Detroit’s Bankrupt – Is Uncle Sam Next?

Lessons are often learned the hard way, particularly when history is ignored and society dismisses decades of clues pointing to a monumental fiscal crisis.
9378
bankrupt.gif

Prior to 2007, most Detroiters would have found General Motors succumbing to bankruptcy unimaginable. By the same token, most Americans would have thought it next to impossible for an icon city like Detroit — the Arsenal of Democracy — to be declared legally insolvent. For the same reason, others have difficulty accepting the probability that entire states such as California and Illinois will likely assume the status of financial supplicants.

Today, despite the reminders of the 18 federal government shutdowns since 1976 and trillions of dollars in accumulated new debt bombarding headlines and TV newscasts, there remains an even greater disconnect: Our inability to recognize an insolvency looming on a national level.

The reality of a United States bankruptcy, as well as its disastrous economic implications, has yet to penetrate the psyche of many elected officials. In fact, unless one was alive at the time and consciously experienced the upheavals associated with financial insolvency in countries like Germany (1923), Hungary (1946), and Zimbabwe (2008), it is unlikely that the average citizen would find U.S. bankruptcy a credible concept.

But denial is a dangerous conceit. It reflects complaisance in the face of the same perilous trends that GM and Detroit (private and public sectors) ignored, and failed to reverse in time. For far too long, no individual or group of leaders had the vision, articulation, or staying power to downsize operational outlays to match revenue input, whether corporate or municipal.

Sadly, the path to U.S. bankruptcy has progressed onto the same superhighway. How can this be? It is happening on a national scale, and the potential final act of bankruptcy can come swiftly and suddenly — a legal recognition of what decades of fiscal carelessness have slowly and stealthily wrought.

Legally, bankruptcy is defined as a condition in which a debtor is judged insolvent, unable to pay all debts. Financially, bankruptcy is considered to be a condition of ruination or impoverishment.

Certainly it is understandable why relatively few Americans today actually expect the U.S. to be declared bankrupt, or to experience extensive poverty on a grandiose scale. But that naivety exists largely because the magnitude of the impending storm is hidden from the American public. And yet, ironically, evidence of the endgame is everywhere:

  • Downgrades of United States credit by rating agencies.
  • Failure to pass Constitutionally mandated budgets for all to see, rather than the euphemisms known as “continuing resolutions.”
  •  Shrinking tax bases of full-time employees.
  • Plunging participation rates among young cohorts of the workforce.
  • Burgeoning dependencies in our population, resulting in the redistribution of incomes and wealth.
  • Record U.S. Treasury borrowings to support uncontrollable expansion of programs such as food stamps, disability and unemployment benefits, subsidies to favored businesses, proliferating entitlements, regulations, and the nationalization of health care and student loans.
 

Most revealing is the complicity of a politicalized central bank, the Federal Reserve System. Astonishingly, under the leadership of Ben Bernanke, the Fed has been corralled and pressured into years of “pump-priming,” whereby its “quantitative easing” initiatives (now nearing a fourth round) have already pushed more than $3 trillion of new high-powered money reserves into the banking system.

One sure tipoff to savvy observers that something is seriously amiss in our nation’s fiscal outlook is the surfeit of newly created money reserves compared to real GDP growth. Put differently, money creation with no corresponding output of real goods and services to the U.S. market basket (real GDP) foreshadows a rising price level and accelerating inflation.

As it stands, inflation is an insidious form of taxation because not one person in a million can identify the real villain. After all, the Fed — our monetary authority created in 1913 to be independent of political manipulation — is entrusted with the most important economic and financial function: To maintain trust in a strong and stable dollar.

By creating money reserves in excess of real economic output (for half a decade, 2008-2013), the Federal Reserve, in effect, hands the Treasury a free pass to borrow and finance even more debt at lower interest rates than would exist in a competitive financial marketplace.

This helps Washington policymakers conceal their broken campaign pledges — the affordability and availability of social benefits promised to retirees later in this century — and their rupturing of the dollar’s integrity as a premier world currency for transactions and as a store of value to generations of current and future investors in America.

Specifically, for the past five years, the Federal Reserve has forced interest rates to the lowest levels in memory. Pushing interest rates down is one thing. Holding yields below inflation rates for years is something quite different. The policy is a prolonged contrivance aimed at enabling the U.S. Treasury to borrow and float debt at super low costs in order to enable the federal government to pay for its countless “stimulus” programs.

