Federal Deficit Reality: An Update
JOHN WILLIAMS' SHADOW GOVERNMENT STATISTICS
www.shadowstats.com
FEDERAL DEFICIT REALITY: AN UPDATE
July 7, 2005
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U.S. Treasury Shows Actual 2004 Budget Deficit at $11.1 Trillion
Ultimate Crisis for Dollar Moves Beyond Possible Remedies
Hyperinflation and New Gold-Based Currency
System Are Likely Consequences
Foreword
From time to time, the U.S. financial markets manifest some concern about the nation's twin deficits -- the federal budget and the current account shortfalls. These episodes have been short-lived, however. Generally, the markets have been very sanguine about these problems -- much too sanguine, in our view! We believe there is a great deal about which to be concerned in both areas, and that longer run, the U.S. markets will indeed reflect it -- negatively, of course. This article updates our thoughts, etc. on the federal budget deficit.
When the U.S. Treasury reported the official 2004 federal budget deficit at a record $413 billion last October, the hisses and boos in the financial media were unrelenting. Two months later, the Treasury reported the actual 2004 deficit -- using generally accepted accounting principles (GAAP) -- was really an incredible $11.1 trillion [1], up from $3.7 trillion in 2003, yet nary a word was heard in the financial media, from Wall Street or from any political denizen of that former malarial swamp on the Potomac. An exception, of course, was Treasury Secretary John Snow, who signed the government's financial statements, but the data release was as low key as physically possible.
The silence partially reflects the financial-market terror that would accompany an effective national bankruptcy. Such is the risk when a government's fiscal ills spin so wildly out of control that they no longer are containable within the existing system.
Consider the traditional solution of raising taxes. Putting the $11.1 trillion deficit in perspective, if the government raised individual and corporate income taxes to 100%, seizing all salaries, wages and profits, the government's 2004 operations still would have been in deficit by trillions of dollars. The deficit has moved beyond practical fiscal control! Many in government and the markets are aware of the underlying deficit reality, but few dare to sound the alarm, for the ultimate resolutions to the situation all are political or financial nightmares.
The government's GAAP-based accounting generally is as used by Corporate America. It includes accrual accounting for money not yet physically disbursed or received but that otherwise is committed. The largest differences come from the bookkeeping related to Social Security and Medicare, where year-to-year changes in the net present value (discounted for the time value of money) of any unfunded liabilities are counted. In contrast, traditional deficit accounting is on a cash basis. It counts the cash received from payroll taxes (social Security, etc.) as income, but it does not reflect any offsetting obligations to the Social Security system.
For nearly four decades, officially sanctioned accounting gimmicks have masked federal deficit reality. Surpluses in trust accounts, such as Social Security, have been used to obscure the true shortfall in government spending. With less than one tenth of the actual deficit being reported each year, a cumulative negative net worth for the U.S. government has built up in stealth to a level that now tops $45 trillion, with total obligations of $47.3 trillion (more than four times annual GDP). The problem has moved beyond crisis to an uncontrollable disaster that threatens the existence of the U.S. dollar and global financial stability.
Indeed, the unfolding fiscal nightmare likely will entail a U.S. hyperinflation and a resulting collapse in the value of the world's primary reserve currency, the dollar. With surviving politicians looking to restore public faith in the global currency system, a new system probably will be based on gold, the only monetary asset that has held public confidence for millennia.
This article updates and expands upon our original background piece on the topic, "Federal Deficit Reality", published in September 2004, and a special economic alert, "Financial Report of the United States Government (FY 2004)", which appeared last December. Portions of those articles are revised and incorporated herein.
Current Detail and Options
Where the official cash-accounting deficit for fiscal-year 2004 (year-ended September 30) widened by 10.0% to $413 billion, the broad GAAP-based deficit (including Social Security, etc.) blew up to $11.1 trillion (96% of GDP) in 2004, triple the 2003 deficit level of $3.7 trillion.
