"Skunked": Bill Gross On How "The U.S. Will Likely Default On Its Debt"

Tyler Durden's picture

In a letter focusing on what has been well known to Zero Hedge readers for about two years now, Bill Gross' latest investment outlook does the usual attack of Beltway stupidity (as if Congress is in any way competent of making math-related decisions - they do what Wall Street - that's you Bill! - tell them to do, and you know it), emphasizing the impossible math of total US entitlement liabilities (on a net present value basis), which Gross estimates at $75 trillion. That Gross conclusion is predetermined from the onset is not surprising: "Unless entitlements are substantially reformed, I
am confident that this country will default on its debt; not in
conventional ways, but by picking the pocket of savers via a combination
of less observable, yet historically verifiable policies – inflation,
currency devaluation and low to negative real interest rates
."
Then again, that America is bankrupt is not really news to anyone. Neither is it news, that Gross, as we first reported, no longer has any US bonds to dispose of. What will be news is the inflection point at which Gross starts purchasing Treasuries once again. And after all with $220 billion in AUM in the Total Return Fund, what else will he do: hold on to cash? Buy Netflix? Then the only question will be how Gross spins the inevitable capitulation of the re-hypocrisy trade, validating that he, in a narrow sense, and PIMCO in a broad one, is perhaps the biggest cog in the very system that Bill spends so many hours writing letters about and complaining against. But yes, even that won't be all that surprising to us. After all, in this bizarro world absolutely everything is now priced in.

From PIMCO

Skunked

  • Medicare, Medicaid and Social Security now account for 44% of total federal spending and are steadily rising.
  • Previous Congresses (and Administrations) have relied on the
    assumption that we can grow our way out of this onerous debt burden.
  • Unless entitlements are substantially reformed, the U.S. will likely
    default on its debt; not in conventional ways, but via inflation,
    currency devaluation and low to negative real interest rates.

That adorable skunk, Pepé Le Pew, is one of my wife Sue’s favorite
cartoon characters. There’s something affable, even romantic about him
as he seeks to woo his female companions with a French accent and
promises of a skunk bungalow and bedrooms full of little Pepés in future
years. It’s easy to love a skunk – but only on the silver screen, and
if in real life – at a considerable distance. I think of Congress that
way. Every two or six years, they dress up in full makeup, pretending to
be the change, vowing to correct what hasn’t been corrected, promising
discipline as opposed to profligate overspending and undertaxation, and
striving to balance the budget when all others have failed. Oooh Pepé –
Mon Chéri! But don’t believe them – hold your nose instead! Oh, I kid
the Congress. Perhaps they don’t have black and white stripes with bushy
tails. Perhaps there’s just a stink bomb that the Congressional
sergeant-at-arms sets off every time they convene and the gavel falls to
signify the beginning of the “people’s business.” Perhaps. But, in all
cases, citizens of America – hold your noses. You ain’t smelled nothin’
yet.

I speak, of course, to the budget deficit and Washington’s inability
to recognize the intractable: 75% of the budget is non-discretionary and
entitlement based. Without attacking entitlements – Medicare, Medicaid
and Social Security – we are smelling $1 trillion deficits as far as the
nose can sniff. Once dominated by defense spending, these three
categories now account for 44% of total Federal spending and are
steadily rising. As Chart 1 points out, after defense and interest
payments on the national debt are excluded, remaining discretionary
expenses for education, infrastructure, agriculture and housing
constitute at most 25% of the 2011 fiscal year federal spending budget
of $4 trillion. You could eliminate it all and still wind up with a
deficit of nearly $700 billion! So come on you stinkers; enough of the
Pepé Le Pew romance and promises. Entitlement spending is where the
money is and you need to reform it.

Even then, the situation is almost beyond repair. Check out
the Treasury’s and Health and Human Services’ own data for the net
present value of entitlement liabilities shown in Chart 2.

