Coyotes, anvils, and the US government debt

Is the US government debt really a problem?

It used to be the debt was like the weather – everyone complained about it but no one wanted to do anything about it. Now the debt is more like a girlfriend you broke up with years ago – you know she’s still out there somewhere, but she doesn’t really come to mind much, and you like it that way. I think the debt is really more like the anvil plummeting down on Wile E. Coyote – he may not be thinking about it, but it’s gonna flatten him all the same.

What do you do about debt?

When a family or business borrows money, they have one of two rational plans: they’ve already budgeted the money to repay the debt, or they are planning on increased income to allow them to repay the debt. In the case of US government debt, it’s been pretty clear for many years that Washington has no stomach for paying the debt instead of spending the money elsewhere. Our only alternative is to rely on increased income to pay. However, we are so far into debt that we can’t do that any more.

That’s a painful conclusion, and before we accept the pain we should understand why it’s inescapable. First, some rough numbers on the US debt:

$19 trillion total debt.

$3.25 trillion annual receipts.

$440 billion annual deficit.

1.25% rate paid on debt, $236 billion per year.

To pay off this debt, we could cut spending – cut $440 billion first just to break even, then any more could go against the debt. Since most of the US government spending is direct payments to individuals, moving money to paying down the debt means less money to pay to voters who keep you in office. Not much chance of that.

Some folks say the debt doesn’t matter and we should just keep doing what we’ve been doing. At our current pace, we’ll owe $30 trillion in just 12 years, and will have to borrow $2 billion just to make it to year 13. In 17 years, we’ll owe $43 trillion, and paying the interest on the debt will be more than all other government spending combined. We’re headed off a cliff, and staying the course just means that we drive off.

Another approach is to raise taxes, so that the government takes more of the economy’s output. We increase government receipts, and use that to pay off debt. This might sound possible, but we have two big problems. First, every politician sells their tax increase by the new spending it will enable; raising taxes without giving away more goodies doesn’t get many votes. Second, at some point we are on the wrong side of the Laffer curve, where raising taxes actually reduces government receipts (since people are smart enough to stop working so hard when the government takes too big a cut).

The usual smiley face alternative says that we’ll grow the economy, and paying off today’s debt will be easy as our economy makes more money (and the government gets its cut in taxes). This was always my preferred explanation. It just required better government, and the ingenuity and work ethic of the American people, and everything would be ok. Unfortunately, the US debt is now so large that we can no longer grow our way out of it.

This doesn’t seem right. If we get a raise at work, we can just set some of the raise aside to pay down our individual debt. That’s classic “get out of debt” advice. It doesn't work for the US debt because the rate of economic growth is tied to the interest rate the US has to pay on the debt, and that changes everything.

What is this tie? Imagine you’re an investor, with a few billion dollars to manage. You can invest in US debt, or in US companies. If you invest in US debt, your return is the interest rate paid on government bonds. If you invest in US companies, your rate of return (on average) is the rate of growth of the US economy. If the economy grows faster, then the US must offer to pay higher interest rates or all the money will go to equity investments in companies. This is logically true, and borne out by many years of evidence. The yield on US government bonds tracks very closely to the rate of economic growth. In fact, when those rates diverge from the historical link it’s time to change your bond/equity investments.

The numbers that kill us.

The US economy is currently growing at about 1.25% per year. The interest rate paid on the US debt is similar. We already know what happens if everything stays the same – we drive off a cliff in a decade or so. If we are going to grow our way out of debt, we have to increase the rate of economic growth. What happens if we increase economic growth to 3% per year? Tax receipts go up by $97 billion, but interest on the debt goes up by $334 billion. Our annual deficit increases to $675 billion, and we reach the cliff a lot sooner.

What if we get more aggressive, and increase economic growth to 12% per year? Tax receipts go up by $390 billion, but interest on the debt goes up by $2 trillion. We run off the cliff tomorrow.