Much of the increase in the broad GAAP-based deficit was due to a set-up charge from booking the 2004 "enhancements" to the Medicare system. Net of the $6.4 trillion one-time increase in net unfunded liabilities, the annual broad deficit was about $4.7 trillion, which still would have been a shortfall with 100% taxation.
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U.S. Government - Alternate Fiscal Deficit and Debt (Source: US
Treasury; $s Are Either Billions or Trillions, as Indicated)
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Formal GAAP GAAP GAAP Tot. Fed-
Cash- Ex-SS With SS Federal Gross eral Ob-
Fiscal Based Etc. Etc. Negative Federal ligations
Year Deficit Deficit Deficit Net Worth Debt (GAAP)
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(Bil) (Bil) (Tril) (Tril) (Tril) (Tril)
------ ------ ------ ------ ------ ------
2004 $412.8 $615.6 $11.1* 45.9 $7.4 $47.3
2003 374.8 667.6 3.7 34.8 6.8 36.2
2002 157.8 364.5 1.5 32.1 6.2 32.7
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*$4.7 trillion, excluding one-time setup costs of the Medicare
Prescription Drug, Improvement, and Modernization Act of 2003
(enacted December 8, 2003).
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Nonetheless, the total numbers reflect something close to true liability. The new Medicare charges show how quickly politicians can make an already impossible situation significantly worse. By adding features to Medicare without setting up full funding for same, the Administration and Congress helped increase the total net present value of unfunded federal government obligations by 31%, from $36.2 trillion to $47.3 trillion in just one year.
In like manner, any "fix" to Social Security, such as raising the retirement age, would result in a one-time change to the unfunded liabilities, but the ongoing annual shortfalls would be affected only minimally. An annual minimum broad GAAP-based deficit of $4.5 to $5.0 trillion appears to be in place.
Wall Street hypesters recently have been touting how the official 2005 federal deficit will narrow from 2004, and the Administration is promising ongoing deficit reductions from the official 2004 level. First, if the economy falls into recession, which it appears to be doing, all such projections are worthless. Second, even if the promised cuts came to pass, after full reductions in an about-$4.5-trillion broad GAAP-based deficit, the mere billions saved would still leave the annual deficit rounded to about $4.5 trillion.
The impossibility of the current circumstance working out happily is why lame-duck Federal Reserve Chairman Alan Greenspan has been urging politicians in Washington to come clean on not being able to deliver promised Social Security and Medicare benefits already under obligation. He suggests,correctly, that there is no chance of economic or productivity growth resolving the matter. The funding shortfall projections already encompass optimistic economic assumptions.
The current circumstance also is why the Bush Administration has been pushing for Social Security reform, but the plans discussed do not come close to touching the magnitude of the problem. Most Congressional Democrats will not even admit there is a problem. Indeed, neither side of the aisle is willing even to mention the scope of the actual shortfall or talk about the Medicare problem, which is even worse than Social Security.
If the Administration and Congress were willing to address the unfolding fiscal Armageddon, only two very unpleasant general solutions are available:
* The first solution is draconian spending cuts, particularly in Social Security and Medicare, accompanied by massive tax increases. The needed spending cuts and tax increases are so large as to be political impossibilities.
* In the absence of political action, the second solution is tacit bankruptcy, with the U.S. government facing some form of insolvency within the next decade or so. Shy of Uncle Sam defaulting on debt, the most likely eventual outcome is the Fed massively monetizing the U.S. debt, triggering a hyperinflation. U.S. obligations then would be paid off in a significantly debased and devalued dollar at literally pennies on the hundred dollars.
These alternatives are politically unthinkable and unspeakable for the Administration and Congress, hence the silence. Yet, these same political bodies are responsible for the current circumstance, along with the acquiescence of the financial community and an uninformed or disinterested voting public.
