Bacon's Rebellion

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Boomergeddon Watch: Uncle Sam’s Other Debt

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by

James A. Bacon
in ,

Towering mountains of debt. Watch out for avalanches.
Towering mountains of debt. Watch out for avalanches.

by James A. Bacon

The federal government is far more exposed to a rise in interest rates than commonly believed. As I frequently remind Bacon’s Rebellion readers, the national debt stands at $17 trillion, a sum that is increasing with no end in sight. But Uncle Sam’s total financial liabilities are far larger, says James D. Hamilton, a University of California-San Diego economist, in “Off-Balance-Sheet Federal Liabilities.”

Off-balance sheet liabilities — mortgage guarantees, deposit insurance, student loans, government trust funds, Federal Reserve instruments — amount to some $70 trillion, Hamilton calculates. Admittedly, those liabilities are not the same as the national debt. They are offset by corresponding assets. But the assets and liabilities all shift in value, depending upon economic circumstances. Should the economy tank, the feds could be on the hook for billions of dollars in bad loans. And if interest rates rise, the asset value of loans could tumble.

Things can look fine one day, then change the next. Hamilton points to the example of Ireland, which in the Great Recession responded to a banking crisis by guaranteeing all deposits and most debt of its six largest banks. Kaboom. Gross government debt soared from a responsible 25% of GDP to a disastrous 100%, and interest rates on Irish government debt shot up from 4.2% to 14%.

“I am not predicting that a similar crisis is on the verge of unfolding for the United States,” Hamilton makes clear. “But one thing seems undeniable — [off-balance-sheet debts] are huge. And implicit or explicit commitments of such a huge size have the potential to have huge economic consequences, perhaps for the better, perhaps for the worse. Acknowledging their size is a necessary first step for making wise policy decisions.”

Bacon’s bottom line: If interest rates return to the average rates experienced during the 1990s, government interest payments on the national debt, currently around $350 billion a year, would double or triple. It is simply unknowable what would happen to the $70 trillion in off-balance-sheet obligations, but the impact could be measured in the trillions of dollars. While it’s conceivable that the whole jury-rigged financial infrastructure will stay intact, only a fool would deny the possibility that things could spin horribly out of control.

Fiscal precautionary principle. Those who believe that global warming might represent an existential threat to humanity concede that the future is unknowable but they invoke the precautionary principle: If there is a reasonable chance that the global climate could spin out of control, we should make every exertion to avert the possibility. I would invoke the precautionary principle for national finances. We must take precautions. Failure to do so could lead to Great Depression-level calamity.

Personally, I have no confidence that our gridlocked political system in Washington, D.C., will enact the painful changes needed to avert a fiscal meltdown, so I don’t even bother to address the miscreants there. But I still have hope that state and local politicians are accessible to reason. Our goal in Virginia should be to create an oasis of stability capable of riding out Boomergeddon, should it come. But the clock is running out. We need to get serious. We need to start now.

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9 responses to “Boomergeddon Watch: Uncle Sam’s Other Debt”

  1. DJRippert Avatar
    DJRippert

    I remain confused by some of your points. You understand that rising interest rates cause the underlying debt instrument to fall in value when traded. In other words, a 20 year, $1,000 face value bond paying 10% will yield $100 per year regardless of the level of interest rates. If interest rates are at 10% then everything is fine. However, if interest rates rise to 20% then the bond is worth less than $1,000 since it still yields $100 per year. Forgetting about the redemption value, the bond would trade at $500.

    In the case of student loans the issuing authority doesn’t have to sell the debt. It can keep the debt and continue to collect the principal and interest (although at below market rates). As the debt is paid the issuing authority can lend that collected monies out at higher interest rates. There may be more defaults if rising interest rates contract the economy but I don’t see a collapse of student loan debt.

    Your other concern deals with retirement portfolios. If the portfolio is holding equity we would expect that equity to fall in value as interest rates rise and debt becomes relatively more attractive. If the portfolio holds debt then the debt will fall in value (if traded) as interest rates rise. All fine and good. However, professional money managers are paid (and paid well) to reduce these risks. Bond ladders are managed by maturity with many bonds being paid off in the near future. The face value of these bonds will not fall in proportion to interest rates since the bond repayment (at full face value) is imminent. Meanwhile, stock investments in a number of industries will do well in a period of rising interest rates. Money managers know this and presumably will be holding those stocks.

    Your point about government needing to issue debt at higher interest rates is a good one. However, the government will also pay off their debt with deflated dollars.

