Tipping Point

Has the world economy passed the point of no return?

Picture in your mind a man sitting in a wooden chair with four legs. Then imagine what would happen if he slowly begins to tip the chair backward, lifting the front legs off the floor. The chair will remain stable up to a certain point, where it will be barely balancing on its two rear legs. At that point, just a small additional push and the man and chair will crash over backward. That point is “the tipping point.”

National economies can be very much like that chair. Consider that when governments spend more than they receive, they typically finance the difference by borrowing. The interest rate they must pay is determined primarily by the investors’ confidence regarding repayment and monetary inflation in the borrowing nation.

When governments accumulate large amounts of debt relative to the size of their economies, investors get worried. The credit rating of the government may be downgraded, which increases their borrowing costs. The increased borrowing costs further limit the government’s ability to service the debt—which again reduces their creditworthiness even more—which increases borrowing costs again. As their credit dries up, the government must increase taxes and reduce expenditures—called “austerity”—which restricts the economy, compounding the problem. A devastating downward economic and credit spiral can begin.

Cry for Argentina?

Argentina is a beautiful country of 40 million people blessed with great natural resources, fertile plains called pampas and a world-famous wine-growing region near the majestic Andes Mountains. But in 2002 the nation defaulted on its sovereign debt. “When Argentina defaulted on some $100 billion in bonds 11 years ago, its debt represented 166 percent of gross domestic product. Bank deposits were frozen and devalued, the economy shrank 11 percent in one year, and millions lost their jobs” (Reuters, May 13, 2013, Hilary Burke). Argentina had experienced hyperinflation, riots and the fall of its government. After that collapse, the Argentine economy rebounded for a while, but the nation lost its access to many of the world’s capital markets. Once again, sadly, this beautiful country is experiencing high inflation, a weak economy and social unrest. Default on at least some of debt is again a concern. Will the U.S. soon experience a similar circumstance?

The U.S. Debt Bomb: By the Numbers

In 2004, the total sovereign debt of the United States stood at $7.3 trillion or about $70,000 per taxpayer. But after the financial crisis in 2008, the government began incurring trillion-dollar deficits attempting to stimulate the economy. For the current fiscal year, according to the Congressional Budget Office, the staggering pace of debt buildup is projected to decline somewhat to around $759 billion—about 4 percent of GDP. That is far less than the $1.4 trillion deficit—10.1 percent of GDP—that the government ran in 2009, but it is still an unsustainable pace.

Regrettably, the 2013 projected decline may be temporary, since it came largely from temporary, one-time gains from mortgage giants, FNMA and FMCC. Foxnews.com reported Rep. Chris Van Hollen, (D-MD), top Democrat of the House Budget Committee, as saying, “The good news is the near-term deficit is dropping, but it appears to be dropping primarily as a result of additional, one-time revenues rather than any uptick in economic growth” (foxnews.com, May 15, 2013). Maya MacGuineas, president of the Committee for a Responsible Federal Budget added, “The rosier-than-expected near-term projections do not change the fact that rising health care costs, an aging population, Social Security’s looming insolvency and ever-increasing interest payments will greatly expand the national debt” (ibid.).

This year’s shortfall would register at 4 percent of the economy, far less than the 10.1 percent experienced in 2009 when the government ran a record $1.4 trillion deficit. Often, people think that China is absorbing all this U.S. sovereign debt. but that is incorrect. Indeed, as of July 2013, China held more than $1.2 trillion in U.S. Treasuries, buying new Treasuries even as other foreign investors have increasingly been net sellers. In recent years, China has purchased new U.S. debt at about the same rate that the existing bonds come due and are paying off. The U.S. Federal Reserve is by far the largest purchaser of U.S. sovereign debt, buying up the bulk of new issues. The U.S. is buying its own debt.