Decades of Deception -- Historical Perspective
Misleading accounting used by the U.S. government, both in financial and economic reporting, far exceeds the scope of corporate accounting wrongdoing that keeps making financial headlines. The bad boys of Corporate America, however, still have been subject to significant regulatory oversight and at least the appearance of the application of GAAP accounting to their books. In contrast, the government's operations and economic reporting have been subject to oversight solely by Congress, America's only "distinctly native criminal class." [2]
Nearly four decades ago, President Lyndon Johnson's political sensitivities led him and the Congress to slough off some of the costs of an escalating Vietnam War through the use of accounting gimmicks. To mask the rapid growth in the federal government's budget deficit, revenues from the surplus being generated by Social Security taxes were added into the general cash fund, without making any accounting allowance for the accompanying and increasing Social Security liabilities. This accounting-gimmicked reporting was dubbed "unified" budget accounting.
The government's accounting then, as it is now, was on a cash basis, reflecting cash revenues versus cash expenditures. There were no accruals made for monies owed by or due to the government or to the government's trust funds at some time in the future.
The bogus accounting understated the actual deficit for decades and even allowed for claims of budget surpluses in the years 1998 to 2001. While there were extensive self-congratulatory comments between the President, Congress and the Fed Chairman, at the time, all involved knew there never were any actual budget surpluses. There has not been an actual balanced budget, let alone a surplus, since before Johnson and his cronies cooked the bookkeeping.
The doctored fiscal reporting complemented the short-term political interests of both major political parties. Additionally, the ignorance and/or complicity of Pollyannaish analysts on Wall Street and in the financial media -- eager to discourage negative market activity -- helped to keep the fiscal crisis from arousing significant concern among a dumbed-down U.S. populace.
There were those, however, who believed the government's bookkeeping should be as accurate as possible. In the 1970s, the then "Big Ten" accounting firms proposed setting up for the federal government an accrual accounting and reporting system similar to that used in the business community. Purchases of capital equipment, weapons and buildings would be booked as assets and depreciated, taxes receivable and accounts payable would better reflect near-term cash needs. Accrued liabilities, such as Social Security payments due in the future, would reflect longer-term cash-flow needs.
As the project progressed, GAAP accounting was applied to the government's operations and prototype annual statements were published beginning in 1974. The appropriate accounting for Social Security liabilities, however, was discarded during the Reagan administration as being politically untenable.
Under the eventual mandate of Congress, the accounting project culminated in the U.S. Treasury publishing its first formal Financial Report of the United States Government for fiscal year 2000, consistent with GAAP, except for Social Security and similar accounts such as Medicare, Medicaid and the Railroad Retirement Fund.
The gimmicked accounting standards, as established during the Johnson era, still guide today's official, unified budget reporting. To the credit of the current Bush administration, however, the later GAAP reports, published in April 2003, April 2004 and December 2004 for fiscal years 2002, 2003 and 2004, indicated for the first time since the 1980s what the Social Security and related numbers would look like if they were included in the accounting, just as corporations need to account for pension and retiree health benefit liabilities.
An Important Aside, Re: U.S. Government Economic Data
One of SGS' more important missions is to analyze, then report on the poor and deteriorating quality of "official" U.S. economic data. This growing lack of quality and the attendant diminution of accuracy contributes to bad business and investment decisions -- even bad political ones.
In the June edition of the newsletter, we took our mission a step further with the following announcement:
"Due to popular demand, SGS plans to begin publishing an alternate, monthly consumer price index by fourth-quarter 2005. The index numbers will be set -- not subject to revision -- and usable in calculations in the same manner as the official CPI. A history going back to 1990 will be reconstructed, with a bridge to pre-1990 CPI reporting. Annual inflation in the new series will tend to run about three-percent higher than the government's official inflation reporting of recent years.
"A full methodology will be published, in advance, and results will be replicable. The SGS index calculations will be fully transparent and based on publicly available data, not on massaged surveying by the Bureau of Labor Statistics, or over-modeled and over-theorized price levels. Further details will follow in upcoming newsletters. Comments and suggestions are welcomed."
Anyone wishing to learn more about this project and follow its progress is cordially invited to do so by letting us know at "CONTACT US". To help in properly responding to requests, we request that you provide your name as well as e-mail address. However, this is by no means obligatory.
