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.