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How to Bankrupt a Nation

By: Michael S. Rozeff


-- Posted Monday, 27 October 2008 | Digg This ArticleDigg It! | Source: GoldSeek.com

How would you bankrupt yourself? You’d want to get yourself into a position where you could not pay off your debts. You’d run up big credit card bills. You’d borrow heavily. You’d mortgage and re-mortgage your house. You’d splurge on your spending. The money would go – to clothes, restaurants, and hairdressers.

While you were on your spending spree, you might run down your savings and assets. You might travel to Las Vegas and drop a few thousands at the tables. Or you might make bad investments. Buy a stock for $190 and hold it until it is worth a few pennies. Your income from your job is a big asset. It would help the cause if you lost your job.

You’d buy everything in sight using borrowed money. You’d live beyond your means, spending way more than your income. You’d run through your assets and you’d lower your sources of income.

The recipe for going bankrupt is Borrow, Spend, and Run Down One’s Assets.

When you no longer had enough cash flow to make the interest payments that are coming due, you’d go bankrupt.

Your creditors would have losses that they could not recover, not unless you worked for them for the next 100 years, although they might recover partially by taking back some items such as your boat, car, and house.

Borrowing and national debt

Government is not different. But a government need not become entirely bankrupt in order that its citizens suffer the ill effects of excessive borrowing and spending. One of the most fateful first steps of any new government is funding its liabilities, that is, creating a permanent national debt. James Jackson, on February 9, 1790, urged the First Congress of the United States of America to pay off its obligations then and there by taxes, and not to fund the debt. England, he noted, began with a debt of 5 million pounds in 1706, which by 1786 had become 236 million pounds.

England’s experience is typical. A national debt grows, once the government adopts the principle of funding its debts rather than pay-as-you-go, because the interest payments are shifted to future taxpayers; and this provides an incentive to borrow now, spend now, and avoid having to pay in full for one’s consumption.

If Congress owes $1,000, we know that that sum if funded into a national debt is equivalent to a perpetual payment of $50 a year in interest forever after (at an assumed 5% rate). Future generations are burdened with taxes in order to pay interest on a portion of the debts incurred by a prior generation, and they in turn have an incentive to burden future generations with having to pay taxes to support the debts that they incur.

The national debt becomes a burden on productivity, since the interest payments must be paid for with taxes on those who are producing income. They are made that much poorer. Those who are taxed get nothing in return for making these interest payments; the preceding generations have already reaped the benefits of the loans. The national debt becomes a means to sustain the immoral practice of stealing from one’s children to sustain one’s own consumption. The national debt becomes a focal point of inter-generational conflict.

The U.S. national debt was 2,600 billions of dollars in 1988. It is now 10,000 billions. This means that most of the existing debt has been incurred by the governments of the generations that are still alive.

The recipients of the interest payments are whoever invests in the debt obligations. Having paid a fair price for them in the market, they get a fair return. The debts of a sovereign are not without risk of default. For many countries, the risk is substantial.

Eventually, the size of the debt is so large and the interest payments so great that either the government goes bankrupt (repudiating the debt), or destroys its currency (another form of repudiation), or is forced to reduce its programs and activities.

Spending to hold up prices

One thing governments are fond of doing is throwing money into bad investments. Nowadays they call their spending "investment." Spending is bad, but investment is good, right? Not when the investments are lousy. The government loves lousy investments. Governments will buy just about anything that you and I would never go near. In fact, their economists will argue that they are making the investments that you and I should have made and didn’t. Baloney. You and I are not shy at gambling on just about any venture. How many biotech companies are there with continual deficits? These economists have no idea when to shift their own savings out of overpriced stocks, but they are experts at sinking our untold billions into lost causes like depreciated mortgages and depreciating currencies.

To understand this point fully, consider the case of Nelson Bunker Hunt and William Herbert Hunt. Their wealth was in the billion-dollar range before they went bankrupt. They lost their fortune by overtrading, that is, buying too much of what seemed like a good thing, often on borrowed money. Overtrading (and overtrading via borrowing) is the cardinal sin of successful speculators. It is what leads to the demise of more speculators than any other single cause.

The Hunts bought futures and forward contracts in silver (in conjunction with a Saudi Arabian syndicate.) They also bought silver itself. They began buying in 1973 when silver was $2 an ounce. They continued buying in the 1970s when silver ranged between $3.75 and $6.25 an ounce. Along with gold, silver began a steep ascent from 1978 until February of 1980, when silver reached $50 an ounce. The Hunt brothers owned 50 million ounces outright and had bought futures contracts on another 80 million ounces.

But precious metals prices began to plummet. In three months, silver fell from $50 to $10. The Hunts held on and bought more. According to news reports they borrowed $1.7 billion to maintain their futures position that was losing money. In addition to cash collateral, they also pledged the silver they owned. When silver fell more in price, their silver collateral declined along with the value of their futures contracts. On March 26, 1980, they could not meet a margin call of $100 million and they did not have time to sell other assets they owned. They were forced to liquidate. Their fortune had disappeared. Eventually, under the weight of lawsuits, they declared bankruptcy.

The Hunts, despite their huge wealth and silver positions, could not stop the market price of silver from declining. It was part of a more general decline since gold also had soared and then collapsed. The U.S. economy was entering a recessionary period, and it was not long before the world price of oil also collapsed. These markets have very high (negative) price elasticity of demand. This means that if the price is $10 and you will pay $11, you will be inundated with an enormous supply. The price is also elastic at $10. Traders will buy enormous amounts at $10 and resell them to you at $11 until you are bankrupt.