    Don’t get me wrong – I agree with the generalized risk of the Fed’s endless pumping. Obama seems quite content to throw the dice with the American economy for the entirety of his two terms. When the fit finally hits the shan he will probably not even still be in office. My gripe is that artificially low interest rates blow up the economy in unique and unpredictable ways. I am not convinced that your mechanical analysis of the coming meltdown will prove true even if I believe a meltdown is inevitable.

    1. James A. Bacon Avatar
      James A. Bacon

      Don, If we disagree, its mainly on the margins. Let me try to clarify a couple of points you raise.

      Regarding student loans, the problem there is not rising interest rates reducing the value of the loan portfolio. The problem is interest rates (now pegged at 2 points higher than the 10-year Treasury, I believe) causing more people to default on their loans, creating a big bad debt problem for Uncle Sam. Ultimately, that bad debt will have to be covered by the Treasury.

      Regarding personal retirement portfolios, are you talking about government pension funds, or are you talking about personal retirement accounts? I can’t respond until I’m clear on that point.

      Finally, you made the point that “government will also pay off their debt with deflated dollars.” (I assume you mean inflated dollars, signifying that the dollars are worth less.) That’s an interesting point, and it’s one, to be honest, that I do not fully understand. All I can say is that those who DO understand money and banking are divided, for reasons too arcane for me to explain, on whether inflation or deflation is the more likely outcome of current policies. If overseas economies (particularly the Chinese) continue to slow, deflation (meaning dollars become scarcer and more valuable and harder to pay off) may become a reality.

      No one knows the future. I don’t pretend to. But we can identify large systemic risks (known unknowns, in the parlance of Donald Rumsfeld). And we should be mindful of the unknown unknowns (black swans, in the parlance of Nassim Taleb) that can seemingly come out of nowhere.

      Some institutions are fragile (to borrow again from Taleb), which means they are vulnerable to major disruption. Some are robust, which means they can survive a major disruption. And some are antifragile, meaning that they can prosper from a major disruption.

      My argument is that if Virginia can structure its affairs to be an oasis of stability and order amid fiscal chaos, should it come, it will be antifragile. It will prosper while those around us are drowning because talent and capital will flow to where stability and order prevail.

      1. DJRippert Avatar
        DJRippert

        We are not that far apart.

        1. Student loans – historically, the government has used tough enforcement mechanisms to get repayment of student loans. For example, federal student loans are much more difficult to discharge in bankruptcy than other types of debt. The real risk here is political. I am already hearing the whining, sniveling crybabies of the left talking about “forgiving” student loans.

        2. Personal retirement vs government pension funds – Shouldn’t really matter which. If the funds are intelligently managed then they should be able to weather a rise in interest rates without being decimated. For example, in both cases, if you think interest rates are going to rise you should shorten the average maturities in the bonds you hold. While this will reduce yields in the short term it will also protect you from loss of face value in the mid to long term. Interest rates have fallen and rise throughout US history. Each rise does not lead to a meltdown in investment portfolios. The big question is whether the government is lying to us. Are the government managed pensions using a reasonable expected return in their actuarial calculations? I’d say generally “no”.

        3. Artificially holding down interest rates (the price of capital) is a breeding house for black swans. What will go BANG this time? Who knows but something will definitely go BANG.

        4. There is little Virginia can do in a world where money and many industries are fungible across geographies. Localities can affect things like the education and job skills of their citizens. Countries can manage their economies to an extent. But states are largely helpless. A state is too big to take direct action and too small to take macro action. The single biggest managerial flaw in Virginia today is the colonial era belief that the state – level is the best level with which to manage the affairs of the residents of Virginia. The problems in Martinsville bear no resemblance to the problems in Arlington County.

        However, if you must focus on the state level, Virginia was one of the slowest growing states in 2012 as measured by growth in state GDP. Texas grew 4X faster than Virginia, California grew 3X faster and Maryland grew twice as fast. Why? It’s not because those states share a common region of the country or political philosophy.

  2. larryg Avatar
    larryg

    re: student loan liability –

    ya’ll should read this to see who really is at risk:

    http://ficoforums.myfico.com/t5/Student-Loans/Cosigning-Student-Loans-Learn-From-My-Mistakes-Please-Read/td-p/278380

    but the problem that Jim talks about also applies to all businesses and investment companies, insurance companies, etc… it’s not just govt.

    and let me point out something else. Your mortgage on your home can be terminated and all of it due upon termination.

    many people have lost this homes this way back during the depression and even now…

    re: off balance sheet debt

    In Va – the pension liabilities are no longer off sheet. Just watching the BOS the other night who had bond counsel presenting – both county and schools have to now show their pension and health care retiree liabilities.