As of early 2013, total U.S. sovereign debt has risen to $16.8 trillion—$148,000 per taxpayer, of which $12 trillion—75 percent of GDP—is held by the public and the rest is intra-governmental debt such as debts owed to the Social Security Trust Fund and the Medicare Trust Fund. All the money collected from payroll taxes for these trust funds is quickly spent by the government and substituted with unmarketable U.S. Treasury obligations. These intra-governmental obligations will have to be repaid in the future if Medicare and Social Security benefits are to be continued as promised to the public, so essentially, the debt is owed to the public. Total U.S. sovereign debt is now about 105 percent of GDP. And the creditors will want their money paid back with interest.

A Tip from Rising Rates

Could the tipping point come from rising interest rates? Many analysts think that there is a “point of no return” when an economy enters a downward spiral from which it cannot recover. Recently, interest rates on U.S. debt heave been at historic lows, but yields on long-term U.S. Treasury Notes have increased dramatically in the last twelve months. A return to a normal rate environment will mean a huge increase in debt service costs. If rates should spike upward, the deficit could increase dramatically, further increasing the nation’s debt burden. And rates are now rising.

Economist and commentator Bill Mauldin calls the tipping point “the Bang! moment” and advises “…debt is not a problem until it becomes one. And then it reaches a critical mass and you have what they called the Bang! moment… With debt-to-GDP ratios, all we know for now is that the Bang! moment exists, but the precise point for any one given country is not something we can calculate. But wherever that line happens to fall, once it is crossed, Bang! Everything changes” (February 22, 2013).

But other economists think that we can know the tipping point number. In a study paper presented to the U.S. Monetary Forum earlier this yearin New York, a group of leading economists had this to say: “Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe. We analyze the recent experience of advanced economies using both econometric methods and case studies and conclude that countries with debt above 80 percent of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics. Such feedback is left out of current long-term U.S. budget projections and could make it much more difficult for the U.S. to maintain a sustainable budget course. A potential fiscal crunch also puts fundamental limits on what monetary policy is able to achieve” (Crunch Time: Fiscal Crises and the Role of Monetary Policy, February 22, 2013).

Is the Fed Shooting Blanks?

One of the U.S. Federal Reserve’s primary roles is to control the nation’s monetary supply, called “M2,” which is the total of cash and demand deposits (such as checking and savings accounts) in the economy. Indeed, the Fed has been purchasing massive amounts of securities in the last few years in what is called “Quantitative Easing.” This drives interest rates down and also means that the securities purchases by the Fed inject huge amounts of money into the U.S. economy—in an attempt to stimulate it. The economists quoted above are saying that at the tipping point, monetary policy becomes ineffective in controlling the money supply and the economy. Is there any evidence that is the case?

Over the last five years of attempted monetary expansion, a disconnect has been brewing. In the first quarter of 2013, the Fed purchased $277.5 billion in securities, injecting that amount into the economy, but the money supply, M2, actually contracted by $55 billion during that period. This is largely because the more money the Fed injects, the slower the circulation of money—called the velocity of money (“V”)—becomes. The velocity of money is at its lowest level in over half a century. Since the economy is not using it and price levels are not increasing much, all that extra money piles up in banks, which deposit it as excess reserves in… The Federal Reserve! Over the last 5 years, the Fed’s balance sheet has ballooned from about $890 billion in early 2008 to $3.75 trillion as of mid-October 2013! It appears that not only are our regulators missing their monetary targets, they may be shooting blanks!

Inflation or Deflation?

Large fiscal deficits, and increases in the monetary supply of an economic system, often presage an inflationary spiral. As prices absorb excess monetary supply, inflationary expectations increase, fueling more price increases. Inflation can get out of control as it did in Germany in the 1920s. At its worst in 1923–24, German hyperinflation reached one trillion marks for one U.S. dollar, and prices were doubling every two days. The currency became worthless.

More recently, Argentina endured hyperinflation during its crisis of 1989–92. During hyperinflation, price levels are difficult to measure, but economists say that Argentine price levels increased at an annual rate above 10,000 percent per year. One peso in 1992 equaled 100,000,000,000 pesos from a decade earlier. A deep recession ensued, followed by collapse of the government.