The core problem is not government debt. It’s that government debt is so large – so large that changes in interest have overwhelming impact, and so large that government interest rates and economic growth are linked. Our individual debts are so small that we don’t have any real effect on interest rates, so we can work more hours and make more money without increasing the interest we pay. The government, however, has to pay more interest when we all try to work harder

The other alternative, and the one most countries have followed, is to inflate away the debt. We just add a few zeroes to all our dollar bills, and pay the debt with those reduced value dollars. This works, but only once. The interest rate paid by the government also reflects investors’ expectations of inflation. If investors expect that the government will reduce the value of the dollar, then investors will want interest to cover that decrease in value. You can hit investors with massive, unexpected inflation once, when they’re not expecting it. Everyone holding US government debt gets hit with a huge loss, but we’ve reduced our debt. The problem is that you can’t borrow any more. This contributed to the collapse of the Roman empire, the defeat of the colonial Spanish empire, the transition from the French Revolution to Napolean’s dictatorship, the continuing disasters in Argentina’s economy. Hyperinflation is like a bankruptcy – you can do it once, but you have to have your house in order for a long time after. If we can’t get our house in order today, will we be able to then?

What should we do? We should quit throwing money away on unproductive, unaccountable government-dictated activities. We should realize that we cannot vote our way to prosperity, that we cannot vote out the laws of reality, that we cannot vote a chicken in every pot – we have to raise the chickens, and make the pots. We probably won’t.

What will we do? Probably the same thing every society before us has done. An increasing majority of us will vote to try to push reality away for another week or two. That will work, until it doesn’t. The deeper we dig the hole, the more it will hurt when we fall into it. 

What do you think? Is there another road? What do you do as an individual when the US car is headed off a cliff?

Bernie says big profits are bad. Are they really?

Your friend has a business idea, and needs your help. He needs $20,000 to start a part-time business, but only has $10,000. He knows you’ve been saving for a new car, but if you’ll invest your $10,000 in his business instead, he will sell you half the business. He will split the profits, after his salary and all other expenses, evenly with you. Of course, if there are no profits then you don’t get anything. And if the company fails, then you don’t get anything and you lose your $10,000. If the business succeeds, he expects that it’ll make about $1,000 profit per year. After reinvesting some for future growth, about $750 will be available for the owners, so you’ll get $375 per year. Also, if the business is successful and grows, you’ll own half of it. First decision: What do you think? Would you give him the money? You get a 3.75% return, and maybe the company will grow, but it might fail and you lose all your money. Second decision: if you give him the money, and take the $375 per year plus half the company, are you taking unfair advantage of him? Are you evil? Is your share of the profits unfair to the rest of society? Should other people be able to make similar deals, and start similar businesses?

Change the story a little: your friend is a bit more ambitious. This business requires 500 times as much money to buy tools and build buildings. He has to raise $10,000,000 instead of $20,000. The deal is the same, though - for each $10,000 you invest, you expect $375 per year return, plus a proportionate share of ownership (0.1% instead of 50%, since the company is 500 times bigger). He has to get 1000 investors to cooperate now, so there will be some kind of owner voting structure (instead of just meeting at lunch) to make important decisions about the company. Does this larger cooperation change your answers? Is it ok for 1000 people to each invest in the company, and get ownership and 3.75% return? Would it be ok if you took two pieces of the pie - invested $20,000, and got 0.2% ownership to go with your $750 per year return?

Now let’s do this 20,000 times, or about once in every city in the US. Your friend joins forces with these 20,000 other compatible businesses. The owners each have a smaller piece of the much larger pie. They still just invested $10,000, and still just get $375 per year, but when you add them all together the totals are bigger. The owner voting is a bit more complicated, since so many owners have to be involved, but basically we’re just doing the same things we did in the first story, but cooperating with more investors, more employees, more buildings and tools. Question: Is there anything evil about our financial arrangements? Have we cheated anybody - the customers who voluntarily buy our products, the staff who run the tools that make the business go, the owners who put up the money and get their 3.75% return?

This is all a little abstract, so let’s put add some color. Let’s say our business is to make drugs that help treat and cure diseases. And let’s name our big cooperative Pfizer. The numbers haven’t changed, but Bernie Sanders now says we’re obscene. Maybe he doesn’t like people cooperating, unless they do what he wants. Or unless they stay in small enough groups that they don’t attract his attention. Or maybe he just doesn’t understand that it’s not evil to add small numbers to get big numbers.

What do you think? Comment if you think I’ve missed something. Share if you think this will help others to think and understand.

Bernie and Pfizer - what happens to those obscene profits?

