Guest Post: Subprime Government And The Liquidity Trap, Parts I and II

Submitted by nopat

Subprime Government and the Liquidity Trap

Part I

Intragovernmental debt holdings have been one of the more underreported topics during the last few economic cycles.  This isn’t surprising.  We’ve turned the federal debt argument into a legal, rather than financial or moral, debate where the fairness doctrine of universal applicability means any inconsistency of logic on the part renders the whole invalid.  The result of this is the public grossly misunderstands the burden of proof to be the lack of controvertible evidence, and with it any hope of meaningful discourse is lost in the chicanes of grandiose political gestures.  Arguments get boiled down into easy-to-swallow pills ready for mass consumption.  We rally against illegal immigration without questioning who built our houses, and condemn illegal drug use while washing down an oxycodone with a highball of scotch.  National debt is now far too high and government spending and waste far too pervasive.  We must stop at nothing to rid ourselves of this indentured servitude.

Oh, dear Faust, if it were only that easy.

Like all political debates, the rub isn’t the national debt as a whole, it’s the composition of the national debt between publicly-held and held by agencies.  To be fair, publicly-held debt is the larger amount – $9.4T of the $14T, or two-thirds.  But focusing on the public portion of the national debt means the federal government can still dip its fingers in the other third of the pie that is the intragovernmental debt holdings without invalidating the “debt = the devil” position voters love casting, like a pair of bunched-up panties at a Tom Jones concert, their ballots towards.  Clinton’s sepia’d legacy will be defined by the moment he paid down the national debt, if by “paid down” you mean “increased” $588B between 1996-2001 by raiding the Federal Trust Fund.
The whole thing works just like any institution sitting on a ton of cash: due to the timing between assets and liabilities (receiving money and paying expenses), it makes perfect financial sense to put that cash to work provided there’s an asset class with low enough risk so as not to disrupt operations.  And there’s no single riskless asset class like US Federal Debt, backed by the full faith and credit of the US Government.

One of the reforms Lyndon Johnson ushered in with his Great Society was the creation of the General Trust Fund.  The government isn’t “The Government”, it’s a collection of agencies waging a pitched battle for precious taxpayer resources.  Now, on the rare occasion that spending is less than projected, or as is more likely, tax receipts earmarked for a specific agency came in above what was budgeted, this “surplus” is pooled into a general trust and lent out to other agencies at a rate assumed similar to a government market issue maturing and/or callable after 4 years.  In other words, a medium-term to long-term Treasury note with terms set accordingly including interest paid back to the issuing agency. 

In a manner of speaking, it was a way to become “half-pregnant”.  For agencies like the SSA collecting 40 or 50 years of taxes from an individual before a withdrawal would be seen, this represents a massive source of funding for government operations.  Without having to access the capital markets, interest rates would remain lower than they ordinarily would and the drag on the economy would be reduced.  More importantly, it allowed politicians to expand the size of government without having to increase the direct tax burden.  For the generation of guns-and-butter baby boomers who were raised during the unrivaled prosperity of post-WWII America, capitalism was now like being an organ donor, something at the bottom of a form you could opt into.  It became as much of an inalienable Constitutional right as free speech, turkey at Thanksgiving, and the best education American tax dollars can buy.

Now, this is where the story takes a bit of a turn.  The dollar is the de facto reserve currency, and has been since Bretton Woods.  When an
emerging economy wants to access the capital markets, investors demand the transaction to occur in dollars to ensure sufficient liquidity – that, in the event things fall apart quickly, there will be sufficient physical currency to be able to exit their positions.  The same applies for commodities, precious metals, and a whole host of other asset classes.  This influx of capital increases pressure on the currency markets to the effect of driving down the dollar (where capital is leaving) and increasing the value of the foreign currency (where capital is entering).  To keep their goods cheaper for export, foreign central banks intervene by using their new influx of US dollars to buy assets priced in US dollars, causing dollars to increase in value relative to their currency.  Given the need to quickly enter and exit these positions in response to changes in the market, the preference is for the next most liquid asset other than dollars – US Treasuries.