In the short term, yes, low financing costs have stimulated the housing and auto sales sectors. That’s because, as Detroiters know, demand for new homes and vehicles is especially responsive to easy credit and low mortgage and auto financing rates. Indeed, the entire construction and automotive industries constitute the bulk of good news on business activity carried in press releases since 2011.

 

If other industries were sharing the economic bounty of easy-money policies, then our economy today would be growing consistently at 3 percent annual rates, rather than 1.5 percent to 2 percent per year. Instead, we know that the U.S. economy has been significantly underperforming its long-term potential real GDP growth, not to mention its traditional job-creation capacity.

In addition, annual budget deficits emanating from Washington would be largely neutralized by now. Since the Great Recession (2007-2013), U.S. real GDP expansion has averaged 0.75 percent. This sluggishness impugns both fiscal and monetary policy.

One explanation for this snail’s pace of recovery — a major fly in the ointment — is the very low yield on Treasury debt held by the U.S. public. Low yields on savings and certificates of deposit crimp confidence, dampen reinvestment opportunities, and hobble consumer spending for at least 40 million retirees whose retirement nest eggs are partly tied into unexpectedly low-yielding investment instruments. This is just one example of Washington-built policies that fail to discern the forest for the trees. Let’s examine how this works.

In a typical retiree’s financial plan, pension income is $18,000 and a couple can expect $23,000 in Social Security benefits. According to the tables, that average household has saved $200,000, which, for safety and yield, was invested over time in Treasury notes with a 5 percent yield, generating another $10,000 annually. In total, the couple took in $51,000 per year — sufficient income, even after taxes and moderate inflation, to do passably well in retirement.

Now, what happens to the couple’s income from 2007-2013? Yields on Treasuries are forced down to between zero and 2 percent. Inflation is still averaging between 2 and 3 percent. As existing Treasuries mature, the reinvestment yield drops to 2 percent, bringing the $10,000 return on their $200,000 nest egg to $4,000 (a loss of $6,000 in annual income).

Moreover, the resulting $4,000 interest income is taxed 15 percent ($600), while a 2.5 percent inflation rate dents the purchasing power of the remaining $3,400 by another $85 per year. To make matters worse, unless the retiree’s pension is protected by a cost of living adjustment, then he or she has just lost another $450 in buying power.

 

All told, the former income stream of $51,000 per year ($49,288 post-tax and inflation) is now reduced to $43,865. The 11 percent drop in real disposable income accounts for merely a portion of the shriveling income condition and economic malaise of households and firms. According to the most recent U.S. Census data, median household income in 2011 (at $50,054) remained nearly 1.5 percent below the pre-recession level of $50,740 in 2007.

But the more profound story in this example harkens back to our national road to bankruptcy. What’s really happening is that the loss of income from investment in Treasuries, together with the loss in purchasing power due to inflation and the direct tax on pension and investment income, represents transfers of resources from the private sector to support Washington’s continuing profligacy.

In 2012 and 2013, the U.S. Treasury essentially confiscated real income via another round of tax hikes. And the Federal Reserve — by monetizing Washington’s new spending in partnership with the Treasury — has stiffed investors with low yields and a depreciating dollar (e.g., the dollar’s fall vs. the Euro).

Fundamentally, Washington’s budget plight is becoming irreparable. That’s because its policies aren’t changing, any more than those of Detroit or its automakers had changed in the years leading up to their respective bankruptcies. We can better visualize the magnitude of our national budgetary and debt problems by translating a U.S. financial statement into a household or small firm’s budget. Add eight zeros to the unsustainable household budget and we begin to fathom what confronts Washington even before the recent sequester and shutdown.

Rather than reform, prioritize, focus, and reduce spending, Washington is lifting U.S. debt ceilings with greater frequency. Elected officials occupying the executive and legislative branches of government must be responsible and place intergenerational promises on sound financial footing. Imagine a competitive firm in Michigan’s private sector, whose CEO, department heads, managers, and legal staff annually engaged in a complicit “bipartisan” scheme to kick the company’s budgetary cans down the road.

How long would that last? And what about the firm’s future obligations, such as contractual pensions and health care benefits?
Gargantuan volumes of unfunded liabilities, upward of $126 trillion, now threaten to swamp unborn generations of Americans with intractable debt, including such programs as Medicaid, Medicare, Social Security, and student loans. In 2013, every U.S. taxpayer owes $1.1 million in national debt — which, as a national aggregate, is growing at a rate of $45,486 each second.

What’s more, the national debt at mid-year 2013 exceeded the size of GDP, even without reference to unfunded liabilities. The latter item is not trivial.

