ICangles Investment Post…
The Three Bears Economy has seen us move through the doctom bubble of corporate debt, the real estate bubble of consumer debt and now we are deep into the government bubble of debt. Previously people got rich oftentimes only on paper from dotcom stocks before they fell and then many saw their wealth on paper rise and fall with their home values. Now we are well into the era of people making money from government, including paper millionaires—retirees with million plus dollar government retirement plans. Pension millionaires include the ex-police chief of Stockton California, who after two years as chief, retired with an annual pension of over $200,000. Add in benefits and on paper you get to over a million dollars in payouts pretty quickly. But the government largesse the ex-chief and many Americans to a lesser extent are growing accustomed to will turn out to be as solid as pets.com stock or sky high real estate values, because it is built on unsustainable debt. In the case of Stockton the city is already in bankruptcy, and in the case of the global economy the clock is ticking on how much longer government spending will prop up living standards.
When easy money led to the East Asian Crisis and then the dotcom bubble, the solution from governments was more easy credit leading to a global real estate bubble. When that popped and brought on the so-called Great Recession the supposed solution was more easy credit. Although consumers and businesses shunned taking on more debt, government borrowed and spent. The chart below shows that because of U.S. government borrowing debt levels continue to rise. I’ve written previously about the trillions of dollars in major central bank balance sheets as money has been printed to purchase oftentimes government debt securities. I would argue it has all cushioned the pain from the preceding two recessions. But in kicking the can down the road and continuing to pile up debt by “investing” in non-productive areas we have reduced the growth potential of the economy and increased the eventual economic pain when this third and last bubble pops.
Today we are looking at unemployment and underemployment levels commensurate with a depression (well above the reported 8 percent rate, as I blogged previously). In fact one money manager argues we are in an Invisible Depression where if the one of seven Americans on food stamps were to stand in lines at soup kitchens and people forced out of houses they no longer make payments on we would more appreciate the depths of the problems. But I would argue unsustainable government largesse is such to have postponed much of the pain that will be eventually faced in the same way the residential real estate bubble postponed pain from the dotom corporate bubble bursting. And as the chart below shows rising government spending at both the federal, state and local levels is increasingly about transferring money and benefits, rather than providing goods and services.
The rise in U.S. federal government borrowing and spending has indeed increased the federal government’s share of spending as a percentage of the economy measured by GDP to levels not seen since World War Two. The federal government’s stimulus plan also helped state and local government spending remain close to record levels as share of GDP. But it is very unlikely that the next downturn will see the federal government again supporting state and local governments. Instead a scenario of retrenchment on both fronts is likely. But in the meantime government continues to spend as an increasingly greater share of the economy as seen below.
The below chart on employment, table on wages and chart on retirement benefits comparing government workers with private sector employees shows that some of that government money is going to employ and compensate government workers above the rate of their private sector peers. Gone is the day of the bargain where government workers accepted less pay for greater job security. Nowadays it is the government sector that is flush with cash from borrowing and going deeper in debt, while it is the private sector that is struggling, as corporations and consumers pay down debt and deleverage. Just as the dotcom bubble felt good for tech workers and the real estate bubble felt good for home owners, things are feeling about as good as they ever will for the increasing percentage of the population working for government. Of course when government is finally forced to deleverage that will change.
While the above chart shows employment doing better for government workers, the below table shows the compensation advantage enjoyed by those in the government.
The biggest advantage enjoyed by government workers over their private sector peers is in retirement benefits. As the below chart shows that focuses on California working for government often pays well in retirement. As the baby boom enters retirement those working for government are typically enjoying a better lifestyle. The catch as we will see in a bit, however, is that especially for employees of local governments those retirement benefits are only as good as a city’s ability to pay. And some of the benefit packages are so “good” that they are not sustainable.
While government workers are benefiting most from government borrowing, the largess of the government has been increasingly spread throughout the economy. Just as technology spending by corporations or home construction and spending was felt throughout the economy, the government bubble is spreading the borrowed money around. The below chart shows the steep rise in the number of households receiving some government benefits rising to almost half the country.
The benefits being received by American households aren’t insignificant. The bellow chart shows them constituting over a third of wages and salaries.
Nor are these benefits any more sustainable than the income derived from the previous two bubbles. As shown bellow Americans are receiving more in government benefits than what they are paying in taxes. Consider for a moment that government does more than merely collect money and redistribute it and the unsustainable nature of the current paradigm becomes clear.
Benefit participation includes a food stamp program that one out of every seven Americans participates. The growth rate of the program is well above what the economic environment would imply, as participation is increasing despite the economy improving.
There is no question that fraud is responsible for a significant amount of food stamp spending. The below chart also shows that fraud in the form of disability benefits is also driving up government spending. Either the American work environment is becoming alarmingly dangerous or more and more people are committing fraud to take advantage of benefits that especially for government workers can be extremely lucrative. This should not come as a surprise. Bubbles leveraged by debt invite fraud whether financial firms and banks with the Internet and housing bubbles or today’s government bubble as people look to get a share of the easy money.
Unfortunately all parties and bubbles must eventually come to an end. The bellow illustration shows the precarious state of state and local government finances. Although some critics contend we have not seen the avalanche of municipal bankruptcies some have forecast they might want to worry we are seeing some during an economic recovery and also consider what will happen if the next downturn sees rising borrowing costs, falling employment and revenues with no bail outs from a cash-strapped federal government. Many state and local governments are poorly positioned to survive the coming years if moderate growth is realized let alone the next recession when it does come.
