 36%. The buildup and involvement in World War II – plus new social programs during the Roosevelt and Truman presidencies in the 1930s and '40s – caused a sixteen-fold increase in the gross public debt from $16 billion in 1930 to $260 billion in 1950.

After this period, the growth of the national debt closely matched the rate of inflation where it tripled in size from $260 billion in 1950 to around $909 billion in 1980.  In 1982, the national debt first surpassed $1 trillion.  The national debt in nominal dollars quadrupled during the Reagan and Bush presidencies from 1980 to 1992 when the debt first topped $4 trillion.

During the administration of President George W. Bush, the national debt increased from $5.7 trillion in January 2001 to $10.7 trillion by December 2008, and I criticized him for it dozens of times in my newsletters and these weekly E-Letters.  Under President Barack Obama, the debt increased from $10.7 trillion to $14.2 trillion by February 2011.  That’s an increase of $3.5 trillion in just two years!

What is the National Debt Ceiling?

Up until 1917, Congress approved each government debt offering by the Treasury.  These debt approvals were more or less automatic.  But in September of 1917, Congress decided there should be a limit on how much the national debt could go up.  As a result, it passed the Second Liberty Bond Act of 1917, which established a statutory limit on federal debt – the so-called “debt ceiling.”

In preparing to write this E-Letter, I looked everywhere I could think of to find how many times the US debt ceiling has been raised since 1917, some 93 years ago.  I can find it nowhere.  But there is a pattern, especially in the last few decades.  The pattern is that increases in the debt ceiling have become smaller as a percentage of outstanding debt, and this has meant that such increases have become more frequent.

United States Debt Ceiling

In the last decade, for example, there has been an increase in the debt ceiling every year since 2002.  In 2008 and 2009, the debt ceiling had to be raised twice!  And with each debt ceiling increase, the perceived political fight has been more heated, thanks in part to the media coverage.  But all of this is just a joke on us!  Everyone – including every member of Congress and the sitting President – knows that the debt ceiling will be increased each time.

Yet each and every time we approach the debt ceiling limit, the media makes us think:  this time it might not happen and the government will shut down and will default on our debt.  No Social Security checks for seniors, etc., etc.  This is absurd!  I could go on about this debt ceiling façade, but we must move on.

Ten Years, Ten Increases to the Debt Limit

Even when the debt ceiling is reached, the US Treasury has several mechanisms to temporarily acquire a limited amount of funding to buy some time and not default (see details in SPECIAL ARTICLES below).  Plus, it can spend any income tax revenues that come in just ahead as well.  These emergency mechanisms were last used in 2004, when the debt ceiling was reached on October 14.  The Treasury employed these mechanisms to fund the government until the debt ceiling was raised on November 16, 2004 by $800 billion to a total of $8.184 trillion.

These same mechanisms are in place today.  The current debt ceiling is $14.294 trillion and was signed into law on February 12, 2010.  Treasury Secretary Geithner originally warned that the debt ceiling would be reached by May 16.  But in the last week, he has said that by using the emergency mechanisms and the increase in income taxes in April, the Treasury could stay under the debt limit until August 2.  That bought Congress some time.

President Obama and most Democrats want to raise the debt ceiling from the current $14.3 trillion to $16.5 trillion. The increase of $2.2 trillion, assuming they get it, would be the largest ever.  They estimate that we will need $2.2 trillion to get us through the 2012 election and the end of next year.

The Tea Party and the freshmen Congress members they elected last year do not want to increase the debt ceiling at all.  Then you have the Republicans who are willing to raise the ceiling by some amount to avoid a government shutdown, but they are insisting on some serious spending cuts in the FY2012 budget, more or less in line with the proposed cuts in Rep. Paul Ryan’s budget.  That budget, which was recently passed by the House, calls for federal spending to go back to 2008 levels.  President Obama has said the Ryan budget is a non-starter, and he promised to veto it in the very unlikely event it passed the Senate.