 

To illustrate how desperate the situation has become, consider the economic impact between now and 2019 if global markets lose confidence in the willingness or ability of Washington to fix its budgetary woes, along with its unfunded program promises. Today’s low interest rates enable the U.S. Treasury to cover the interest costs of our $17 trillion debt with annual budget outlays of less than $300 billion.

However, if purchasers of our debt, both foreign and domestic, demand much higher yields to compensate them for greater risk of U.S. default (which includes government delays in payments to lenders and vendors, as was the case for Detroit and GM), then rates could double from recent levels of near zero to 3 percent. Doubling yields on Treasury borrowings could raise the annual interest costs of our debt by more than half a trillion dollars very quickly.

Two additional factors will undoubtedly aggravate actual interest costs of future debt. First, our national debt has already hurtled beyond $17 trillion. Just the $8.3 trillion spurt in the last five years practically guarantees that the nation’s debt will be $20.3 trillion by the end of 2016, according to Forbes (using current rates).

What that means is that higher interest rates on borrowings will be applied to another $8 trillion to $10 trillion in debt. If this happens, the annual budgets passed by Congress and signed by the president will require more than $1 trillion merely to cover yearly payments to bondholders.

Does this begin to sound like the story of the city of Detroit in 2013? This trend portends insolvency, as it snuffs out growth in the productive private sector and renders Uncle Sam incapable of funding the most essential functions of a federal government — namely, the protection of life and security of property.

Yet there is a second factor piling onto this trend. In this case, it is a cyclical feature with long-standing quantitative verifiability. On average, recurring U.S. recessions double the size of annual deficits within two years. This phenomenon is an important ingredient to incorporate into any plans for meaningful fiscal reform.

Why? Because a recession removes justification for tax hikes from any sane reform package. It is axiomatic that when you tax something, you get less of it. If Washington were to again hike taxes on income, sales, and investments, budget planners would topple an already hobbled and fretful economy, exacerbating and compounding the national debt, borrowing costs, and unfunded liabilities.

 

Financial options become few and stark if we reach that impasse. That’s because overall federal spending and borrowing will begin escalating geometrically, along with the price level and interest rates.
The difference between a national bankruptcy and that of Detroit (2013), Michigan (1850), GM and Chrysler (2009), and all other nonfederal entities that reached insolvency, is the legal ability to print money. Only Uncle Sam has recourse to a central bank and its money-printing machine. For a short while longer, the Federal Reserve can create inflation to devalue debt held by lenders and impair the real financial position of citizens, firms, and bondholders everywhere.

Fortunately, the agony usually doesn’t last long. After Germany’s climactic October 1923 hyperinflation, Germans restarted with a new currency. Ditto for Hungary, in the wake of their catastrophic July 1946 hyperinflation. It was the same for Zimbabwe, in the wake of its November 2008 hyperinflation. But who can really conceive of America’s price level doubling as it did every 5.7 days, 1 day, or 15 hours, respectively, in the examples cited?

Even today, as Washington moves its financial stakes to higher levels and future years, growing uncertainty stalks domestic and global markets.

Should the U.S. declare or verge on bankruptcy, firms and households will need to adapt to threats of inflation, recession, and serious interruptions of the smooth flow of products, services, and financial transactions.

More cash will be held in reserve rather than invested in productive human capital or equipment. Inventories of vital materials — those necessary to assure continuity of operations — will accumulate.

Additional time and manpower will be devoted to paying experts (lobbyists, investment firms, consultants) to monitor and help plan for contingencies that might save the firm or household from catastrophic losses.

Be it a supplier to the auto industry or a firm attempting to meet its payroll obligations, barter techniques will become commonplace. It is clear from our experience with the failed wage-price and interest-rate control programs of the early 1970s, and from the rampant inflation of the late 1970s, that there is great merit in adopting policies of barter-style defense.

Low-profile agreements and contracts with suppliers and vendors to assure continuity and quality of services are essential. If history is any guide, then arrangements will include pre-planned trades that are tantamount to barter transactions. Such agreements among trustworthy entities can bridge a crisis, as long as it doesn’t persist for many months.

 

Preceding calamitous bankruptcy, we can anticipate other likely Beltway thrusts to forestall the inevitable. IRS navigators will value all employee benefits so they can be taxed as imputed income (wage and salary increments). Washington will, as the EU nations have done, introduce national value-added sales taxes, beginning at rates of 5 percent to 10 percent.

