Sunday, January 16, 2011


Here’s what you need to know about the federal government’s finances. Even if Congress doubled personal and corporate income taxes, the federal government would still have a deficit of at least $1 trillion per year. Your first reaction might be that this number doesn’t make sense; the news media report that the deficit is about $1.2 trillion out of a $3.8 trillion federal budget. If you doubled taxes, then there should be more than enough to fill the gap, right?

Here are the estimated revenue numbers for 2011. Personal and corporate income taxes are projected to be about $1,400 billion this year. Your next reaction is probably that the numbers still don’t add up. There’s at least a trillion dollars missing somewhere. The difference is projected withholding for Social Security and Medicare equal to about $930 billion and other revenue estimated at about $220 billion.

Now here’s my question for you. If you were the CEO of American Ingenuity, Inc., and you were taking money you were supposed to be setting aside for your employees' future retirement and medical expenses (like Social Security and Medicare), as you told your bond holders you would, and spending it on current expenses, and you were still 30 percent in the red, what do you think your life would be like?

It would be a living hell. You would have busloads of investigators and attorneys from the SEC, the U. S. Attorney’s Office, and the FBI issuing subpoenas and executing search warrants on you, your CFO, your Investor Relations officer, every other officer of your company, your sister, your maid, and your dog. Those buses would be followed by several more busloads of very sharp, very uptight corporate and securities lawyers representing your bond holders all knocking on your door wanting a word with you. In addition to these headaches, your stock price would be heading straight for the South Pole, and you would be laying off employees left and right.

This is the federal government’s current yearly budget situation. It’s spending money it’s supposed to be putting aside for future expenses on current expenses, and it’s still in the red.

It's long term financial picture looks like this.  It has to pay back at least $14 trillion dollars it borrowed in the past (almost equal to the current yearly product of the entire national labor). Plus it has unfunded liabilities for Social Security and Medicare topping $100 trillion. On top of that it has trillions in additional liabilities to Fannie Mae, Freddie Mac, other Government Sponsored Enterprises, ongoing care and rehabilitation of wounded soldiers, federal employee pensions, etc., etc., etc.

Here’s the problem. At what point do people stop loaning the federal government money and what happens when they stop? Much of the federal government’s bond debt is short term - 90 day T-bills, one-year and two-year treasury bonds, and so on. It is constantly being rolled over in the bond market. When the market decides that it no longer wants to loan the federal government money because it can’t balance its budget and people don’t think it can make good on its debts, the price of that debt will drop (simple supply and demand). When the price of a bond drops, the “yield” (a.k.a. the interest rate) increases. When the interest rate increases, interest payments increase.

This is exactly the situation that happened with the mortgage mess in 2008. People borrowed money at a low interest rate, at payments they could afford. When interest rates rose, their payments rose. When the payments rose, they were no longer able to make the payments. You know the rest of the story.

The same thing will happen with the federal government if it doesn’t get its budget under control. Only the size of the problem is a hundred times larger, and the consequences will be socially devastating.

Try to imagine what will happen to the lives of ordinary Americans when Congress is forced to choose what it can spend money on because it can no longer charge to the federal credit card. As interest payments balloon, they will squeeze out other budgetary items. Will Congress cut farm subsidies, food stamps, Social Security payments, college loans, subsidies for electric cars, environmental programs, end the wars in Iraq and Afghanistan, withdraw troops from other overseas posts, cut the Department of Education, the Department of Energy, the Department of this or that, or any of a thousand other things it spends money on? Choices will have to be made, and those choices will affect those people that were counting on receiving money from the federal government. If choices aren’t made, there is only one conceivable outcome – bankruptcy of the federal government and the corresponding social and financial upheaval associated with the inability of the federal government to function as it has in the past.

What are the options?

1. Print more money. This debases the currency. It is in effect a hidden tax stealing even more money from the American people. It is also a way of cheating foreign creditors out of their money. They won’t let that go on forever. You can see their response already in their efforts to debase their own currencies. If Congress doesn’t get its affairs in order, these efforts will escalate with currency controls, trade wars, increased inspections/delays, and under a worst case scenario, real war.

2. Increase personal and corporate taxes. If Congress doubled personal and corporate income taxes, my guess is that unemployment would double overnight. Marginal tax increases reduce productivity and job creation.

3. Hope that significant new, real wealth is created that can provide jobs and increase federal revenue. The development of new technology (new wealth) would absorb the excess liquidity created to prop up failed businesses and investments.

Can such additional new wealth be created? I believe man’s curiosity will revealed more useful possibilities of this universe, and additional wealth will be created in the future. No doubt there will be huge strides in medical technology, and discoveries of new energy sources are possible. At this point, though, we can only speculate about what will come and when it will come.

4. Hope Congress comes to its senses, balances the federal budget, and begins to pay down the federal debt. This will also require sustainable policies based on government at the appropriate level. First and foremost is to eliminate the idea that Washington has to be involved in every aspect of our lives. Washington doesn’t have all the answers. If it did, they would have solved them by now. The only thing that centralizing decisions in Washington does is increase the power of Washington politicians. The single most important adjustment at the federal level is sound money. Fiat money created this monster. If fiat money is allowed to continue, then all of these problems will reoccur.

When you look at these scenarios, which one seems the most probable?

• Increasing taxes to any large extent is political and economic suicide. If Congress successfully increased taxes, it would only encourage them to spend even more money.

• Hoping for new wealth is just a hope. Even it there is some dramatic new development in our future, it may come too late.

• The tea party phenomenon is a hopeful development. Until these new members of Congress successfully cut spending, though, all the talk is just a pleasant revelry.

• The most likely scenario is that the Federal Reserve will keep printing money and papering over the problems until the whole thing comes crashing down.

I’m by nature an optimist, but the current state of affairs has me feeling very pessimistic these days. My most optimistic prediction is that Congress and the American people will continue to bury their heads until they have no other choice. Then we’ll hear no end of blaming someone else. If we’re lucky, we may renew our constitutional principles after the meltdown. Most likely we will see some “reforms.” The worst case scenario is that circumstances get really bad, and some beguiling madman steps forward during the chaos. Heaven help us if that’s where we wind up.

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