Last night (Monday), House Speaker Boehner stated that he wants at least $2 trillion in spending cuts in order to sign off on the debt ceiling increase.  Not going to happen.  I’ll make this prediction: The Republicans will cave and Obama and the Democrats will get most, if not all, the debt ceiling increase they want with only limited spending cuts.  It is my view that the Republicans lost much of their power when they caved on the 2011 budget in March.

The Republicans Have No Leverage

The Republicans won the majority in the House primarily by promising spending cuts of at least $100 billion in their first year in office.  They broke that promise earlier this year with the passage of a Continuing Budget Resolution (CR) which contained only $61 billion in cuts.  The Senate Democrats countered with a CR containing only $33 billion in cuts. 

The Republicans settled for $38 billion in cuts, most of which were smoke and mirrors or don’t count this year (see my April 19 E-Letter).  The Republicans were willing to cave on $23 billion in cuts (61 minus 38), while the Democrats only agreed to $5 billion more in cuts.  In my view, the Republicans’ cave-in on the budget has taken away much of their leverage.  Yes, they still have a majority in the House, but all the other political players know they are soft.

We are about to witness another game of “chicken” when it comes to raising the debt ceiling, and President Obama and the Democrats fully expect the Republicans to blink, especially with a government shutdown looming.  This is why I expect that Obama and the Dems will get pretty much all they want from the debt ceiling increase, with only a limited number of spending cuts.

[Editor’s Note: To my liberal readers who love to give me grief, the four paragraphs above are yet another example of me criticizing the Republicans.  Feel free to e-mail me with some credit!  I won’t hold my breath, though.]

Democrats Link Debt Ceiling With New Taxes

The Democrats consider the Republicans so weakened after their cave-in on the budget that they are once again proposing tax increases.  Most political observers had thought that the idea of raising income taxes was off the table until the end of 2012 when the Bush tax cuts expire.  This matter was considered settled when President Obama launched his re-election campaign on April 4 at which time he vowed that he would not extend the Bush tax cuts for families making over $250,000 a year beyond 2012.

Yet at last Thursday’s initial debt ceiling meeting, the idea of raising taxes came up again.  Vice President Biden and Treasury Secretary Geithner met with senior congressional leaders in Washington late last week to see just how far apart both sides are on raising the debt ceiling.  As discussed above, the Republicans are hoping to see how much in spending cuts they can get in return for their agreement to raise the debt ceiling. 

But President Obama had a surprise in store for them.  Treasury Secretary Geithner reportedly opened the meeting with a proposal to raise income taxes.  As of yet, we don’t know if Geithner proposed some new tax hikes to be linked to the increase in the debt ceiling, or if he merely wants the Republicans to sign onto letting the Bush tax cuts expire at the end of 2012 for those families making over $250,000 a year.

In any event, if the goal of the initial meeting was to determine how far apart the two sides are on raising the debt ceiling limit, we can now say that the two sides are very far apart.  The group did agree to hold twice weekly meetings until the debt ceiling increase is resolved, and the next meeting is scheduled for today.  I’ll keep you posted in the weeks just ahead.

What Happens When the Bond Market “Blows Up”?

As regular readers know, my main theme over the last year or two has been the massive buildup of government debt under President Obama.  I had similar concerns about the buildup of debt during the George W. Bush years, but not on this level.  As I have said repeatedly, if our massive debt continues to accelerate as it has in recent years, it will end in disaster.

I ended my April 26 E-Letter with the following paragraph:

“In closing, it is now becoming clear that we have reached the age of unsustainability.  Common sense tells us that we simply can’t keep going down the same path and kicking the national debt can down the road.  Some sources, such as the CBO, have been saying this for years.  Others, like the S&P, are joining an ever-growing chorus of experts and analysts who believe that the current trend in US spending and debt is unsustainable.  When will our elected officials get the message?  Not until the bond market blows up, unfortunately.”