Inflation nearly got out of control in the U.S. during the Carter Administration, climbing from 5.2 percent when he took office in 1979 to more than 14 percent in 1980. Fed Chairman Paul Volcker slammed on the monetary brakes by raising the Federal Funds Rate to 20 percent, and the prime rate of interest that banks charge leapt to 21.5 percent in 1981! But inflation subsided and the U.S. economy returned to growth in the 1980s. The U.S. economy was at a tipping point with inflation, and Fed Chairman Volcker pulled the economy back from it in the nick of time.

So, do large government deficits always produce inflation? And where is the evidence of impending inflation in today’s economy? It may appear in the future, but it is not evident yet, at least not dramatically so. Even with all the deficits and Quantitative Easing, for the first eight months of 2013, the monthly inflation rate has averaged just 1.6 percent. Deflation, which occurs when price levels decrease, can be very difficult for central bankers to control and most would rather cope with inflation than deflation. Governments can increase interest rates to combat inflation—as Paul Volcker did—but they cannot reduce interest rates below zero. The yield on U.S. 13–week Treasury Bills has been barely above zero for the last five years.

Deflation can be tenacious. For two decades, Japan has had the most extreme deficit spending of any industrialized nation—its total debt is over 230 percent of its GDP, as compared to Greece’s debt of 175 percent of GDP. Yet Japan has experienced what has been called “The Lost Decades” of 1990 to 2010 in which the economy has struggled against persistent deflation. Interest rates have been near zero in Japan for over a decade, without producing inflation. Japanese Prime Minister Abe is taking drastic measures to try to re-inflate the Japanese economy. The situation in the U.S. is not exactly the same as in Japan—there are dissimilar reasons for Japanese deflation—but many similarities do exist. The U.S. faces deflationary pressures such as high unemployment, sagging commodity prices and a slowing velocity of money., and its economy and price levels are becoming less and less responsive to the Federal Reserve’s Quantitative Easing policy.

The tipping point for deflation comes when demand for goods and services contracts, reducing prices, which in turn, slows down the economy, further reducing demand. High unemployment tends to be deflationary, since competition for jobs reduces wages—which further reduces demand. So down the spiral goes, and once it begins, it is very difficult for governments to reverse. That was the situation for many of the world’s economies during the Great Depression of the 1930s.

A Tip from Long Ago

The U.S. has been blessed greatly by God, and in past generations, the leaders and people generally have acknowledged that their blessings have come from God. God tells us that it is He who makes our creation of wealth possible, but He warns us about it as well. “Beware that you do not forget the Lord your God by not keeping His commandments, His judgments, and His statutes which I command you today, lest—when you have eaten and are full, and have built beautiful houses and dwell in them; and when your herds and your flocks multiply, and your silver and your gold are multiplied, and all that you have is multiplied; when your heart is lifted up, and you forget the Lord your God… then you say in your heart, ‘My power and the might of my hand have gained me this wealth.’ And you shall remember the Lord your God, for it is He who gives you power to get wealth…” (Deuteronomy 8:11–14, 17–18). So, in which way will the U.S. economy tip?

A nation that is being blessed by God in creating wealth is often a lender to other nations. This was the situation with the U.S. in the past. “The Lord will open to you His good treasure, the heavens, to give the rain to your land in its season, and to bless all the work of your hand. You shall lend to many nations, but you shall not borrow. And the Lord will make you the head and not the tail; you shall be above only, and not be beneath, if you heed the commandments of the Lord your God, which I command you today, and are careful to observe them” (Deuteronomy 28:12–13).

But what does God say will happen when He withdraws His blessing? Debts, for one thing. “The alien who is among you shall rise higher and higher above you, and you shall come down lower and lower. He shall lend to you, but you shall not lend to him; he shall be the head, and you shall be the tail” (Deuteronomy 28:43–44).

Some will have to learn the hard way that the “borrower is servant to the lender” (Proverbs 22:7).