»The Daily Reckoning by Bill Borner

Is a 16 point cut in US' debt to GDP enough?
23 JANUARY 2012

Baltimore, Maryland

We went around the world last week. We wish we could say we learned something. But modern travel has been standardized...and culture and technology have been "globalized"....so that the more you travel the more you feel you never left home.

"How was your trip around the world," asked our assistant when we got back in the office in Baltimore.

"No problem. Nothing special," we replied.

How could a trip around the world not be 'special?' Well, the airports all look alike. The planes are all alike. The restaurants and hotels are all alike, usually international chains. So are the shops...and the products.

You can travel to the far side of the globe...and except for the fact that you can't quite remember where you are...or what time it is...you might as well have stayed put... More below...

Returning to the US...

We got the big news when we picked up a copy of USA Today in LA airport.

"Light at the end of the debt tunnel?" asked the headline.

We thought we knew the answer before we started reading.

But the report in USA Today tells the results of a study by McKinsey Global Institute. As a percentage of GDP, the US cut its "private and public debt" by 16 points, since 2008, it says. That puts it tied with South Korea in the debt-cutting derby.

We were only a paragraph into this report when we began to suspect that neither the reporter nor the McKinsey researchers had any idea what was going on.

Sixteen percentage points is not bad. But, as we recall, total debt in the US was around 325% of GDP. Take off 16 points...it's only a 5% reduction. Besides, US government debt alone INCREASED during this period. The feds are the largest debtors in the world. And they added 66% to their debt over the last three years. It was $9 trillion in '08. Now it's $15 trillion. An addition of $6 trillion.

The dots given in the USA Today report don't connect with the dots we know. It maintains that total debt in the US was 279% of GDP in the second quarter of last year. And it says financial debt fell by less than $2 trillion and household debt by half a trillion. Huh? That doesn't sound like $6 trillion.

We found a better report in the Financial Times. Gillian Tett explains that while the private sector is de-leveraging, the public sector is borrowing and spending more than ever. She goes on to take issue with McKinsey's "light at the end of the tunnel" conclusion.

Yes, the private sector is de-leveraging - just as you'd expect. Most of the debt that is being eliminated is mortgage debt and most of it is eliminated by default and foreclosure. At this rate, McKinsey reasons, US consumers "could reach sustainable debt levels in two years or more."

Hallelujah! We just have to wait until 2014 for a recovery.

But wait a minute. McKinsey's conclusion was based on the experiences of two Scandinavian countries, Finland and Sweden, in the 1990s. The two countries spent too much. Then, they had to cut back. The private sector went into a slump and the public sector took up the slack. When, after a few years, the private sector had reduced its debt sufficiently, it could resume its former growth...while the government gradually paid down its debts. All was well that ended well. The researchers on the project argue that "today the United States most closely follows this debt-reduction path."

We don't think so. We think the US is on a very different path. Finland and Sweden could pull of this 'rescue' because conditions were completely different.

First, they have smallish populations with much social and political cohesion.

Second, they were able to get back on the growth path because there was a boom going on almost everywhere else; they exported their way back to financial health.

Third, they didn't have that much debt in the first place. The Finns and Swedes could add debt without pushing themselves beyond the point of no return.

Not so the US...on all points. America has too much debt. It has no plausible path to recovery. And the feds are adding more debt than it can pay off.

You can do the math yourself, dear reader. With government debt-to-GDP at 100%...and rising...and the shift to short-term financing over the last few years...the feds are extremely vulnerable to an increase in interest rates. A chart in Sylla and Homer's "A History of Interest Rates" suggests that investors want a real rate of return from government bonds in the 3% to 5% range. That's what they've been getting, according to the chart, all the way back to 1850.

The current CPI-measured rate of inflation is about 2%. This suggests that nominal bond yields should be in the 5% to 7% range. But at 5% interest, the feds would have to pay out about $750 billion in annual interest charges, which is between a third and a quarter of all expected US tax revenues. It's the equivalent of the military budget, for example.

At 5% interest, bond investors would probably be wondering how the feds could stay in business. Most likely, yields would spiral out of control quickly...forcing the feds to print more money to cover deficits. In a matter of days, the whole jig would be up.

Which is what makes the other big news so puzzling.

"Negative yield fails to deter investor appetite for Tips," said one headline.

"30-year US loan rate hits nadir," said another.

What both headlines are telling us is either that we're wrong about how the world works...or the world isn't working quite as well as it should. The second explanation suits us best. The public sector is leveraging up. It is going deeper and deeper into debt. As it adds to the quantity of its debt outstanding, the quality should go down. And the price too. But it's not. So, either the times are out of joint...or we are.

For now, the weaker US finances get, the more people seem to want to lend it money.

This has to end badly...

---------------------------------------- Have an enriching Saturday! ----------------------------------------

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*** The Southern Hemisphere is not a bad place to be in the wintertime. That is, when it is wintertime in the Northern Hemisphere. By the time the chilly winds from Baltimore reach the southern tip of Africa they have been warmed by the South Atlantic. Flowers bloom. The sun shines. Gentle breezes glide over the fields and parking lots.

As near as we can tell, South Africa is booming. Driving along the freeways, you'd scarcely know you weren't in Southern California...or Texas. Except that it seems newer and more modern in Johannesburg than it does LA. Most of the roads...shops...and offices you see in Jo'burg were put up only in the last couple of years. Those in L.A. date back decades.

But there are a lot of poor people in Africa, more than in California. And some of them are not very good neighbors. At intersections that are particularly favored by hijackers, for example, signs warn motorists to watch out. Razor wire, stretched generously and lazily on the top of walls, reminds the visitor that this is no paradise.

Melbourne, Australia, is equally sun-washed this time of year. But it seems cleaner, safer, and more urban. People ride bicycles up and down the Yarro River. Couples stroll hand in hand in front of the old train station or through the narrow alleys, now filled with tables and outdoor dining.

Jo'burg is much cheaper than Melbourne. We paid $44 for a buffet breakfast at the Crowne Plaza hotel. Then again, Melbourne has become one of the world's most expensive and desirable cities. Each year, it and Vancouver vie for the top position in the Economist's list of the world's most livable cities.

To summarize Australia's economic situation: the Aussies sell dirt to the Chinese. Since the Chinese have such a strong appetite for antipodal dirt, the Aussies are making money. Prices are rising. Investors are confident. The boom goes on.

Australian property prices seem way out of line, at least compared to Baltimore. An office building that might sell for $1 or $2 million in the heart of Baltimore is on offer in the St. Kilda area of Melbourne for $7 million. Then again, St. Kilda is lively, hip, and attractive, with an exciting nightlife and a beach next door. Baltimore, on the other hand...oh, never mind.

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