Heading Toward the “Tipping Point” – James Turk
Heading Toward the “Tipping Point” – James Turk for FGMR
In an article last year entitled “Bankruptcy 1995 Revisited”, I presented a detailed analysis of the US government’s financial position. It wasn’t a pretty picture then, and it looks even worse now.
When you take away the political posturing, promises and rhetoric surrounding the US government’s financial position, all the cold, hard facts boil down to one key indicator, the Insolvency Ratio, which measures the percent of government revenue being used to pay interest on its debt. Interest expense can be a burden when carrying too much debt, and the greater the burden, the higher the Insolvency Ratio.
This ratio is based upon three components, and their interplay determine the ratio’s level. They are:
- Amount of the US government’s debt
- Interest expense paid on the debt
- Government revenue
I provide below the 2015-to-2018 data taken from the table in “Bankruptcy 1995 Revisited”, which I recommend reading for background information. Note that I changed the title of column F to “US Government Insolvency Ratio” to use a label that more accurately describes what is being measured.
As the ratio rises, the federal government approaches insolvency and the ominous “tipping point”, which is inevitably reached if corrective actions are not taken. The result is the ongoing erosion of the US dollar’s purchasing power accelerates, leading to its inevitable collapse. It is a curse that afflicts all fiat currencies.
To explain this point, view the US government as an operating entity, with revenue and expenses. If its expenses are greater than its revenue, it incurs a deficit, which must be financed. The accumulation of dollars borrowed to fund these deficits are the US government’s debt, which currently stands at $22 trillion, a mind-boggling number.
Most of this debt is loaned to the government by private investors, but a significant portion is loaned by banks, including central banks. The Federal Reserve has loaned $2.2 trillion to the US Treasury, and it records that $3.1 trillion has been loaned by foreign official and international accounts. That’s 24.1% of the US government’s total debt, and here’s the problem. Banks turn that debt into US dollar currency, and there is no limit as to how far they can go.
In contrast, under the classical gold standard there was a limit, which was the weight of gold held in a central bank’s vault. The gold was a ball-and-chain tied to the ankle of bankers that prevented rampant monetary expansion.
Without this external discipline of a limit imposed by gold, central banks erode the currency’s purchasing power by creating too much of it. They create the currency that finances the government’s deficits. The present hyperinflation in Venezuela is just the latest of hundreds of examples illustrating this harmful process of currency debasement.
It starts when a government runs a deficit and accumulates debt. As the debt grows, the interest expense the government pays on its debt also grows, until the “tipping point” is reached. It is the point where the private sector no longer wants to, or possesses the available savings to finance the government. To enable the politicians running the government to meet their spending aspirations, the central bank steps in by creating the currency to fund the deficit that the private sector is unwilling to finance.
This insidious process starts slowly, but gathers speed as a greater percentage of the government’s revenue is being used just to pay the interest expense of carrying the debt, which explains the importance of the Insolvency Ratio. There is no cast-iron rule as to when the “tipping point” for any currency is reached mathematically, so the Insolvency Ratio is used only as a general indicator. But generally, the first signs of trouble appear, as explained in “Bankruptcy 1995 Revisited”, when repeated annual increases take the Insolvency Ratio to 20%, and the US government is not far from that point.
I have included in the following table: (1) actual results for the full fiscal year ending September 30, 2018, which were of course not yet known when I wrote my article in March 2018, (2) the projection of the federal government’s Budget Office for fiscal year 2019 and (3) the actual results through the six months ending March 31, 2019.
|Fiscal Year||Federal Debt||Average Debt||Gross Interest||Implied Interest Rate||US Government Revenue||US Gov’t Insolvency Ratio|
- My estimate for the full 2018 fiscal year presented in “Bankruptcy 1995 Revisited”
- Actual results for the full 2018 fiscal year
- Budget Office projection for the full 2019 fiscal year
- Actual results for the six months of the 2019 fiscal year
- Calculation based on the Budget Office data
There are important observations to be made about the US government’s financial results in the above table.