Pfizer has been demonized a lot lately, especially by Bernie Sanders since Pfizer is one of the big pharma companies that have obscene profits. I want to look more closely at the target of those criticisms. If you say “that football team is bad”, it’s worth considering whether your complaint is with the owner, or the coach, or the players. Pfizer is criticized, but who or what is Pfizer? Pfizer is a corporation, which means it is a legal entity that is owned by its shareholders. The shareholders are the ones who benefit from profits, obscene or not. When we talk about Pfizer’s money, we’re really talking about the money the shareholders own, each in proportion to its share holdings. When we’re criticizing Pfizer’s decisions, we’re really criticizing the shareholders who control the directors and officers who make those decisions.

 

So, who are these partakers of obscene profits?

It’s pretty easy to find out. http://www.nasdaq.com/symbol/pfe/institutional-holdings lists the institutional shareholders of Pfizer. Most of them are money management companies, the places that manage your IRAs and 401ks. Consequently many of the obscene profit takers are people evil enough to save money for retirement. Some of the others are notorious 1%-er money grubbers like retired state employees in California, Florida, New Jersey, Colorado, Alabama, Arizona, Ohio, and Canada (California Public Employees Retirement System - $553 million, State Board of Administration of Florida Retirement System - $256.4 million, State of New Jersey Common Pension Fund - $241 million, Public Employees Retirement Association of Colorado - $98.6 million. Retirement Systems of Alabama - $145.7 million, Arizona State Retirement System - $82.9 million, Public Employees Retirement System of Ohio - $148.8 million, Canada Pension Plan Investment Board - $56.9 million); retired teachers in NY, California, Texas, and Ontario (New York State Teachers Retirement System - $393 million, California State Teachers Retirement System - $388 million, Teacher Retirement System of Texas - $198.8 million, Ontario Teachers Pension Plan Board - $63.9 million),  State of Wisconsin Investment Board ($210 million); students in Texas (Texas Permanent School Fund - $71.7 million); Lutherans buying life insurance and saving for retirement (Thrivent Financial for Lutherans - $146 million);  the state governments of Michigan and South Dakota (State Treasurer State of Michigan - $99.4 million, South Dakota Investment Council - $81.8 million); and non-profit rural electric cooperatives (National Rural Electric Cooperative Association - $135.5 million).

Pfizer’s a really big company (see my other note on that). The profit numbers work out to about 4% return on investment. Let’s try Bernie’s statement, with some real facts and names added:

You people who saved money for retirement, it’s wrong that your savings appreciate because Pfizer makes profits.

When the Texas Permanent School Fund earns $3 million dollars from a $72 million dollar investment, that’s obscene.

 It’s obscene that the New York State Teachers Retirement System earns 4% on its investment in a company that makes drugs to prevent and treat disease.

It’s time to tell the pension plans of public employees in BY, California, New Jersey, Alabama, Colorado, Arizona, and Canada that they can no longer make 4% profit for their retirees, because Bernie doesn’t like big numbers.

Do you Bernie supporters still agree with him when you take away the misdirection? When you look behind the curtain and see who’s really getting those profits?

But what about the fat cat executives that run Pfizer? They really call the shots, and it’s really their exorbitant salaries that Bernie is mad about. 

May be a good point, but that’s not what he said. Let’s assume it was, though. Pfizer’s executives are all subject to Pfizer’s board, which is set by Pfizer’s shareholders. Pfizer’s shareholders elect directors, who in turn hire executives, who in turn manage the company. Pfizer’s shareholders have ultimate control of the whole company; they’ve just hired people to make the daily decisions for them. Again, let’s put some names in the complaint and see what we get:

How dare you, State Treasurer State of Michigan, hire executives to manage the company you invested in.

National Rural Electric Cooperative Association, we think you’re paying your employees too much. 

State Board of Administration of Florida Retirement System, you’ve invested $200 million in this company, but you cannot be trusted to set the salaries of the people you trust to manage the company. 

There may be all sorts of valid issues around Pfizer, about FDA approval processes, about patents on drugs, about details of tax structures (with at least two sides to every issue). Bernie’s complaints, however, reflect such ignorance that they are just silly.

What do you think? Comment if you think I’ve missed something. Share if you think this will help others to think and understand.