Dollar, Debt and Hyperinflation
The financial-market counterpart to the federal deficit is federal debt, where gross federal debt was $7.8 trillion as of June 30, 2005. That level was $7.4 trillion at the end of fiscal 2004, of which $4.3 trillion was borrowed from the public and $3.1 trillion was borrowed from the government (i.e. Social Security). Therein lies the problem. There is and will be too much debt from the U.S. government for the financial markets to absorb and remain stable.
The burgeoning deficit means the U.S. government will be increasing its debt level significantly for years to come. Near term, the amount borrowed will increase more rapidly than the markets are expecting, with the economy slowing down and entering recession. The ultimate question is who will lend the money to the U.S. Treasury? The answer is not U.S. investors.
The Federal Reserve's flow of funds accounts show that foreign investors, both official and private, owned 42.5% of U.S. Treasuries at the end of 2004, up from 18.2% at the end of 1994. In 2004, foreign investors bought 98.5% of new U.S. Treasury issuance. (See "A Look at Foreign Investment Behavior in the Latest Flow-of-Funds Data," courtesy of Gillespie Research Associates.)
Part of the reason for this relates to another deficit crisis the United States faces on the trade front, where an exploding trade deficit is throwing excess dollars into global circulation. By holding dollars and investing in Treasuries, instead of converting dollars to a local currency, foreign investors have been helping to fund much of the U.S. deficit.
The combination of the rapidly deteriorating trade and budget deficits guarantee this will change. At some point, willingness among foreign investors to hold dollars will evaporate along with the reality that currency losses are more than offsetting any investment gains. When sentiment shifts away from the greenback, not only are foreign investors going to stop buying U.S. Treasuries, but also they likely will dump their holdings of existing Treasuries along with the U.S. dollar. Such actions would lead to a sharp dollar decline, a sharp spike in interest rates and a sharp sell-off in equities. The question, again, is who is going to buy the Treasuries?
With new debt continually hitting the market, eventually the Fed will have to step in to buy the Treasuries -- as lender of last resort -- effectively monetizing the debt. The more the Fed monetizes, the greater will be the growth in the money supply, the greater will be the weakness in the dollar, the greater will be the rate of inflation.
Where the numbers already are there for this to happen, fiscal pressures will get even worse. Already, the Pension Benefit Guaranty Corporation looks like it needs a federal bailout. As the economy deteriorates, the Congress or the Fed will step in as needed to prevent the collapse of any major financial institution that would threaten the system. Such action, though, will prove fiscally expensive.
The Fed let the banks fail in the 1930s, which helped intensify a decline in the money supply. That in turn was given major credit for deepening the Great Depression. The Fed will try to avoid the mistakes of the 1930s, but, in the process, it likely will end up triggering a hyperinflationary depression.
Last year, we discussed in some detail that the U.S. government's sovereign credit rating of AAA more appropriately should be around B-, a below-investment-grade category, based on the 2003 GAAP statements ("Federal Deficit Reality".) Based on the 2004 GAAP statements, that rating now should be at C-, just above the default level. Never has an investment-grade overeign rating, let alone a AAA country, been supported by such negative extremes in underlying fiscal condition. Based on the latest numbers, the broad GAAP deficit for 2004 represents 96% of GDP, up from 33% in 2003, with total obligations now at 409% of GDP, up from 334% in 2003.
For political reasons, none of the rating agencies are likely to take a credit action against U.S. Treasuries under current circumstances, but that could change in the event of a major dumping of U.S. securities by those wishing to exit U.S. dollar exposure.
As noted by Fitch Ratings [3] in its Sovereign Ratings Rating Methodology: "Sovereign borrowers usually enjoy the very highest credit standing for obligations in their own currency. If they retain the right to print their own money, the question of default is largely an academic one. The risk instead is that a country may service its debt through excessive money creation, effectively eroding the value of its obligations through inflation."
Such has been the traditional cure for countries that borrowed so far beyond their means that they ended up with a choice between bankruptcy and hyperinflation. Hyperinflation seems to be the easier political route, although, for the first time, it will involve the world's primary reserve currency.