1) The actual results for the full fiscal year through September 30, 2018 proved to be worse than my March 15, 2018 forecast. As it turned out, debt was higher; revenue was lower; and its interest expense was greater. These three factors together resulted in an Insolvency Ratio of 15.7%, higher than my 15.3% forecast, and it continues to climb, which was a worrying issue I pointed out and explained in my article.
2) US government revenue is running well below budget. If the same pace is maintained in the second half of the current fiscal year, revenue will be 82.7% of the Budget Office’s forecast.
3) For the 6-month period ending March 31, 2019, the US government’s Insolvency Ratio is 17.2%, already well above the Budget’s Office forecast of 16.3% for the full fiscal year. It is also the highest Insolvency Ratio since 18.0% in 2011 when US government debt load increased because of the bank bailouts resulting from the 2008 financial collapse.
The Insolvency Ratio is a time-tested measure, and it applies to all debtors. So consider the US government’s sky-high ratio compared to, say, Ford Motor Company, whose ratio is only 0.8% and IBM with a 0.9% ratio. It seems obvious that any company paying $17.20 of interest expense for every $100 of revenue would have long ago reached insolvency. Inexplicably investors are more forgiving when it comes to governments, perhaps because they are swayed by the promises of politicians without looking at the cold, hard facts.
The Insolvency Ratio explains why the Federal Reserve recently stopped raising interest rates. They did it to maintain the illusion that the US government is solvent, even though it is actually struggling with its huge and growing debt load.
Rising interest rates were speeding up the US government’s relentless march to insolvency. Rising interest rates were increasing the US government’s interest expense burden and its Insolvency Ratio. So despite the hollow rhetoric about its so-called ‘independence’, the Federal Reserve tried to help.
While the Federal Reserve’s dual mandate to maximize employment and stabilize prices is well known, its primary mandate is rarely mentioned. The Federal Reserve’s real purpose is to maintain the illusion that the US government is solvent. The underlying reality is that today’s banking and monetary system is a house-of-cards, and the US government lies at the center of that shaky, ephemeral structure. The Federal Reserve will do “whatever it takes”, including skillful deception, to maintain the illusion that the US government looks solvent.
There are six months remaining before the US government’s current fiscal year concludes on September 30th, and things could change for the better. Perhaps the economy will pick up and federal revenue will grow much faster in this year’s second half to meet the Budget Office’s projection, and expenses could somehow end up less than forecast, which is probably unlikely because spending cuts are rare.
The other factor is interest rates. The Federal Reserve has announced that it is not raising interest rates from current levels. Along with their incessant jawboning and cheerleading about the economy and soundness of the banking system, it’s their way to help keep the US government’s Insolvency Ratio from climbing, which brings us to the worrying part.
When a government’s debt becomes large enough, and the US government is rapidly reaching that level, the ever-growing interest expense burden is like a snowball rolling down a mountain that starts to pick up momentum and becomes unstoppable. To put it starkly, the situation is becoming out of control.
The US government is heading for the “tipping point”, unless it cuts back on spending – unlikely – or the Federal Reserve again drops interest rates to zero, which is the likely outcome. But at this stage given the debt load, the Federal Reserve is just buying a little more time to maintain the illusion that the US government remains solvent. The US government is liquid, in that it can pay its bills and the Federal Reserve will always make sure it receives the dollars needed to do that, but being liquid is entirely different than being solvent. If the Federal Reserve weren’t standing by with its banker pals, the insolvency of the US government would be obvious.
Maybe the deterioration of the US government’s financial condition is the real reason that President Trump implored the Federal Reserve to stop raising interest rates. His Budget Office no doubt has explained to him the US government’s precarious financial position and the negative implications resulting from its sensitivity to higher interest rates.
Most everyone recognizes that the problem is too much debt, but that is a consequence of the underlying cause. The US government’s debt mountain arises from the ongoing abuse of financial principles and irresponsible self-indulgent behavior by politicians who allow it to happen, apparently oblivious to – and unconcerned about – the consequences for the US dollar. Actions always have consequences, and the actions of the US government are pushing the dollar toward some ominous consequences. The repercussions to the US dollar will be harsh.