Sunday, February 15, 2009

Deflation vs. Stagflation: Choices Facing an Insolvent Government?

Much attention has been given to the issue of whether or not major banks are solvent. But how about the federal government? Is it solvent? Much of the answer depends upon how one accounts for assets and liabilities on the federal balance sheet. A recent article, quoted below, raises doubts about the budgetary health of the government:

"Truthfully," Williams pointed out, "there is no Social Security 'lock-box.' There are no funds held in reserve today for Social Security and Medicare obligations that are earned each year. It's only a matter of time until the public realizes that the government is truly bankrupt and no taxes are being held in reserve to pay in the future the Social Security and Medicare benefits taxpayers are earning today."

The $65.5 trillion total federal obligations under GAAP (Generally Accepted Accounting Practices) accounting not only now exceed four times the U.S. gross domestic product, or GDP, the $65.5 trillion deficit exceeds total world GDP (my emphasis).

Thus far, U.S. Treasury instruments have been viewed as safe havens, so there has been little concern over stimulus solutions that add massive debt to a debt-laden balance sheet. At some point, the appetite for expanding Treasury issuance will falter, as countries are challenged to raise their own funds and stimulate their own economies.

At that juncture, will we have rising rates in a fragile economy, adding to deflationary forces? Will the Federal Reserve need to monetize debt by aggressively purchasing Treasuries further out on the yield curve, courting significant inflation? Gold has been holding its own vis a vis other commodities and especially vis a vis non-U.S. currencies; so far, it seems to be betting that a deflation-wary Fed will choose a stagflationary path.


The Market Sniper said...

Hey Bret!

I thoroughly enjoy your informative posts! You do outstanding work and are a great contributor to the trading community. Have you left out a third probability here? Hyper inflation. As the Fed moves into direct monetization due to the huge increase in debt to be sold and diminished capital avalable to buy it, the spectre of Weimar could walk the land.

The Market Sniper

adan said...

just to add fuel on the deflation / stagflatlion / hyperinflation debate,

i'll add that, supposedly, europe's debt load is significantly higher a % of their gdp vs ours

dollar amts, via credit instruments and derivatives, are being destroyed faster significantly faster than monies being created

falling demand and fear is destroying pricing power

finally, mentioned briefly by obama and others during the democratic primary, all it'd take is a reduction of our military budget and off-balance sheet war spending (= to greater than the entire rest of the world's total military spending), to tilt the budget dramatically away from red, and toward black

so, for the interim intermediate term, i see deflation

after that....

Steve van Emmerik said...

I really don't think we know if there is going to be significant inflation or deflation at this point. Just that both are risks. Godl price headign up and breaking last 10 years 0.9 correlation with US dollar does suggest inflation is a real risk. I think it may also simply could be a flight to safety though so may not mean a lot for future inflation.

Excellent point re unfunded liabilites of government! This and the underlying budget defict are the real issues not the stimulus. The stimulus less than 1 trillion unfunded liabilties 75 million makes it virtually irrelvant by comparison. Why all the media debate about the small issue and virtually none about the big issue?

Agree there si a real risk to treasuies. At this stage China is saying we'll keep buying US treasuries because there is little alternative and if we stop doing it demand for our products in the US will be much worse. However in the long term this is a strategic problem for the US. So whether gold is going up due to inflation fears or due to flight for safety it is telling us US treasuires are gettign riskier (due to inflation or loss of Us dollar safe haven status).

Brett Steenbarger, Ph.D. said...

Thanks for the comments; I think getting the deflation vs inflation call right for the next few years will be the greatest challenge facing investors--