That’s the inside joke when we get into a pissing match over trade.  A country wants to keep its currency cheap, so it makes our currency more expensive.  The more expensive our currency, the cheaper it is for us to borrow.  Borrowing devalues the currency, and the cycle continues, for as long as there is a buyer, dollars will be printed.  Without a buyer, the currency becomes cheaper, borrowing costs increase, and inflation grips the economy.  That’s the trade – we get their goods plus rock-bottom financing.  The economy expands, unemployment drops to the floor, and tax receipts grow.  Trust funds burst at the seams, the cost of borrowing from now lower than ever, allowing the unthinkably easy out of cutting taxes and expanding entitlement services.  In return, they get our inflation.  All gain, no pain.  To a guns-and-butter baby boomer, it’d be inconceivable any other way.  Any less, and the inequity of fairness would be worthy of protest.

Part II

Well, at least that’s the way it’s supposed to work.  Except when it works too well, then it doesn’t work at all.  And for the past 40 years, it’s been working exceedingly well.  Which is to say, it’s about to fail miserably.

The interesting thing about the post-war baby boom and our guns-and-butter generation isn’t what happened during or as a result of this population tidal wave, but what didn’t happen:  the birth rate in America abruptly fell during the mid-60s, and continued to fall even through to today.  Compounding the problem, on one hand you have increasing life expectancies and the expansion of benefits placing financial burdens on the retirement system.  On the other hand, increasingly competitive labor markets and trade liberalization placed further importance on education and technological adoption, which both increased the displacement of workers as the domestic value chain moved upstream and delayed the entry of individuals into the labor pool well into their 20s as they traded off starting a family for attaining college educations.  These lengthened dependant obligations (from both ends of the curve) have necessitated longer workforce tenures, and are simultaneously acting as an artificial floor to wages for those already at the peak of their earnings trajectory while creating a ceiling as the next generation is kept in an advancement holding pattern, denied the skills and experience needed to achieve their own maximum earnings potential.  The divide between rich and poor is as much a generational problem as it is access to education, technology, and capital resources.


The other interesting thing about the post-war baby boom was the impact on the savings rate.  The rising percentage of income coming from transfer payments (i.e. entitlement programs) as a result of displacement on one end of the economic spectrum coupled with multiple streams of household income and smaller family sizes on the other drove an insatiable consumer demand that depressed the household savings rate, increased demand for foreign goods, and lowered borrowing costs as a vicious cycle was created.  Attempts at intervening in the markets to protect trade and standards of living did little more than fuel government spending as the domestic value chain moved even higher, displacing more workers and shifting the demand for low-wage labor overseas.


Unless you’ve been living under a rock for the past 3 years…it should be pretty obvious this plan hinges on consumer spending.  Now, consumer spending can come from one of three areas: wages, investments, and borrowing.  Well, wages haven’t moved a whole lot over the past decade, and for that matter neither have investments.  Which leaves borrowing.  Lots of borrowing.  Where possible, from ourselves.  Free money, after all, is free money.

Except when it isn’t.  Part of accessing the General Trust means having to pay interest, which the SSA has been more than willing to accept and the rest of the federal government has been more than willing to pay.  For the past 20 years, each time it accesses these funds, it does so at lower and lower costs, with ever more funds to access as tax revenues have continued to grow.  With borrowing costs lower than at any point in history, this should be a no brainer.

If only it were that easy.

The government at large faces an epic dilemma of where to come up with the cash to keep itself moving forward without drawing too much of a shock to the system.  Nearly 1 in 5 is employed in the Public sector, likely more once you take into consideration all the private industries that live specifically off of government contracts.  Almost $0.30 of every $1 of gross earnings is a government paycheck of some form.  Taking into account that social security benefits paid by your employer isn't income, given it goes directly into someone else's pocket, the picture only gets worse.  Public sentiment is clamoring for a reduction in the federal deficit without an increase in the per-capita level of taxes.  Current spending levels are predicated on cheap and easy access to capital markets, which have left the central bank in the precarious situation of being unable to increase interest rates without increasing the overall costs to government, which can't reduce its size without contributing to a greater economic downturn.  As it stands, the SSA can hope to bring in $114B of interest revenue on the debt currently outstanding, less than what it did in 2010.   Unfortunately, there isn’t any capital left in those funds to roll the interest rates over, and unless there’s a miraculous recovery in the labor market (maybe Bill Hicks’ idea of using the elderly for stunt doubles will come to fruition, at least one can hope), payments will continue to outstrip receipts and a draw-down on $2.6T of the SSA trust will deprive the government of much needed oxygen to keep the machine moving forward. 


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