The above four multi-trillion-dollar liability balls are staggering
in their implications. Remember first of all that the nearly $65
trillion of entitlement liabilities shown above are not some estimate of
future spending. They are the discounted net present value of current
spending should it continue at the projected demographic rate
(importantly ­– it is much higher than the annual CPI + 1% used as a
discounter because demand for healthcare rises much faster than
inflation.) And while some Honorable Congressional Le Pews would counter
that Medicaid is appropriated annually and therefore requires no
discounted reserve, those words would surely count as “sweet nothings,”
believable only to those whom they romance every several years at the
polls. The incredible reality is that the $9.1 trillion federal debt
that constitutes the next-to-tiniest ball in our chart is nothing
compared to unfunded Medicaid and Medicare. It is like comparing Pluto
to Saturn and Jupiter. The former (the $9.1 trillion current Treasury
debt) does not even merit planetary status in our solar system of
discounted future liabilities. It’s really just a large asteroid.

Look at it another way and our dire situation becomes equally
revealing. Suppose that the $65 trillion of entitlement liabilities were
fully funded in a “lockbox,” much like Social Security is falsely
imagined to be. Just suppose. And say the cost of that funding (Treasury
debt) was the same CPI + 1% that was used to produce the above
discounted present value in the first place. Actually, that’s not a bad
guesstimate for the average yield of all Treasury debt. If so, then the
interest expense on the $75 trillion total debt would equal $2.6 trillion,
quite close to the current level of entitlement spending for Social
Security, Medicare and Medicaid. What do we pay now in interest? About $250 billion.
Our annual “lockbox” tab would rise by $2.35 trillion and our deficit
would be close to 15% of GDP! The simple conclusion would be this:
Unless you want to drastically reduce entitlement spending or heaven
forbid raise taxes, then Pepé, you’ve got a stinker of a problem.

Previous Congresses (and Administrations) have relied on the
assumption that we can grow our way out of this onerous debt burden.
Perhaps we could, if it was only $9.1 trillion, as shown in Chart 2.
That would be 65% of GDP and well within reasonable ranges for sovereign
debt burdens. But that is not the reality. As others, such as Pete
Peterson of the Blackstone Group and Mary Meeker, have shown much better
and for far longer than I, the true but unrecorded debt of the U.S.
Treasury is not $9.1 trillion or even $11-12 trillion when Agency and
Student Loan liabilities are thrown in, but $65 trillion more! This
country appears to have an off-balance-sheet, unrecorded debt burden of
close to 500% of GDP! We are out-Greeking the Greeks, dear reader.

If so, and if the USA were a corporation, then it would probably have
a negative net worth of $35-40 trillion once our “assets” were properly
accounted for, as pointed out by Mary Meeker and endorsed by luminaries
such as Paul Volcker and Michael Bloomberg in a recent piece titled
“USA Inc.” However approximate and subjective that number is, no lender
would lend to such a corporation. Because if that company had a printing
press much like the U.S. with an official “reserve currency” seal of
approval affixed to every dollar bill, that lender/saver would have to
know that the only way out of the dilemma, absent very large
entitlement cuts, is to default in one (or a combination) of four ways:
1) outright via contractual abrogation – surely unthinkable, 2)
surreptitiously via accelerating and unexpectedly higher inflation –
likely but not significant in its impact, 3) deceptively via a declining
dollar– currently taking place right in front of our noses, and 4)
stealthily via policy rates and Treasury yields far below historical
levels – paying savers less on their money and hoping they won’t
complain.

If I were sitting before Congress – at a safe olfactory distance –
and giving testimony on our current debt crisis, I would pithily say
something like this:

“I sit before you as a representative of a $1.2 trillion
money manager, historically bond oriented, that has been selling
Treasuries because they have little value within the context of a $75
trillion total debt burden.

Unless entitlements are substantially reformed, I
am confident that this country will default on its debt; not in
conventional ways, but by picking the pocket of savers via a combination
of less observable, yet historically verifiable policies – inflation,
currency devaluation and low to negative real interest rates.
Our
clients, who represent unions, cities, U.S. and global pension funds,
foundations, as well as Main Street citizens, do not want to be
shortchanged or have their pockets picked. It is incumbent, therefore,
in order to preserve the integrity of the U.S. Treasury market along
with its favorable global interest rates, and to promote a stable U.S.
economy, that entitlement spending be reduced, and that future
liabilities be addressed in terms of healthcare and Social Security cost
containment. You must attack entitlements and make ‘debt’ a four-letter word.”

Thank you, and like Pepé Le Pew, why don’t you try changing your
stripes or at least pretend you’re a French-speaking cat. The odor in
these chambers is all too familiar and a skunk needs all the help it can
get