The real time bomb for state and local governments is pension obligations for the newest class of paper millionaires–government workers with retirement benefits worth over a million dollars. Now this would not be a problem if those benefits were backed by properly funded pension plans or were simply not overly generous. But in many states and even more local governments the labor unions largely determined their own benefits with friendly politicians and were greedier than they were smart. By that I mean they created benefit packages so plush that eventual bankruptcy and default of the entity paying the benefit is a likely end result, such as already seen in Stockton California. As one union spokesperson noted negotiating benefits was a bit like a kid getting ice cream every day. Well this all-you-can-eat ice cream buffet isn’t cheap. The below table shows that while things aren’t that bad if a serious of improbable best case scenarios are used, when estimate are made composed of a likely return on investment and real contribution levels to pension plans the state level has over $4 trillion in unfunded pension liabilities. But the solution of funding unfunded benefits with even more borrowing will only work so long, when the liability is set to keep escalating.
State and local governments have already begun to retrench, although it is too little, too late to forestall some real crisis in the future. Serious pension reform is needed at this point for many state and local government workers, with retirement benefits having become a multi-trillion dollar ticking time bomb. Nor should the states and local governments expect to get much help from the federal government in the next downturn. While the federal government spends a great deal of money on a great deal of things, it is entitlement spending for seniors that is set to send its debt level to unsustainable amounts. Of course the federal government can simply renege on its promises, and it does not have to enter into bankruptcy as some cities already have done in order to not pay retirees what they were promised. The “restructuring” of programs so people get less from the government than what they expect is simply a matter of when not if since at a certain point people stop lending money to an entity on a path to destitution.
Although this blog post has focused on the United States the government debt bubble is a global phenomena. The debacle in Greece, and the Eurozone on the precipice of another recession due to its own immense debt problems and unsustainable government spending is a clear indication of this. But as my previous post on China documented this also extends to the emerging Chinese economy many have viewed as escaping unscathed from these problems. Although I expect the actual debt figures to be higher due to ways local Chinese governments evade the rules the bellow chart does illustrate how even China has gone deep into debt to sustain its economy with government spending during the recent global downturn.
After more than a decade of debt being encouraged around the world at the corporate, consumer and government levels the bellow chart demonstrates the extent of the overhang in terms of debt as a percentage of respective economies as measured by Gross Domestic Product. Although I like to term it the Three Bears Economy the Debt Era is also fitting.
Yet, for governments around the world the real nail in the coffin are the demographics. It’s fine to promise big benefits to non-tax payers, such as retirees, when there are many working tax payers to fund such benefits. But when the math reverses and suddenly there are many more people taking more versus giving it there is a problem. In fact this is how all pyramid schemes implode, such as the infamous fund run by Bernie Madoff. The bellow chart shows that the percentage of dependents taking money out of the system is set to rise steeply across nations as the post-World War Two baby boom generation enters retirement. With countries already deep in debt there will not be the option to keep borrowing more money.
And speaking of Bernie Madoff the topic of government regulation is worth exploring briefly. Growth in the number and reach of government regulations is contributing to the rise in government spending and increase in the number of government workers. More regulations also add to the cost of business and lower near-term economic growth and resulting tax revenues that could be collected by the government thereby adding to the debt problem. In fairness the question arises whether the jump in government regulations will in the long-term be more beneficial than detrimental by limiting economically damaging behavior from pollution to outright fraud. Unfortunately, there is not a lot of room for hope on this front.
Sarbanes Oxley for example instead of reforming the public offering market largely killed it and pushed much of it offshore in one more example of the law of unintended consequences at work. In the case of the largest fraud in history committed by Bernie Madoff the federal government refused to act on compelling evidence of the fraud presented multiple times over years by a financial expert, demonstrating an outstanding level of regulatory incompetence. New health care regulations may very well broaden access to care, which could be argued a societal positive, but that doing so will be without greater economic cost is intellectually dishonest. One of the more compelling examples of expanding government reach not resulting in positive benefits is the flat line in U.S. student test scores despite a more than doubling in per pupil spending by government since 1970. Some level of regulations are obviously needed, but government’s recent track record, including its regulation of the housing sector by way of both mandating, subsidizing and actively ignoring dangerous mortgage loans until credit markets began to implode does not inspire confidence that the growing regulatory burden will be an economic positive. Instead, just like in housing, it appears to be contributing to the current bubble.
Unfortunately, in the Three Bears Economy the worst of the downturns is yet to come. Easy money and more debt may have alleviated the Baby Bear of the Internet Bubble and the Mama Bear of the Real Estate Bubble, but more debt spending will not be an option after the Papa Bear of the Government Bubble. We will finally be forced to begin reducing debt and living within our means, which will be a positive for the prospects of future sustainable economic growth, but an unpleasant process where the worst of the three economic downturns of the Three Bears Economy is yet to come. And with credit markets impacted by the trillions in leveraged debt from central banks this bubble is unlikely to be gradually unwound anymore than the previous two. In fact European credit markets are already exhibiting problems due to the unfolding crisis around the Euro. However, the danger should not be exaggerated. Central bank debt leverage within the context of a monetary system predicated on debt is a serious danger to the global economy, but does not represent an economic apocalypse or a sentence of hyperinflation as some alarmists predict.
Of course debt can only prop up the global economy for so long. It will be a real problem when government revenues decline in the next serious downturn. Even more alarming, however, is the potential for borrowing rates to rise. There is a limit to the ability of central banks to print money and buy government debt to suppress interest rates without damaging the value of a currency. At present debt levels the ability to service the debt at low rates is key to avoiding a crisis and there are no plans on what to do if rates rise faster than new revenues grow for governments. Only the ability to take on debt has kept the last decade plus feeling better than a glance at a long-term chart of the stock market would suggest. Removing the ability to borrow and spend on such a level may very well make the future feel worse than the performance of corporate America in the stock market. This secular bear market has not felt as bad as a depression, and conversely with the need to deleverage debt the next secular bull market may not feel as good as a growth era should for the people inhabiting it.