The Pain Has to Go Somewhere, But Where?

Roughly three months later than originally scheduled, the fiscal year 2009 Financial Report of the United States Government came out. I had predicted a few times (latest here) that the final total of debts and unfunded liabilities would be about 4x GDP. Well, I was close:

Category Amount
OASDI (Social Security) (7,677)
Medicare Part A (13,770)
Medicare Part B (17,165)
Medicare Part D (7,172)
Unfunded Liabilities (45,784)
Net Explicit Debt (11,456)
Total Debt and Unfunded Liabilities (57,240)
GDP 9/2009 14,242
Ratio 402%


As I commented in my piece The Biggest, Baddest Bubble of Them All:

This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

That comment was originally written in October 2003. As I commented at RealMoney a number of times, I felt that it was possible that the GSEs would fail — they held so little in reserve against mortgage losses. Back then, the figure wasn’t $57 billion, it was $25 billion for fiscal year 2002, which would be 2.4x GDP.

The US Government has made a lot of promises to pay. I have no idea how big the annual obligations for capital and operating leases are, but it would be cheaper for the Government to borrow and buy their buildings, rather than hiding the debts through Credit Tenant Leases. I also can’t quantify the full range of guarantees they have made, including implicit ones to bail out GSEs, big financials, allies, etc.

A reader wrote me asking:

Would you please write a post on what will happen if the US goes bankrupt? This government spending continues to get worse and I am wondering what if anything I, a retired person, can do to get in front of this.

Okay, here goes. Remember that the US Government has choices. It can raise taxes, inflate, or default. I don’t think default, even if it is only an external default, is the most likely option. Also, the promises for Social Security and Medicare are not guaranteed — they can be reduced or canceled by Congress and the President. Changing Social Security and Medicare would be political suicide, but suicide is an option.

An aside, why have I not mentioned cutting discretionary spending (or defense or entitlements)? Because they aren’t that large a portion of the budget. Defense and entitlements are large, but who could get a consensus on cutting those? Our culture has a “more is better” mentality, even though spending money on “defense” has probably not made us more secure.

In order of highest likelihood, here is how I see the options:

  1. Borrow more
  2. Raise taxes
  3. Inflation
  4. Cut discretionary spending
  5. Cut defense spending
  6. External default
  7. Total default
  8. Cut entitlement spending
  9. Internal default

Much as I would like to see the US Government reduced in size to only core functions, my views are not the consensus. They will try to raise taxes, and failing that, inflate the currency.

To the one who asked the question, I am not a tax expert, so consult one to limit your taxes. On inflation, you probably know the drill: Money market funds, TIPS, commodities, and equities with hard assets or pricing power.

The US government talks about cutting discretionary spending, but rarely does so. Defense is worse; it always expands. For the US to cut defense spending would be a mindshift requiring closing overseas bases, and a quiet surrender of the idea that the world is ours to guard/rule. We think we are neutral, when we are genuinely self-interested.

External default would not be enough to solve the problems the US faces, and, it would enrage the rest of the world. We would find our assets abroad seized by foreign governments. Say goodbye to goodwill and globalization.

I don’t know what to say about total default, aside from depression everywhere, with many financial institutions failing in the US and abroad. If the global reserve currency fails, well, those that rely on it will fail.

I don’t view cutting entitlement spending or an internal default only as likely. They are political suicide for whoever does it.

My sense is when the ability to raise taxes fails, inflation will be the solution. If/when the political outcry becomes too great against inflation, then the lesser remedies will be considered.

The pain has to go somewhere — we’ve been really good at ignoring the problem, delaying the payment, etc., but it has only had the effect of building up the eventual pain that will have to be taken. Our leaders are seemingly opting for a Japan-style solution — stagnation for two-plus decades with debt shifted from private to public entities. We have better much better demographics, but Japan has had better saving in the past — more of their explicit debts are internally funded compared to the US.

The trouble with offering advice in a situation like this is that the right answer depends on what our officials do. The best or worst investment could be long Treasury zero coupon bonds. Or it could be gold. Remember, many thought the Great Depression would end with inflation, but it didn’t, at least not to the degree that many feared. Me? I am invested in a mix of well financed businesses that generate a lot of cash and would be difficult to do without, and some money market funds, where I suffer the punishment of a saver, while retaining flexibility.

There are no easy answers here.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website ( Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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