Budget Lies

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“Portugal’s prime minister said Tuesday that the country won’t need a bailout…. A look at what happened when Ireland and Greece officials made similar statements last year shows that when those two European sovereigns declared they were fine on their own, it took less than a week for them to start sounding a different tune. Within a month of their statements, both had done full about-faces and sought financial aid from the European Union and International Monetary Fund.”

Despite the best efforts of the statist-ticians to quell the voices of those warning of sovereign default, their case continues to grow stronger. It is, after all, just a matter of time. At least that is the impression you get if you look back at history. That’s what Reinhart and Rogoff did in their book This Time is Different. As you read their recollection of sovereign defaults, several things pop out at you. More like slap you in the face, really.

The frequency and regularity of sovereign defaults in the last two centuries defies belief. And after prolonged periods without default, things tend to suddenly hot up across specific regions of the globe. Also, sovereign defaults have a habit of coming after banking crises. Especially when governments try to bail out the banking sector. And they often involve wars and revolutions.

In other words, we’re well overdue.

Perhaps the most remarkable piece of information in This Time is Different is the discussion of whether countries can grow their way out of public debt. It’s not much of a discussion really. The authors simply mention that it hasn’t happened, but for one case – Swaziland in 1985. That’s about it.

The only options are to repay the debt at the expense of growth, or to default via inflation, restructuring or repudiation.

So, which is it to be for the world’s overextended governments?

Europe is attempting to repay its debt, or at least pay it down. Restructuring may be required in some nations. That makes European bonds a risky bet, but with yields to compensate.

The US, on the other hand, thinks it can join Swaziland in the “grow your way out of debt” camp. At least that is the PR story. In reality, American politicians are betting on their Chairman to inflate away the debt. Chairman Bernanke, that is. By monetising debt, the Fed can simultaneously reduce the interest bill on the government’s debt (by bidding up bond prices), and reduce the debt’s real value.

Many Keynesians see this as a perfectly reasonable policy. It has been used many times in the past by “defaulting” nations. But there is a major catch, as far as the US is concerned.

To understand it, you need to glimpse into the world of bonds for a moment. When the government issues a bond, it must pay a certain interest rate on that debt going forward. But the price of the bond can fluctuate, changing the yield. Crucially, the government’s interest bill remains the same as the yield fluctuates.

But when new government debt must be issued, the existing yields become important. For example, if the government issued bonds at 5% interest rates, but the price drops and the yield goes to 6%, it is likely that the government will have to pay 6% on its next issue of bonds.

Because so much of the US’s debt is in short term securities, it must be rolled over regularly. That means a change in yields is felt in the size of the interest bill very quickly.

So, if Bernanke attempts to inflate away the debt and yields rise to take into account this inflation, the government’s interest bill will rise along with inflation. The strategy of inflating away debt is severely hampered. Much more inflation is required. It may require too much to be politically feasible.

The US too, will have to default. And boy do they know it.

Statistics may be malleable, but the assumptions used to come up with the statistics are often farcical. And if you hope to escape ridiculous assumptions by avoiding academia, you aren’t going to have much luck. They permeate the real world too.

Austrian Economics followers Peter Schiff and Michael Pento have uncovered what are probably the most ridiculous assumptions ever heard of, when adjusted for how important they are. Schiff outlines them in his daily radio show here.

They relate to Obama’s much discussed budget. In particular, the assumptions made to arrive at the $1.1 trillion in reduced debt which the budget is expected to achieve … over 10 years.

Let’s get into the figures:

1. GDP
Obama’s budget projections assume a 3.22% average GDP growth per year for the next 10 years. This compares to the ten year period of mid 1998 to mid 2008, when average GDP growth was 2.17% per year.

So, that means Obama expects the next decade’s GDP growth to be 50% better than GDP growth for the decade before the financial crisis – the decade during which massive bubbles and spending took place.

2. Unemployment
Obama’s budget projections assume the average unemployment rate for the upcoming decade to be 5.93%. Considering it currently sits at 9%, this requires one hell of a recovery.

3. Inflation (“This is where it really gets rich” comments Schiff)
Obama’s budget projections assume the average CPI increase over the coming decade will be 2.04% per year. That compares to a 4.97% average increase per year between 1981 and 2010. Looking at the US money supply, Bernanke’s stated goals for inflation and current commodity prices, this is truly laughable.

4. Government finances
Obama’s budget projections assume a 10 year bond yield average of 4.91% for the upcoming 10 years. It is currently about 3.7%, but the average from 1969 to today is 7.31%. And the US was in much better fiscal shape during that period than it is now. And the outlook isn’t exactly rosy for rates either. The government thinks it can add 8 trillion (76% of GDP) to the publicly traded portion of debt (taking it to 18.3 trillion) and keep interest expense at 4.3%!

Not that Obama understands interest payments. He simply excludes them from his version of the budget when giving speeches.

Given all these ridiculous assumptions, Obama recons his budget will reduce debt by US$1.1 trillion over 10 years. That is, it will reduce the increase in debt. He isn’t actually reducing the level of debt.

