E-piphany

It is not surprising to realize that politicians are mathematically challenged. Nor is it particularly surprising, I suppose, to realize that equity investors often are as well (otherwise there is no way to explain equity prices in the late 1990s that implied long-term growth rates on Internet stocks would allow them to represent the full output of the global economy in a short span of years). But I begin to wonder if the numbers we are seeing these days are so big that people are afraid to even do the math.

Of course, I am talking about the 2011 federal budget, which was unveiled today (really, the true question is how they even managed to get the veil on that beast in the first place. Where did they find such a huge veil?). For whatever reason, stocks greeting the news of a forthcoming $1.56 trillion deficit (before emergency spending, of course) with enthusiasm, rising 1.4% on the day.

It may have been that the ISM Manufacturing report suggested somewhat greater strength than economists had been expecting, although it is somewhat concerning that the Prices Paid subindex jumped aggressively to 70.0 from 61.5. Ordinarily, Prices Paid simply tracks energy prices with a lag, but energy prices haven’t done much of note recently. This is a potential concern, if prices for input goods are rising somewhat more than implied by the biggest industrial input, energy. Keynesians keep saying that such a thing is impossible, that there is too much slack in the economy to get inflation, but it seems normal people are disagreeing more frequently these days.  We will come back to this in a moment.

The wonder of the day however was clearly the 2011 budget announcement, although in some sense there isn’t a lot to be surprised about here: we knew we were going to see mammoth numbers, and the deficit figure (to be fair, it represents only about $5 per star in the Milky Way galaxy) did not disappoint. But I am starting to wonder whether people really understand what this number means.

$1.56 trillion is the difference between income and outlays for the federal government. Another way to say the same thing is to observe that the debt will increase about $1.56 trillion next year. The deficits, of course, must be financed.

A back-of-the-envelope calculation suggests there are somewhat fewer than 200 Treasury auctions per year. $1.56 trillion, divided by 200 auctions, is a mere $7.8 billion per auction. But remember, in addition to raising “new money,” the Treasury must refinance the maturing debt as well. Of the $7.5 trillion in marketable debt already outstanding, some 39% will mature over the next 12 months (Source: Bloomberg). That means another $13.8 billion or so per auction. So, if there were as many as 200 auctions per year the average auction size would have to be $22.6bln.

Now, not all of those auctions can be that large. It is hard to move $20bln 30y bonds, for example, and while TIPS could handle more the Treasury seems reluctant to do it.

And the next year, Treasury will have to roll roughly 40% again of (7.5+1.5 trillion), plus $1.27 trillion in new money.

Lest we get too optimistic about these figures, let’s review the assumptions that the Administration had to make to get the deficit down even as far as it has: 2.7% real growth in 2010,  3.8% in ’11, 4.3% in ’12, 4.2% in ’13, 4.0% in ’14, 3.6% in ’15, 3.2% in ’16, 2.8% in ’17, 2.6% in ’18, 2.5% each in ’19 and ’20. The budget assumes an 11-year expansion, and not a slouch expansion either!

The deluge of issuance that hit the market last year, which was considerably less than will land on the market this year, was made possible by a few things, and it’s worth reviewing which of these things can be repeated. The Fed bought a few hundred billion of Treasuries and, by buying lots more agencies and MBS forced some substitution into Treasuries. The Treasury Department added a couple of new maturities (3y, 7y), increased T-Bill sizes, and increased the frequency of some auctions. Corporate treasurers didn’t really compete hard for the investors, as overall corporate issuance was slow for the first half of the year especially (so investors flocked to Treasury debt as the only game in town), and lingering concern over the parlous state of the global economy kept many investors with heavier weights in so-called risk-free debt than would otherwise have been the case. Most of these factors are not at work this year. Maybe this is one reason that T-Note futures closed 9 ticks lower today (I am kidding, but the direction seems right).

This year, the bill auctions will probably move from the $25bln range to the $30-35bln range (per auction, per week). Next year, perhaps that becomes $40-45bln. As those auctions (and others) grow, the federal government will be sucking more and more savings into unproductive federal projects and wealth distribution, and less and less will be available for private investment. This dynamic cannot produce an 11-year expansion. More likely, it raises the cost of private capital and slows long-term growth as a result of diminished investment in productive private projects. This is bad for future revenues, and the budget will collapse on itself at some point. The nation cannot keep spending without bound, and the amount of taxes that would need to be raised cannot be shaken down from hedge funds, banks, and high-income individuals. Those groups are simply too small to raise these kinds of numbers. No, if the budget deficit is to decline, it will have to be on the backs of the lower and middle class.

That will not happen explicitly. No Congress and no Administration will vote to hike taxes by a significant amount on those who pay almost no taxes now, or who are currently net receivers from the government. Perhaps, if there was a calamity, then this may be an option – let’s watch Greece and see. Or perhaps a hyper-conservative government will be elected, which slashes “non-discretionary” spending such as defense, Social Security, and Medicare. There are not many options here once we’ve headed down the trillion-dollar-per-year route.

None of those things will happen in the near-term, and it is the near-term that should worry us. It is instructive to remember that many if not most crises for failing businesses come to a head not because expenses exceed revenues but because negative cash flow ceases to be financeable. A company starves slowly with no earnings, but if it fails to roll its debt it is death by firing squad: short, spectacular, and final. This is what made the 2008 crisis so terrifying: Bear, Stearns was shot. Lehman was shot. Other banks were within days or sometimes mere hours of being shot.

And our government is tying on its own blindfold and handing out firearms by forcing itself to increase the number and size of its auctions to never-scaled heights.

If, somehow, an auction were to fail to attract enough bids, then the Treasury would likely proceed nervously to the next auction, draw down balances, etc, and pretend as if nothing had happened. One auction failure wouldn’t trigger the crisis, but it would be a very scary sign. And it could lead to exactly the loss of confidence that Fannie Mae and Freddie Mac experienced during the crisis and led to several failed auctions. They had the feds to back them up…but who backs up the feds?

The ultimate failure of the country to roll its debt, of course, need not ever actually happen. Default, for a country that controls the currency in which the debt is issued, is never necessary. If the debt is held primarily by domestic investors, then it is neither necessary nor useful. But if the balance is wanting, then either the Fed will print money electronically, or the Treasury will print money physically. The pain of that solution will fall, as any solution of this magnitude must, on the backs of the lower- and middle-class. It would be of course inflationary, output gap or no (if it isn’t, then we should start printing immediately because it is painless!).

And perhaps this means the smartest assets of all today were the inflation-linked bonds. Breakeven inflation rates rose 5-7bps across the board.

These are the thoughts I had today when I started thinking about a trillion.