    1. DJRippert Avatar
      DJRippert

      The pensions will no longer be “off sheet” when a failure to adequately fund a pension (using accepted actuarial method) results in a budget deficit in the year of the short-funding. Corporations which fail to adequately fund their pensions take a charge to earnings in the year when the shortfall occurs. Governments do not. So, Bob McDonnell can still “balance the budget” while failing to adequately fund the state’s pension obligations. This should not be allowed. If you fail to adequately fund the pension obligations in any single year you should have to recognize the equivalent of a cost that year.

      All politicians are slippery eels. They are only too happy to present the fraud of a balanced budget in the face of underfunded pensions. State constitutions which mandate balanced budgets do no good when shortfalls in pension funding can be swept under the “balanced budget” rug.

      LarryG – the politicians who run all levels of our government are practiced liars whose sole worry is getting re-elected. From phony unemployment statistics to so-called balanced budgets, they will lie, cheat and steal their way forward. The only real hope is term limits. While politics may still attract professional liars under term limits they will never get to be as practiced a set of liars as the current crop of misfits.

  3. larryg Avatar
    larryg

    re: public pension accountability and funding.

    two steps forward, etc… now that the localities “see” the numbers, they KNOW that those costs really are real and really do compete for other things in the budget.

    but don’t point too smugly to companies – more than 5000 have bailed out on their pension obligations and taxpayers have had to take over the pensions and the pensioners take major haircuts.

    the idea that only municipalities and govt makes promises they cannot keep is a myth.

    I equate the “what we have liabilities” pension problem to those who also think roads are “free”.

    we’ve made IMHO two HUGE mistakes both public and private . The first is defined contribution pensions and the second is tax-free employer-provided health insurance.

    both are fiscal threats to both public and private sectors.

    note.. I’m NOT saying that pension and health insurance themselves are the problem – it’s the WAY we do and have done them. Both have created winners and losers and impacted markets in ways we have not anticipated.

    I think politicians are a reflection of us myself. It’s sort of like “natural selection” in the way we do end up choosing who represents us and our two-party system at the state and federal level disadvantages legitimate 3rd party challengers so what we get is who each party wants to run not who we may want. That’s how we end up with our current choices.

    I’m not a believer in term limits.. I think elections should do that… the premise that each elected is either already corrupted or will be in a couple years is inherently anti-govt and it leads to efforts to damage govt which might feel good to some but it’s just plain dumb.

    we have two choices in governance – either elective or not-elective.

    as bad as elective is and can be, I’m not in the camp that we need a benevolent dictator instead.

    that’s the truly odd thing about some who want term limits. They want govt damaged if possible but they also want the “right person” to …..”rule”. They’d be just fine if a Ronald Reagan was in charge just as long as Roosevelt was.

  4. Breckinridge Avatar
    Breckinridge

    My problem with this, and I worry about the debt, is that we always look at one side of the balance sheet. We never list the value of the assets the government holds, whether it is physical assets like aircraft carriers and Forest Service fire trucks or the vast mineral wealth on federal lands or federal waters. Granted, much of it depreciates, and it would be hard to realize the cash value of a 30 year old B-52. But just as much of it appreciates over time. There’s still gold in them thar Fed vaults.

    When I started with the original story on the $70 trillion in debt I quickly realized that the premise was largely bogus. I’m not sweating FDIC because if the entire banking system collapses, money is meaningless anyway. There were many items on that list that are secured debts, after all.

    The real problems are bad enough without blowing this up into such a large problem that the natural human reaction is to shrug and ignore it.

    1. James A. Bacon Avatar
      James A. Bacon

      The premise is not bogus at all. A problem occurs when the trillions of dollars in assets stand to depreciate massively if and when interest rates go up. Everything will be fine… until it isn’t. And then it will melt down with frightening rapidity. Corporations strive to understand and control the risks they take when they invest money. Government neither understands nor controls risk.

  5. Richard Avatar
    Richard

    It’s the demographic bulge – Medicare reform, and health care reform to lower overall health care spending – is needed. The government can’t cut off Medicare and Social Security benefits but Boomers can’t expect to get the same benefits their parents got. I suppose I am a Boomergeddon “denier” because I think that we will eventually figure it out and not particularly worried about it right now.

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