On The Mean Reversion Of America's Luck, And Why Interest Outlays Are Really 30% Of US Revenues

When discussing central planning, as manifested by the policies of the world's central banks, a recurring theme is the upcoming reversion to the mean: whether in economic data, in financial statistics, or, as Dylan Grice points out in his latest piece, in luck. While the mandate of every institution, whose existence depends on the perpetuation of the status quo, is to extend the amplitude of all such deviations from the trendline median, there is only so much that hope, myth and endless paper dilution can achieve. And alas for the US, whose 3.5% bond yields are, according to Grice, primarily due to "150% luck", the mean reversion is about to come crashing down with a vengeance after 30 years of rubber band stretching. The primary reason is that while the official percentage of interest expenditures as a portion of total government revenues is roughly 10% based on official propaganda data, the real number, factoring in gross interest expense, and assuming a reversion to the historic average debt yield of 5.8%, means that right now, the US government is already spending 30% of its revenues on gross interest payments! And what is worse, is that the chart has entered the parabolic phase. Once the convergence of theoretical and real rates happens, and all those who wonder who will buy US debt get their answer (which will happen once the 10 Year is trading at 6% or more), the inevitability of the US transition into the next phase of the "Weimar" experiment will become all too obvious. Because once the abovementioned percentage hits 50%, it is game over.

Below Grice lays out the framework for the disinflation delusion that has permeated the minds of all economists to the point where divergence from the mean is now taken as gospel:

What drove the disinflation of the last thirty years? Politicians would say it was because they granted their central banks independence. But the pioneering experiment here didn’t take place until ten years into the disinflation, when the Reserve Bank of New Zealand Act 1989 gave that central bank the sole mandate to pursue price stability. Macroeconomists would site breakthroughs in our understanding. Except there haven’t been any. Today’s hard money/soft money debate is identical to the Monetarist/Keynesian debate of the 1970s, the US bimetallism agitation of the late 19th century, and the Currency vs Banking School controversy in the UK during the 1840s.

Was it the de-unionisation of the workforce? The quiescence of oil markets since the two extreme shocks of the 70s? The dumping of cheap labour from Eastern Europe, China and India onto the global labour market? Technology enhanced productivity growth? Or maybe it was just because the CPI numbers are so heavily manipulated?

Maybe it was all of these things. Maybe it was none of these things … for the little that it’s worth, my theory is that no-one has an adequate theory, other than it being down to the usual combination of luck and judgment on the part of policymakers … or about 150% luck. The problem is luck mean-reverts. The mammoth fiscal challenges (see chart below) currently being shirked by the US political class suggest that mean-reversion is imminent.

Ireland is probably the best example of an entity for which the cognitive dissonance between an imaginary desired universe and a violent snapback to reality has finally manifested itself after a 30 year absence:

Ireland provides a good illustration. Today it’s going through a real and wrenching depression - there is no other word for it and it is heartbreaking to watch – partly because the terms of its bailout are so onerous. And what may well be the seeds of a future popular backlash against the euro can be detected in the election of Fine Gael on a ticket of renegotiating the bailout terms, which currently require them to pay a 5.8% rate of interest.

Unlike Ireland, the US still has the luxury of being able to stick its head deep in the sand of denial.

Look at the following chart showing two hundred years or so of US government borrowing costs. Two hundred years is a lengthy period of time. There have been economic booms and financial panics, localized wars and world wars, empires have risen and empires have fallen, technological change has made each successive generation’s world unrecognizable from that which preceded it. Yet government yields have remained broadly mean-reverting (and the US has been one of the best run economies over that time – other governments’ bond yields demonstrate an unpleasant historic skew towards large numbers). Coincidentally enough, the average rate of interest over that period has been around 5.8%, the rate which the new Irish government today says is ‘crippling.’

And here is the math that nobody in D.C. will ever dare touch with a ten foot pole as it will confirm beyond a reasonable doubt that the US is now well on its way to monetizing its future (read: not winning)

In other words, Ireland is so indebted that it is struggling to pay a rate of interest posterity would barely yawn at. But Ireland isn’t the only one.Take the US government, for example, which currently pays around 10% of its revenues on interest payments. This doesn’t sound too bad. The problem is that those federal government interest payments are calculated net of the coupons paid into federally run programs (e.g. social security) as these are deemed ‘intragovernment transfers.’ Yet those coupons to social security are made to fund a real obligation to American citizens and as such, represent payments on a real liability. On a gross basis the US government pays out 15% of its revenues on interest payments, which makes for less comfortable reading. So the net numbers remain the most widely quoted.

And where the figure gets downright ugly is if one assumes that in order to find buyers for the $4 trillion in debt over the next two years (once the Fed supposedly is out of the picture after June 30), rates revert to the mean. Which they will. What happens next is a cointoss on whether or not we enter a Weimar-style debt crunch.

Suppose the US government had to pay the 5.8% yield it has paid on average over the last two hundred years? The share of revenues spent on gross interest payments would be a staggering 30% (see chart above). If it had  to pay the 6.9% it’s paid on average since WW2, those gross interest payments would account for 37% of revenues. So it’s not difficult to see the potential for a dangerously self-reinforcing spiral of higher yields straining public finances, hurting confidence in the US governments’ ability to repay without inflating, leading to higher yields, etc.

Lastly, Grice makes it all too clear why we are now all screwed, and no matter how many Bernanke dog and pony shows we have, the final outcome is not a matter of if but when.

