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Article posted Aug 01 2011, 11:11 PM Category: Economy Source: Peter Schiff Print

Debt Deal is a Blank Check

by Peter Schiff

By supposedly compromising to raise the debt ceiling, Congress and the President have now paved the way for ever higher levels of federal spending. Although, the nation was spared the trauma of borrowing restrictions, the actual risk of default existed solely in the minds of Washington politicians. But the real crisis is not, nor has it ever been, the debt ceiling. The crisis is the debt itself. Economic Armageddon would not have resulted from failure to raise the ceiling, but it will come because we succeeded in raising it. This outcome falls along the lines that I had forecast (See my commentary, “Don’t Be Fooled by Political Posturing” from July 9th).

Both parties are now pretending that the promised cuts in spending outweigh the increase in the debt limit. But the $900 billion in identified cuts are spread over a decade and are skewed toward the end of that period. There are an additional $1.4 trillion in cuts that the plan assumes will be identified by a bi-partisan budget committee. But similarly empowered panels in the past have almost never delivered on their mandates.

More importantly, none of these “cuts” are actually binding. There is plenty of time for future Congresses to reverse what was so laboriously agreed to over the past few weeks. My guess is renewed economic weakness will be used to justify ultimate suspension of the cuts. In addition, most of the spending reductions were already scheduled to take effect before this agreement. So what did we really get?

The Congressional Budget Office currently projects that $9.5 trillion in new debt will have to be issued over the next 10 years. Even if all of the reductions proposed in the deal were to come to pass, which is highly unlikely, that would still leave $7.1 trillion in new debt accumulation by 2021. Our problems have not been solved by a long shot.

Essentially, the structure announced today allows both political parties to talk about reform without actually changing anything. To underscore that point, the deal involves less than $25 billion in immediate cuts! This is less than a rounding error in a $3.8 trillion dollar budget. This is politics as usual.

Even these estimates are based on rosy economic assumptions that have no chance coming to fruition. For example, for the current fiscal year, Washington estimates GDP growth at 4%. But actual growth for the first half of 2011 is below 1%! If our government is over-estimating our current year’s growth by a factor of 4, how accurate could their forecasts be ten years into the future? A more honest assessment of likely economic performance would reveal future budget deficits spiraling out of control.

Some might say that the primary goal of this deal was to avoid the dreaded credit rating downgrade. Unfortunately, the deal addresses none of the ratings agencies’ stated grievances. If they fail to follow through on their downgrade warnings, the rating agencies will lose whatever credibility they have left. For political reasons, the downgrades may not come right away, but they are inevitable. But as has happened so often in the past, by the time the tardy downgrades arrive, the market will have likely already rendered its verdict.

The debt ceiling itself merely represents a self-imposed limit on US borrowing. Since Congress can vote to raise the limit, its existence has been more of a political nuisance than an actual barrier. The operative factor is not how much we allow ourselves to borrow, but how much our creditors are willing to lend. That type of ceiling can’t be raised by an Act of Congress. Once our creditors come to the conclusion that they have lent beyond our capacity to repay, they will be very reluctant to lend more. As trillions in short-term Treasuries mature, the dwindling pool of buyers will demand higher rates of return to compensate them for the risk. But our government is in no condition to afford those higher rates without gutting the rest of the budget.

Last week, it was revealed that despite Obama’s warnings that a default would immediately occur if the debt ceiling were not raised, the administration had already agreed to prioritize interest payments to avoid default. Such preferential treatment is only possible because current interest rates are so low and debt service represents only about 10% of total revenue. When the pool of willing lenders evaporates, net interest payments could quickly consume more than 50% of federal revenue. This is particularly true since rising rates will also plunge the economy into a recession that will substantially reduce revenues - even as debt payments surge.

At that point, prioritizing interest payments would mean deep sacrifices in the rest of the federal budget - including Social Security, Medicare, and the Armed Forces. The question then becomes: will US politicians really be willing to take the political heat that would emerge from prioritizing interest payments to foreign creditors over payments to American voters?

I expect that as soon as our creditors decide that they are no longer willing to lend to us at ultra-low rates of interest, we will refuse to repay what they have already lent.

Besides default or major cuts to domestic spending, inflation provides the only other means for the government to deal with this intractable crisis. Because of its political palatability, inflation is, in fact, the most likely outcome. Once we go down that path, we risk high inflation turning into hyperinflation, which would decimate the remainder of our economy. So, as our leaders congratulate themselves for saving the nation, the reality is that they may have just sold it down the river.
Peter Schiff is president of Euro Pacific Capital and author of The Little Book of Bull Moves in Bear Markets and Crash Proof: How to Profit from the Coming Economic Collapse. His latest book is How an Economy Grows and Why It Crashes.

Copyright © 2011 Euro Pacific Capital

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