The Coming U.S. Debt Crunch

Much energy has recently been spent gaming Japan’s probability of future default, as their government debt has risen to nearly 200% of Gross Domestic Product  (GDP).  While this number is extraordinarily large, and portends future problems, Japan is not alone.  While the U.S. Federal debt is not at the lofty levels of Japan’s, there are huge issues.  When we look at any budget, we can look at how much cash comes in, and how much cash goes out.  If more cash is spent than is taken in, an entity must go into debt to continue spending at the same level.  Let’s take a look at some numbers from the United States.  Keep in mind, these numbers fluctuate every year, so the numbers used are approximations.

Over the last 50 years, the U.S. government has taken in tax revenue that has averaged 18.2% of Gross Domestic Product (GDP).  In 2008, Medicare spending equaled 3.2% of GDP, while Social Security amounted to 4.4%.  Keep in mind, both of these payments are expected to rise on a percentage basis, as the baby-boomer generation retires.  Using a GDP of $14 billion for 2009, the above percentages yield the following dollar figures:

It is easy to see that we have a huge budget problem.  Tax revenues are down due to the recession, but we used an average tax % gleaned from 50 years of data, likely a higher number.  And, my list of expenses is incomplete.   I haven’t included Federal help for states, NASA, subsidies, or education, or the cost of new entitlements like the new health care bill.   Of utmost importance, I haven’t even talked about the yearly cost of the federal debt.

The problem with debt is that it has to be paid back, plus interest.  The U.S. currently has over $12.5 trillion in federal debt (this does not include Social Security, Medicaid, and other off budget, but real IOUs).  The country added roughly $3 trillion in debt (around a 30% increase in 2009), and will more than likely do it again this year.   Interest has to be paid on this debt.   In 2009, interest was $383 billion.  Doing the math, it appears that the interest cost is currently about 3% per year to borrow the $12+ trillion dollars.

As we know from the current issues in Greece, the more debt a nation takes on, the higher the interest it must pay.  This is common sense.  What happens to the cost of America’s debt as it increases on a scale only approached during World War II?  Will foreigners, banks and U.S. citizens continue to buy it without a “risk” premium (i.e., a higher rate)?  And what happens to the cost of the debt if the economy improves and rates rise as a result?  If the debt cost just goes from 3% to 6%, the interest cost alone rises $400 billion.

Raising taxes to plug the deficit will add fixed costs to businesses.   Businesses are the ultimate source of all revenue, as they provide taxes and wages.  Adding taxes to businesses and consumers will surely slow economic growth, and make the debt burden more difficult to bear, let alone grow out of.  Further, since taxes are politically unpalatable, governments have historically preferred to print more money, the equivalent of an “inflation tax”.

While Ancora West can’t predict exactly how or when the country will be forced to fix the budget issues, we can do our best to protect capital against a potentially hostile climate.  Quality, cash producing assets with minimal liabilities complemented by some inflation hedges are more desirable than ever.  So is a large Margin of Safety.

Matt Marcewicz

April 12, 2010