Carbon taxes will be added. Patriot enterprise taxation will begin, affecting both households and firms. Myriad revenue-raising schemes will further debilitate the productive, creative, and private economy in a futile effort to force-feed an increasingly desperate public sector.

What’s left to do if it comes to this?

Firms must morph into larger enterprises in order to gain leverage, global contacts, markets of scale, and sufficient diversity to survive up to two years of financial and resource chaos while remaining profitable. At the mid-size range of the spectrum, franchise-related firms, in light of their strategy to defend their bottom lines against the known ravages of Obamacare taxes and mandates, will continue to keep labor costs as low as possible.

They will place a premium on outsourcing work, leasing or renting employees, and contracting for project managers who won’t become full-time employees on the firm’s register.

At the micro level, for America’s tens of thousands of small and very small businesses, survival imperatives are more likely to demand strategies aimed at maintaining “below-the-radar” profiles. For one thing, low visibility to Washington’s regulatory agencies can save time, money, and grief. Also, taking thousands of small firms off the tax and regulatory screens might enable them to transact business in real commodities, not just with domestic currency.

Regardless, this is a profile of the kind of portfolio that re-emerges from the throes of hyperinflation and depression. These are the portfolios that reappear and prosper in saner times, as the marketplace redevelops in lieu of the incoherent federal government. They are firms and individuals whose skills and services are characterized by the basics: A need for “better, faster, cheaper” in servicing the “food, clothing, shelter, and health” requirements of any population.

To be sure, Detroit and Michigan have dealt with protracted episodes of national economic strain and have become stronger. But now there is a real question as to whether the three-year comeback of Michigan’s automotive industry has restored financial strength sufficiently to weather another shock. After all, Michigan must factor in the compounding impact of Detroit’s bankruptcy.

Chances are that our firms and households would depend even more heavily on the protection of local police, fire departments, courts, and municipal resources for maintenance of infrastructures and neighborhood safety in the face of inevitable civil unrest. Perhaps this is the impetus for rational consolidation of many local units of government, to the benefit of our locally headquartered offices and plants and to the relief of beleaguered taxpayers.

 

Washington’s political polarity and lack of focus on our economy signal continued inertia. So here is the stark reality likely to confront Americans in January 2019, unless the president and legislators redress their suicidal policies.

America’s total unfunded liabilities, which stood at $126.6 trillion at the end of November 2013, will rise to an estimated $147.6 trillion by January 1, 2019. The hike represents an aggregate of major programs such as Social Security, Medicare, Medicaid, and the prescription drug program that will lack funding to pay for benefits promised citizens and others who paid into them during their working careers. Indeed, broken promises are the essence of how national bankruptcy translates into financial torment at the grass roots level.

Medicare, with unfunded liabilities currently at $87.8 trillion, is on track to reach $102.0 trillion in unfunded liabilities by 2019. The prescription drug add-on, now at $22.1 trillion in unfunded liabilities, will reach $25.5 trillion by that date; and Social Security, including disability payments, advances to $20.1 trillion, from $17.7 trillion, in five years’ time.  Moreover, Obamacare, a single-payer nationalized health care system, if implemented, will entail massive cost overruns as similar systems across the globe have demonstrated since 1950.

More distressing is the fact that these are conservative estimates for trajectories of just a few key “safety-net” programs that have reached insolvency. After all, U.S. GDP growth rates are converging to less than 2 percent annually, whereas the three programs shown are now growing at rates of 3 percent, 2.9 percent, and 2.6 percent, respectively. Together, the weighted average of the three programs is rising at 3.1 percent annually.

What’s more, the growth of unfunded liabilities may prove to be grossly underestimated as recessions induce elected officials to expand the most popular programs. An example is higher national inflation, which could easily raise cost-of-living adjustments.

Furthermore, unfunded liabilities are nearly certain to be adversely impacted by America’s demographic shift, whereby baby boomers are supported by a paucity of employed youth who already comprise a diminished portion of our nation’s aging population pyramid.

Lessons are often learned the hard way, particularly when history is ignored and society dismisses decades of clues pointing to fiscal carelessness and impropriety. As the nation has witnessed, numerous administrations have kicked the can of fiscal debt down the road, where it only gets larger and more difficult to manage.

Until America faces up to its debt crisis — and there’s little hope the White House and Congress will work together to reduce the debt — the United States of America could record the largest bankruptcy the world has ever seen. Such a catastrophe would have a devastating impact on nearly every country in the world. db

Facebook Comments