Debt Limit

By Dave Cantey 2013 9-28-13

Congress handling of the debt limit reminds us of third graders standing around the school yard arguing over how much candy they should have, if they had candy! This begs the question: Is there an actual, or natural, limit to the amount of debt that the US can borrow? When we study history, we find the answer is a resounding yes. Lets explore this. As Warren Buffett has rightly pointed out, when you borrow money you are, relying on the kindness of strangers. Ones borrowing whether individual, family, corporate, state, or sovereign depends entirely on the borrowers ability (and willingness) to repay the loan, and the lenders willingness (and ability) to lend. As the borrowers debts mount, the borrower is deemed a higher risk, and the interest rate rises, if continuing loans are to be made at all. History shows that no one can go on borrowing forever. This phenomenon has resulted in a naturally occurring credit cycle that lasts about 80-years and can be traced back hundreds of years. The fact that we are presently in year 81 of the current credit cycle, dating back to 1932, and having accumulated the largest worldwide debt bubble in the history of mankind, is certainly relevant here. That the current debt bubble is unsustainable has been identified and discussed previously. What we will explore here are the lenders. Traditionally, credit cycles have ended in a stock market crash and economic depression. We had a crash in 2008, but the depression part of the cycle has been forestalled by central bank (Fed) money printing. For example, in 1837, here in the US, there was a credit cycle-ending economic crash, that was not fully resolved, and a second crash came along in 1855, which created a depression. The financial strains placed such stress on the social fabric of the day that the Civil War resulted. The point is, all previous credit cycles have been prelude to major wars, and/or social insurrection, e.g., the French Revolution (Let them eat cake.). A similar outcome is clearly in our future. As our financial structure weakens further, we foresee our social fabric tearing over the issue of wealth disparity between the 1% and the 99%. It will not be pretty. At the turn of the millennium, year 2000, the US debt ratio was 58% of GDP, and the federal government had plenty of capacity for further borrowing. Now, the debt ratio is at 106%. Research shows that things get dicey at about 110% of GDP. So, we are rapidly running out of capacity to borrow. Lenders The US federal debt limit will arrive when the US capacity to borrow runs out, and lenders refuse to make additional loans. Who are our lenders? Where do we find the kindness of strangers that owns the US debt that presently totals some $16.9 trillion? Domestic sources own about 2/3rds of this debt, and foreign sources own the other 1/3. This doesnt sound too bad until we realize that domestic sources now include the Federal Reserve, which owns about 17% of total US debt. When combined with foreign sources, this represents 50% of total US sovereign debt. The composition of this foreign ownership is the Far East (China, Japan, Malaysia, India, including Russia and Australia): 21%, the Euro

Zone, including Great Britain: 7%, and the non-US Western Hemisphere, including Canada, Mexico, and South America: 5%. Clearly, the Far East is our kindest stranger, with China the kindliest of all at 16%. Going forward, as this debt continues to mount, who will increase lending? The US itself is broke. The Euro Zone has deep debt problems of its own (more on this in a moment), and China is said to be lightening up on its ownership of US debt. Japan? Russia? Japan is creating its own debt bubble again by wildly printing money, and Russia needs to keep the cost of oil at least $119 per barrel just to float its own economy (Oil is presently under $110 per barrel, so Putin is agitating in the Middle East in an attempt to raise oil prices). Recently, for the past year, the Federal Reserve has been the lender of last resort. We know we are late in this process because the international markets have begun raising long term interest rates on US debt, starting in July 2012, a little more than a year ago. As the US debt to GDP ratio approaches 110%, we can expect these interest rates to accelerate. (Note: As successive Euro Zone countries sovereign debt exceeded 110% of GDP over the past few years, their incremental interest rates spiked to over 10% very rapidly, e.g., Greece, Spain, and Ireland. But these countries were small enough to be subsequently bailed out. No one is big enough to bail out the US.) The US budget deficit is still at $.8 trillion per year. So, who will continue buying this enormous tidal wave of new debt? For the past year it has been the Federal Reserve. But wait a minute, the Fed is scheduled to start tapering later this year, which means it wants to be a net seller (liquidator) of US debt, not a buyer. So, who has the capacity and willingness, regardless of interest rate, to buy $.8 trillion of new debt over the next year? The Fed wants to liquidate. China, our largest kind stranger is already liquidating. Who is left to buy all this debt? (Note: Historically, all debt bubbles have ended badly. This one is certainly no exception.) Going Forward Believe it or not, soon, Europe could well extend our debt dependence a few more years. Here is how: Now that Angela Merkel has been reelected Chancellor of Germany, it is believed she will continue, or even tighten, her policy of austerity on the rest of the Euro Zone, which will send Europe into another financial crisis. This crisis will cause a small ocean of money to flee out of the Euro and into the dollar and US bonds, which will buy us a couple more years of reckless spending, and debt accumulation. But inevitably, this too will run out, and end badly for the US. In the meantime, watch the stock market explode higher as this money floods in from Europe, but also, watch as inflation begins taking off as well. Problems delayed are problems magnified.