America’s political class might arrest the trend which threatens their government’s solvency (chart below). They might find a palatable solution to the healthcare system’s chronic underfunding. They might defy Churchill’s quip, and skip straight to doing the right thing. But if they don’t, such a spiral becomes a question of when and not if. And what would the Fed do then? Bernanke says the Fed “will not allow inflation to get above low and stable levels.” He says it has learned the lessons of the 1970s. He’s read the books. He can recite the theory. Yet a lifetime reading books about the Great Depression (and writing a few) didn’t help him spot the greatest credit inflation since that catastrophe any more than reading “The Ten Habits of Highly Successful People” would make him successful. It’s the doing that counts. So before lending to the US government for 3.5% over ten years, bear in mind that when it comes to a real inflation fight, not one of the Fed economists you’re betting on has ever been in one.

Our advice to the good doctor and his minions (not to mention all readers), is instead of reading multitudes of history books on the depression, on Japan, or on midget tossing (for those from the SEC), is to read one book. Just one. Link here.

Comments

[Alcoholic Nativ...]

You are not even investing your money anymore with 30 year treasuries, much like 30 year mortgages.  You are simply throwing your money away.

[pauldia]

 Hmmm, Whats missing from Mr Glassmans recommendations?????

Smart asset allocation may be the only protection against chaotic times

http://www.washingtonpost.com/wp-dyn/content/article/2011/03/05/AR2011030503708.html?hpid=topnews

[ebworthen]

Wow.

The book linked at the end is recommended, well written and clear.

The chapter on "Self-Defense" I'm halfway through is worth the download alone.

He does say some negative things about gold but good grist for the mill to contemplate - as gold and PM's will likely be a target of the central banks (reduce values) to try and force money into the markets.

I remember the 1970's inflation and stagflation.  I was a wee pup, but the anger and fear and strife were palpable even to the children.

I remember the news stories of the elderly having to buy cans of Alpo dog food to survive, and SS payments barely being raised 2% when the pace of inflation was 10%.

Not to mention the lines at the gas station that went around the block.  I remember spending over a half-hour in a line with my Mom in the old Chrysler station wagon.  Big V-8 so she would shut it off between moving forward as you would have to sit in one spot for five minutes as somone pumped.

Ugh.

[tom]

Actually gross interest outlays were 19% of revenues in FY10 ($414 billion versus $2.16 trillion). But personally I think it's right to exclude the $202 billion of interest payments on intragovernmental debt, because as the interest rises on that so does the income for the agencies that own it, netting out to zero impact on the federal government's bottom line.

You might also net out the interest payments to the Fed which the Fed refunds to the federal government. That's a bit more than $20 billion I guess. So actually "only" 9% of taxes go towards interest payments on the federal debt.

But anyway Grice is right about the potential for interest payment expenses to explode quickly.

It's an ugly combination: the very low base that interest rates are rising from (so that even a 2-point rise equals a more than 50% increase in interest expenses), and the very rapid pace at which debt is being piled on (by 19% in FY10, from $7.55 trillion to $9.02 trillion, and by another 6% already in the first five months of FY11, to $9.57 trillion).

[Dr. Porkchop]

This is all so foolish. Even a child knows you can't reinflate a burst bubble.

[Alcoholic Nativ...]

You can try, but you start to get air headed and dizzy.

[emsolý]

I can't believe that no one here has thought of the possibility that, you know, this time, really, it could be different...

[linrom]

Few ponits:

---The whole idea in banking is to run up interest expense as high as possible. One way to achieve this is through government deficit spending. The government is then forced to borrow money and then pay interest to those that it should be collecting taxes from! This also helps to increase interest rates as government competes for available capital.

---When it comes to wealth, most Americans fail to understand what it means to be wealthy(they think of themselves as wealthy because they fail to grasp that wealth fits Nassim Taleb's fat tails distribution.) If one considers that global stock market capitalization alone was over $50 trillion just a few years ago and how few people control this vast wealth, then perhaps they'll grasp it.

---Christina Romer, Chairperson of the Council of Economic Advisers made this statement recently: "Taxes will have to increase, and unfortunately that means middle class, because there are so many more of them."

If you do not understand that there is class warfare going on for ALL the marbles, with the Peterson Institute founded by Blackstone LLC being just one such player: they even set school curriculum in one instance, then playing a useful idiot's game might be acceptable to you. As far as I am concerned, the rich should be taxed at 90% as they were before JFK.

[jmc8888]

So monetary collusion is 150 percent luck? How about 150 percent FRAUD DG? Glass-Steagall (which of course, would lower that 30 percent WITHOUT needing bubblicious 0 percent rates [or depending on your view  of it....trapped into them])

[Don Levit]

Tom:

The interest payments on intragovernmental debt are not paid in cash, but in additional Treasury securities.

However, the interest "paid" is part of our total debt (debt held by the public plus intragovernmental debt).

While the interest does net out to zero when intragovernmental debt increases, the asset side, which is the trust fund increase has no immediate impact on the budget.  This is because interest is paid in debt, not cash.

However, the liability side, which is loaned to the Treasury, does have an immediate impact on the budget, for that "money" is used to pay for current expenses and (artificially) lower the budget.

So, the asset side is not used as cash immediately, while the liability side has an immediate positive impact on the budget.

What kind of accounting do you call that, when the liabiliity has a positive short term impact and the asset has no immediate impact on the budget?

Don Levit

[lsjcma]

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