Saturday, November 27, 2010

Point of no Return

This week's edition of the The Economist featured an article on Japan and its demographic (ageing) crisis.

Voodoo Economics
Not surprisingly, the article missed out on by far the most important point regarding Japan and a key point that is instructive for all nations currently running deficits.  The point is that once a country starts running structural deficits to fund operating expenditures, it soon becomes mathematically and politically impossible to ever pay off the debt.  Economists like to point to the ability of countries to "out grow" their debt and deficits via Supply Side Economics.  A third grader is smart enough not to believe such a load of rubbish, but not so today's average economist/politician/bankster.

One can easily construct a financial model to indicate the impact to the Japanese economy were it to even attempt to start paying down its debt.

 - Current Federal debt at 200% of GDP (which it is)
 - Average Duration of debt: 30 years (this is a VERY generous assumption)
 - Average interest rate on debt: 1% (The rate on JGBs fluctuates, but is currently very low)

Now we see why it was so easy to ignore this problem in Japan for so long.  With interest rates at 1%, the conventional wisdom is that "Debt Service Costs" are extremely low, so there is no harm in taking on more debt.  Unfortunately for the purveyors of this "load", there is more to debt service than simply the current interest i.e. principal.

Plug the above figures into Excel and now assume that all of this debt needs to be paid off in 30 years time.  In this model, we are solving for the Payment (a blend of principle + interest) i.e. the true debt service cost and the one that would have saved "The Economist" from devoting a lengthly article to evading the simple truth.

Over 30 years, as a percent of GDP, the payment is: 8%  !!!

Wait, it gets worse.  Obviously in order to pay down debt, a country needs to first stop accruing new debt i.e. first eliminate the annual recurring deficit.  Japan's fiscal deficit for 2010?  10%

The Bottom Line for Japan:
In order for Japan to START paying down its current level of debt over a 30 year period it would have to incur a 16% hit to GDP immediately and that figure will only grow into the future.  (NOTE: 2% of GDP is interest and already included in the deficit).

U.S. Example:
Variables for the U.S.:
 - Current Federal debt at 100% of GDP 
 - Average Duration of debt: 20 years (average duration is currently 5 years, so this is very generous)
 - Average interest rate on debt: 3% 
 - Current annualized deficit for 2010: 10%

Level of GDP that would be removed by paying off debt over 20 years:
[Ongoing debt service cost, amortized over 20 years: 6.7% of GDP] 
Including 10% Deficit: ~14% (after taking out the 3% interest due to double-counting) 

Keep in mind, both countries are applying unprecedented fiscal and monetary stimulus at this juncture and yet there is minimal growth in either country i.e. no sign whatsoever that either country could possibly remove the bulk of stimulus while at same time maintaining a positive economic growth rate MUCH LESS pay down a $1 of debt.

Definition of Recession is Totally Bogus
Officially, according to NBER, the U.S. is out of recession, and has been since June 2009.  Of course, that is totally bogus because the "official" definition of recession does not take into account fiscal deficits, so it is meaningless.  Whether, the deficit was at 0% or 10% of GDP (as it is now), the U.S. would still be deemed to be out of recession.  Currently, as I write, GDP growth is running at ~2% year over year, so in reality, the true economy is running at a negative 8%.  When a country can borrow 10% of its GDP and then declare that the economy is "growing" at 2%, that's the trifecta - bad math, denialism and stupidity all rolled into one.

Legacy of the Baby Boomers
That 14% represents the hole in the economy left behind by the most greed-addled, self-indulgent generation in world history.  Not only are the Boomers spending the wealth inherited from their parents, they've underfunded and raided their own 401k retirement funds, bankrupted Medicare and Social Security, and on top of all that left A GAPING 14% SMOKING CRATER where the economy used to be, for their children and grandchildren to inherit.

As I have said before, GAME OVER, MAN.  We just need Wall Street and the morons with the fancy degrees to wake up and smell the fucking napalm.