But when the Department of Health and Human Services is in real terms more expensive than then when the entire US government was in 1965, the problem completely loses perspective anyway. No wonder nobody can come up with solutions.

Meanwhile, the public bureaucracies remain “busy” doing important and morally righteous work. Like determining how much a human life is worth. The New York Times reports “Under Obama, Federal Agencies Raise Value of a Life”:

“The Environmental Protection Agency set the value of a life at $9.1 million last year in proposing tighter restrictions on air pollution. The agency used numbers as low as $6.8 million during the George W. Bush administration.

“The Food and Drug Administration declared that life was worth $7.9 million last year, up from $5 million in 2008…”

Proof of inflation?

The other side of the pond is taking its economic issues seriously.

Not only is the EU charging down the road of austerity, at least they like to think so, but they are now looking to create a bubble busting agency. “Who ya gonna call? Bubble busters!”

Yes, equipped with sophisticated economic indicators, a bunch of EU bureaucrats will be tasked with identifying imbalances and making policy recommendations to rebalance them. Put simply, they will chase their own tails.

The imbalances come from the very group of people the group is supposed to be advising. And those policy makers won’t take lightly to being told they should stop pushing the free market around. After all, that is a politician’s job.

There is no reason to have faith in this new attempt to tame capitalism. With obvious imbalances that don’t need flagging and no intent to allow them to rebalance in sight, a new agency hardly seems worthwhile.

The Germans, who are being expected to bail out the rest of Europe, wonder “why bother bursting a bubble when you can avoid having it in the first place?”

Ever heard of a German housing bubble? Or a Ersteshauskaufer Grant? Apparently they don’t exist. Why? Because house prices have been stable for a very very long time in Germany. And it has nothing to do with bureaucracy, rules and regulations, or interest rates. No, the free market has managed to overcome the distortions of each of them.

The answer is of course supply. Without restraining supply, price can find its justifiable figure. And how much people are willing to pay for accommodation shouldn’t really vary over time. German supply is apparently not constrained. So, as demand for housing grew (immigration, less people per household,…), more houses were simply built. And people can still afford them!

In the interests of disclosure, your editor’s Grandmother owns several properties in Germany. Importantly, it is the rental income that is the key. At least for her. But don’t go thinking that Germany’s lack of skyrocketing house prices has put the pressure under rents instead. No, your editor’s Grandma rents the place she lives in!

Now anecdotal evidence isn’t always much to go by, but being a renter while owning several properties indicates that the market is pretty nicely balanced.

Meanwhile, closer to home, unaffordability isn’t met with supply increases. No, prices remain high and construction constrained. But why?

Perhaps Australia’s housing bubble is too politically sensitive to pop. That’s what sub-prime was in the US. But negative gearing can only make sense for so long. The outlook of a cash losing investment isn’t good. So, eventually, house prices in Australia will fall. It will be fascinating to see if the Australian government tries to prop them up. But amongst the collapsing prices one feature will stand out. The supply still won’t go up and the problem still won’t be solved.

Nikolai Hubble
For Daily Reckoning Australia

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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Comments

  1. “Ever heard of a German housing bubble? Or a Ersteshauskaufer Grant? Apparently they don’t exist. Why? Because house prices have been stable for a very very long time in Germany. And it has nothing to do with bureaucracy, rules and regulations, or interest rates. No, the free market has managed to overcome the distortions of each of them.

    The answer is of course supply. Without restraining supply, price can find its justifiable figure. And how much people are willing to pay for accommodation shouldn’t really vary over time. German supply is apparently not constrained. So, as demand for housing grew (immigration, less people per household,…), more houses were simply built. And people can still afford them!”

    Not true. The reason why Germany is unaffected by speculative house price increase (ie bubble) is because German property law specifically discourages property price inflation. One must wait ten years before selling a purchased house, in order to avoid massive CGT. After ten years however, one can sell the property and pay minimal capital gains tax. Thats why, thats the reason, your reason was wrong.

    Reply
  2. Another view basically seems to say that the post re-unification German housing bubble of the 1990s that burst a decade or so ago simply hasn’t recovered yet:

    “Effectively, the tax incentives were so generous that people over-invested and that meant there was a glut of supply in Berlin, for example,” Julian Power, director of London-based Berlin Capital Investments, which advises individuals and companies on investing in German real estate, told SPIEGEL ONLINE. “People could renovate a property and they couldn’t lose, as they could write off the whole cost against their tax bill. … So people were doing it whether or not there was a demand for it.”

    http://www.spiegel.de/international/business/0,1518,552901,00.html

    Be interested to read Ross’ comment. He’s spent time in Germany if I recall correctly?

    Reply
  3. “It will be fascinating to see if the Australian government tries to prop them up”.

    Haven’t they already been doing that. What is it with these Mortgage Backed Securities. I was of the impression they haven’t stopped them. Keeping the punch bowl at the table is surely their attempt at defying gravity.

    Reply

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