My closing comment – Not until the bond market blows up, unfortunately. – sparked questions from several readers.  Specifically, they asked, what do you mean by “the bond market blows up”?  I am happy to answer that question today for those who don’t know what I meant.

Let’s start this way.  President Obama’s 10-year budget recommendation that he submitted last February would add $9.5 trillion to our already $14.3 trillion national debt over the next decade.  If enacted, it would probably add much more than $9.5 trillion, since his forecast assumptions were likely far too optimistic – such as no recessions over the next decade.

I have maintained all along that the national debt will NOT increase by $9.5 trillion over the next decade because the bond market won’t allow it.  Many other financial writers agree.  So what does this mean?  Let me explain by revisiting Government Debt 101, to use a college term.

The United States finances its debt by selling a variety of government securities each month.  These securities include Treasury bills, Treasury notes and Treasury bonds.  These securities are considered among the safest investments on the planet because they are backed by the “full faith and credit of the United States government.”

The US Treasury bond market is the largest single securities market in the world.  Domestic institutions and domestic investors regularly hold Treasury bonds in their portfolios.  Ditto for foreign institutions and foreign investors.  This huge demand for our Treasury securities is key for keeping US interest rates on these securities reasonably low.

At some point, if the US continues down this path of exploding government debt that Obama recommends, we risk reaching the point that the “full faith and credit of the United States government” will come into question.  Just last month, Standard & Poor’s downgraded its outlook for the safety of US debt, although it still maintained the AAA credit rating, for now.

Or we could also reach the point that inflation becomes out of control as it did in the late 1970s.  The US inflation rate increased modestly in 2010 and is trending even higher this year thanks to exploding food and energy prices.

Whether it is concerns about the “full faith and credit” issues or concerns about significantly higher inflation, foreign buyers of our debt could decide that they don’t want to continue their purchases, or at least demand higher interest rates.  Foreigners currently own 46.6% of our outstanding debt held by the public.  Read that again – foreigners, some of whom don’t even like us, own almost half of our outstanding public debt.  China is the largest foreign owner of our debt with over $1.15 trillion.  That’s scary!  Click here to see the list of foreign owner of our debt.

If foreigners decided to significantly reduce their purchases of US debt, that would cause a new bear market in Treasury securities.  Interest rates on these instruments would increase significantly.  Next, if foreigners decided they want to unload US debt they already own, that would cause a further increase in interest rates.

Finally, if US institutions decided to curtail or stop their purchases of US debt, then rates go even higher.  Likewise, if US institutions decided to unload some of their existing US debt, then rates go through the roof! 

Somewhere along this chronology, we have a financial crisis that will make the credit crisis of 2008 look like a walk in the park!  Think Depression 2.0!!  This is where we’re headed if our leaders in Washington don’t take dramatic actions to stop the explosion in our debt.

So, when I refer to the bond market “blowing up,” this is what I mean.

The same result could occur if the US dollar continues to plummet.  The dollar recently hit a three-year low.  I’ll save that discussion for another time.

Either way, the result would inevitably be a spike in interest rates.  We have seen this before.  Interest rates on Treasury bonds spiked above 14% in 1980 when our national debt was a fraction of what it is today.  Imagine what would happen now when our national debt is exponentially higher.

Given the seriousness of today’s topic – the spiraling national debt, out-of-control spending, etc. – I encourage you to forward this E-Letter to as many like-minded people as you can.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

Why Republicans Must Not Cave on the Debt Ceiling
http://www.foxnews.com/opinion/2011/05/10/republicans-cave-debt-ceiling/

Treasury's tools to delay hitting debt limit:
http://www.reuters.com/article/2011/05/10/us-usa-debt-limit-idUSTRE7490UR20110510

Welcome to the McJobs Recovery
http://motherjones.com/politics/2011/05/mcdonalds-national-hiring-day


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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