The government may be large. It may be powerful. But the markets for assets (stocks, bonds, real estate, real assets, money market instruments, money) are far, far larger than even the largest and most powerful government can control. And they are certainly far larger than any typical government. George Soros is famous for having bet against the British pound and won in 1992. His track record in speculation has been excellent.

When a government defends an overvalued currency by buying its own currency with other currencies it holds in reserve, it is trying to hold up the price. Many governments are now doing this and getting the aid of the bright boys at the IMF who also like lost causes. This is like the Hunts trying to hold up a high silver price when the market value is much less. The government can buy and buy and buy, but it will lose if the currency is overvalued for fundamental reasons and the equilibrium price is lower. Its buying only serves to provide a market for the traders who wish to sell out. Soros revealed this in 1992 when he said: "Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell."

In the same way, the U.S. government cannot succeed in holding up real estate prices that have fallen. If it borrows $700 billion and buys bank loans or invests in banks who then hold these loans, it will lose money as surely as the Hunts lost their fortune and as surely as the British government lost to Soros in trying to defend the pound at an unrealistically high value. Buying overvalued assets is a sure way to lose money, for you, for me, and for a government! A government has no special power to hold up the prices (in real terms) and prevent them from falling and no special power to cause low prices to rise to a higher level (in real terms.) Oh, I suppose it has the power to print money and drive its currency value down to zero (and other prices up), but in the process it will destroy the government and burn up a lot of its citizens’ wealth.

The Federal Reserve and the U.S. Treasury, with the aid and comfort of the Congress, are all embarked on a massive exercise in futility that is only weakening them and us. If they push their policies of supporting the asset prices of failed assets and assets with deflated prices far enough, they will bankrupt themselves and destroy huge amounts of American wealth in the process.

Running down assets

The third link in the bankruptcy chain is to waste the money being spent and/or run down the assets. If the government had spent the money on things of value, we’d be able to point to them, things like roads, bridges, harbors, healthier human beings, and marble buildings. We would not be looking at crumbling highways and bridges. But the lion’s share of the spending has disappeared. It has gone to bombs, rockets, submarines, fighters, bombers, body armor, and battleships. Great sums have gone to various groups who have spent them on their own consumption.

If current and future spending would raise the income-producing potential of Americans by more than what it costs, that would postpone bankruptcy. It would increase the value of assets, not run them down. There is no sign that this has happened in the past or will happen in the future.

Where the U.S. government stands

Governments go bankrupt too. Your personal finances may be in good shape, but behind your back the government is borrowing. Household credit in America is $14 trillion, but the government has borrowed $10 trillion more and has made promises to pay out vastly greater sums than that. Governments have the capacity to take their citizens down with them because of their ability to ruin the currency.

The U.S. government is not near bankruptcy. However, in all three departments, spending, borrowing, and running down its assets, it is doing an excellent job of heading for that target. Take spending. The annual growth rate of government spending has exceeded the growth rate of production by one-third over the last 100 years or so. This high growth rate of federal government spending has driven spending as a percentage of total U.S. production from 2 percent to 21 percent. There is no sign of any slowing in the government’s rate of spending. As Social Security and Medicare arrive for the baby boom generation, government spending will accelerate.

This spending has not been on a pay-as-you-go basis. Instead, the government has borrowed heavily to pay for the spending spree. This means that debt has grown even faster than government spending which in turn has grown even faster than national product. Someone must have a copy of the bankruptcy recipe and be sending it to each new Congressman. They are getting the message.

The federal government has an official debt of around 10,000 billion dollars. The liabilities of programs such as Social Security and Medicare add another 60,000 billion dollars. They will add to the debt in years to come. This debt will never be repaid. Think of it as a perpetual mortgage on which you and all your heirs must always pay interest forever.

Medicare spending is about $15,000 per person per year. When 30,000,000 more persons are on Medicare (the baby-boomers), the added spending will be 450 billions a year. That excludes inflation. It’s an under-estimate. That increase will fall on 30 million fewer people who work and pay taxes. Some combination of higher taxes and borrowing can finance the spending, but they will depress economic growth and make the financing that much more difficult. Benefits will probably also be cut and/or the quality of health care will decline.

There has been a slow-motion slide toward bankruptcy as the cash flows coming in fail to match the cash flows going out. Spending keeps exceeding the income, which is not rising fast enough to prevent more and more borrowing in order to stay afloat. At present, Uncle Sam is taking in 2,700 billions and spending 3,100 billions. The difference is borrowed, which makes for another 400 billions of debt.

Higher debt and higher interest rates

The slide is accelerating with the financial crisis. Income growth is slowing and government spending and debt are soaring as it plows money into bad loans and banks. The federal debt will soon rise by 1,000 billions in one year alone.

Younger people are going to face higher taxes to pay both for social programs and the added interest on funded debt that will be issued to pay for the social programs. It will be in their interest to fund the debt rather than pay higher taxes. They will want to shift the burden to future Americans.

The lobby for more debt is unstoppable. Not too far down the road, the result is going to be higher interest rates (lower bond prices). It will be the only way to induce savers to supply the additional funds that will be needed to pay for the consumption inherent in the social programs like Medicare.

The real rate of interest will rise. The risk premium on government debt will rise because the debt is growing relative to national income. The inflation premium will rise because there is more of a threat of inflation when there is more debt. Productive investments will face higher costs of capital, and this will crimp the stock market and economic growth. It’s not a pretty picture.

October 27, 2008

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

Copyright © 2008 LewRockwell.com


-- Posted Monday, 27 October 2008 | Digg This Article | Source: GoldSeek.com


-- Visit LewRockwell.com



 



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