In a hyperinflation, the currency very rapidly becomes worthless. In the classic case of the Weimar Republic of the 1920s, a 100,000-Mark note became more valuable as toilet paper than as currency; wheel barrows full of currency were needed to buy a loaf of bread; an expensive bottle of wine one night was worth even more the next morning, empty, as scrap glass. That is the eventual environment the United States faces because of its out-of-control fiscal madness.
For decades, "The deficit doesn't matter" and "The dollar doesn't matter" have been guiding principles in Washington. The deficit and the dollar do matter, greatly, as Washington, the U.S. public and the global markets will learn shortly.
A New Gold Standard?
The dollar, as we know it, soon will be history. Dollar inflation has been through a number of cycles since the founding of the Republic, but its current perpetual uptrend -- net of some bouncing during the Great Depression -- only began once the Federal Reserve was created in 1914. Now, with fiscal policy careening beyond any chance of containment, the Federal Reserve will get to oversee the U.S. currency's demise.
It is not that the Fed wants to monetize the federal debt and trigger a hyperinflation -- the U.S. Central Bank certainly will do its utmost to avoid that outcome -- but it will have no politically acceptable alternative. The system otherwise would tend to right itself anyway through the economic shakeout of a hyperinflationary depression. While the Fed might hope to mitigate and to control the disaster, given the Fed's nature, it is more likely to exacerbate conditions rather than to improve them.
When the dollar loses most of its value, through hyperinflation and/or currency dumping, the global currency system and economy will be in shambles, and a new currency system will have to be established. Those setting up the new system will need to establish its credibility, and there is only one monetary asset that can accomplish that: Gold.
Gold is the only commodity that has held up as a liquid store of wealth over the millennia. The amount of gold used to buy a loaf of bread in Ancient Rome still buys a loaf of bread today. In like manner, the amount of gold that bought a regular haircut for a man in 1914, still buys a similar haircut today. Where the public does not trust today's politicians and central bankers, it does trust gold.
Whatever structure evolves for the new currency system, it most likely will have gold at its base. That is one reason that central banks rarely have followed through on threatened gold sales in recent years. The threats usually were nothing but jawboning aimed at depressing current market prices. Those countries holding the most gold will have the greatest advantage in any new currency system, and the central bankers know that, including Mr. Greenspan.
Timing of Related Currency and Financial Market Troubles
Central banks, OPEC, corporations and investors, both foreign and domestic -- as holders of U.S. dollars -- increasingly will sense or realize the greenback is headed for the dumpster. It only is a matter of when, not if.
The dumping of the U.S. dollar and/or U.S. debt by investors likely will hit quickly, with little advance notice. All the official actions that in turn could trigger hyperinflation would follow rapidly, with a full-fledged dollar collapse and developing hyperinflation possibly unfolding in a matter of weeks.
When this will happen is the tough question. It could be years; it could be next week. Without knowing the precise proximal trigger of the shift in sentiment against the U.S. currency, the timing is impossible to call. Nonetheless, some early warning signs may be evident in unusual anti-dollar activity in the currency markets, or in unusually sharp and unexplained spikes in the price of gold.
It would be extraordinarily surprising if the ultimate dollar collapse can be held off three to five years, let alone a decade. The pending global financial crisis conceivably could break in the immediate future, triggered possibly by one or more of the following developments: action by China to peg its currency to a basket of currencies instead of the dollar, OPEC pricing oil using a basket of currencies instead of the dollar, a sovereign credit rating downgrade on U.S. Treasuries, a major terrorist act, a very bad monthly trade report, a misstatement by an Administration official or some other event that may appear obvious in retrospect.
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Footnotes:
[1] "2004 Financial Report of the United States Government." The full document is available as a PDF file at www.fms.treas.gov/fr/04frusg/04frusg.pdf. The table published in the Overall Perspective on page 11 shows the $11.1 trillion annual eterioration in the government's net worth. As an aside, check the GAO's auditor's letter as to why they will not certify the statements.
[2] Samuel Clemens.
[3] Fitch Ratings website.