Government Debt – Out of Control and What It Means to You

This seems like a very esoteric subject for a blog, but the beauty of blogs is that you can write about whatever interests you.

I have been fascinated by increases in government spending, reduction of taxes and the excess consumption in North America for quite a while. Maybe since university Economics 101 where I first learned that if you don’t balance your budget, you will eventually run into serious trouble. Although the blog focusses on the United States, as the expression goes, make no mistake about it - the same applies to Canada.

In the mid 1970’s New York City was bankrupt and Richard Ravitch was appointed to fix things. He did through serious budget cutting and raising taxes, plus short term borrowing. By the mid 1990’s NYC was thriving. As Lieutenant Governor of New York State, he was asked to do the same thing recently for the State – the finances of NYS are in a shambles but he was stymied. Things have changed. Listen to him on This American Life podcast June 18 2010.

About 6 years ago I was in Los Angeles in a bar talking to my nephew and his lawyer buddies, all about 30 years old. I had just finished reading a full length article in Atlantic Magazine on the American balance of trade deficit. My nephew's group expressed virtually no concern about the deficit or what impact it could have on the US dollar, almost as though they were living in isolation from the rest of the world. And this discussion was only the balance of trade deficit, not the budget deficit.

There has been an endless amount written about deficit financing. I took a look at the Atlantic Maganzine website and found numerous articles, for example – Feb. 1989 –  “Is the Deficit so Bad” by Jonathan Rauch, and Jan. 2008 - “The $1.4 Trillion Question” by James Fallows. The focus of the articles is on the balance of trade deficit but, as we can see from the plight of NYC and NYS, budget deficits present their own difficulties.

The balance of trade deficit and the budget deficit are different. The first represents the net outflow of capital from USA over the course of a year. The second is the amount by which the expenditure by government exceeds its revenues.

The balance of trade deficit results from Americans buying and consuming more foreign products than they export to other countries. The greatest part of that deficit comes from purchasing Chinese goods at a price which is much lower than they could ever be produced in the US. China has intentionally kept its currenty, the RMB, pegged low so that American consumers can afford all those Chinese made goods. Oddly, the Chinese government is saving its US dollars by buying US treasury bonds rather than spending its US dollars or investing them in infrastructure at home,  All this seems like a great deal for the US until you realize that you have to pay interest to the Chinese on those treasuries and if the Chinese government ever decided it no longer wanted the greenback, the $US would suddenly collapse in value. This is not good in the long run, though US consumers are undoubtedly enjoying it in the short run. Their kids are not going to be happy campers when payback day arrives.

The budget deficit is just as bad. Governments simply don’t seem to be able to control their spending, nor are they willing to increase taxes to balance their budgets. Taxpayers refuse to elect politicians who are going to raise taxes or take away their entitlements. Greece is a perfect example of this, where in the past few months people rioted in the streets against lowering wages and reducing benefits of government workers.  [More on this generally in the episode of This American Life - see above.]

The balance of trade deficit and the budget deficit have something in common. They effectively are borrowing against the future.

So everyone pretty much agrees that deficits are bad though some say "Don't Balance the Budget" - you can keep on increasing the deficit lock-step with the Gross National Product (“GNP”). That assumes your starting point is a reasonable and sustainable deficit and that you will reduce your deficit if there is a dip in the GNP or increase in interest rates (both of which are highly dubious).

The foreign holders of $US eventually have to do something with their money beside buying US Treasury Bills. The Chinese recently bought a few billion dollars of Blackstone, a US Hedge Fund, and lost much of it. [See $1.4 Trillion Question for more on this.] At a an investment seminar I attended recently, the presenter predicted foreign creditors will buy up massive amounts of property and businesses in the US, effectively triggering one of the greatest transfers of ownership of capital goods in history. The transfer would allow aging boomers to support their lifestyles, much like the reverse mortgages which give the elderly income while transferring their equity in their homes to the lender. Depending on the amounts involved, US may become more like a 19th century colony. Foreign owners will dictate how the businesses operate, what investment decisions are made and what will be produced. As the dollar drops in value, US citizens will have even less say about what happens in their own country, particularly about assets then owned by foreigners.

At least noone will be able to demonize the US as a colonial oppressor any more.

How does this apply to us as individuals. Does it have any significance? For starters, our kids may be the next generation’s second class citizens. Instead of having the highest living standard in the world, they are going to be moving down relative to people in other countries who have been more prudent about their finances and consumption. This is a different paradigm from the North America which has been the envy of the world economically and politically. Some of the dangers are that when hope and prospects fade, democracy is threatened. The tendency for men (who still dominate politics and probably will for a while yet) is towards anger and blame and this leads to conflict.

Now for the question. What are we going to do personally,  apart from voting for higher taxes and fewer services and reducing purchases of HD TV’s, digital cameras, computers, appliances, BMW’s and just about everything else which is manufactured outside North America (that is just about everything because not much is manufactured in North America any more), and donating to democratic watchdogs.

Middle and upper class people are likely in denial or just not thinking about how this all applies to them. They may believe that education and their current asset base can protect them. Even today in the US, the middle class is struggling to pay for services, education and health care. They are also concerned about job security and pensions, and rightly so. According to the OECD, Education is a great investment, but protecting your asset base and the purchasing power and amount of your pension fund is more difficult.

So, going back to my previous blog, I think I got the question right but haven’t come up with any answers. I am spending my kid’s inheritance to send them to university. Like most boomers, I am working longer. I could also spend less (unlikely) or die sooner. How to invest is a problem when you live in a country which is likely to experience a decline in currency value relative to countries that are producing the goods you want and gobs of money are competing for low risk investments. I could invest in RMB (Chinese money) but China seems to be on the verge of its own bubble bursting. Real estate may be a good investment depending on rental rates, interest rates and vacancy rates, but it is too expensive and sellers are greedy. Certainly those foreign investors with all the $US and $CDN love real estate, but many of them could care less about return. The stock market has been relatively steady over the past 400 years (so say the pundits) but will the future be like the past?

My answer – build a house near the beach in the Baja, Mexico [architect's rendering - not yet reality]. I don’t have to worry about what to do with my available cash – just dump it into pesos. Then I will enjoy it with my family and friends and hope climate change doesn’t make it too hot for comfort.