Fiscal Sanity for Dummies (reprint)

Fiscal Sanity for Dummies (reprint)

Almost 12 years ago, we published the post below on a previous website called Brushfires of Freedom.  [You can get a copy of it, and of many other key posts from the nine years of Brushfires of Freedom, here]

The post in 2011 was triggered in part by the then current iteration of the “raise the debt ceiling” debate, and was also an attempt to explain how rising interest rates have calamitous consequences on over-leveraged homeowners (or anyone else who has too much debt, such as the US Government).

The warnings of the post are starker today than 12 years ago.   The US Government’s financial condition is now far beyond simple balance sheet bankruptcy; insane levels of spending have made it into a flimsy house of cards that won’t stand up to a stiff breeze, much less a real storm.

With the Silicon Valley Bank collapse now in the mix, and the Fed pretty much all out of tricks to bail the macro-mess out, America is in uncharted and very stormy waters.


Fiscal Sanity for Dummies

There is a great website out there called “US Government Revenue”. You can add a thousand layers of complexity to what follows in order to make yourself appear sophisticated, but if all you want is a basic understanding of where the federal government finds itself, here are some simple ideas extractable from data on this site:

  1. A rule-of-thumb for household borrowing is that you can handle a mortgage of about three times the level of your annual income—e.g., if you make $120K per year, you can handle a mortgage of around $360,000.
  2. It’s important to remember that a big part of the reason you can handle debt larger than your annual income is the term (or duration or maturity) of the debt. When people speak of the 3 to 1 ratio for mortgage principal amount-to-annual income, their implicit assumption is for a 30 year mortgage—a $360K debt amortized over 30 years. If a mortgage were 15 years in duration, it would be much more difficult to handle a $360K debt on $120K of annual income.
  3. As they say, ‘do the math’: $120K in annual income is $10K per month. A $360K mortgage amortizable for 30 years at 3.5% interest results in monthly payments of $1,617. Shorten the mortgage term to 15 years, and at the same 3.5% interest rate, the monthly payments become $2,574.
  4. Another important factor in how much debt a household can handle is the interest rate on the debt. Take the same $360K mortgage, make it amortizable over 30 years, then watch what happens when you change the interest rate:
Interest Rate Monthly Payment
3.5% $1,617
7.0% $2,395
10.5% $3,293
  1. Now try a double whammy on the household. Shorten the mortgage maturity to 15 years AND try out different interest rates:
Interest Rate Monthly Payment
3.5% $2,574
7.0% $3,236
10.5% $3,979

To really get the picture: if interest rates went to 10.5%, and the $360K mortgage was limited to 15 years, the household making $120K per year, or $10K per month, would be paying nearly $4K per month on just the monthly mortgage payment.

Can that household live on the remaining $6K? First, subtract a minimum of $2.5K for taxes. So that leaves $3.5K for all other household expenses: insurance, cars, gas, electricity, phones, food, clothing, health care, child care, etc. That’s going to be very, very tight—probably not workable.

  1. So the point for the household is: the 3 to 1 ratio that is considered safe for purposes of incurring your major household debt in relation to your income depends on all of that debt being of long duration (30 years), and also depends on the interest rate being relatively stable and low.
  2. Now look at the federal government. As recently as 2007 (just five years ago), the ‘gross public debt’ (call it the national mortgage) was $8.95T, and the ‘total direct revenue’ (call it annual income) was $2.568T—which leads to a ratio of about 3.48 to 1.

So in 2007, you might say the federal government’s financial household was being managed within shouting distance of a 3 to 1 ratio. Still too high for a real household, but maybe doable so long as the debt is very long term and interest rates stay low. But of course the federal government’s ‘gross public debt’ is not all of one maturity, and certainly does not average 30 years or more in terms of maturities. So if interest rates went up, even a 3.48 to 1 ratio would be very difficult to handle based on the level of ‘total direct revenue’ or annual income.

  1. In 2011, the gross public debt is $15.476T, and the total direct revenue is $2,173T, for a ratio of 7.1 to 1. This is akin to the household earning $120K per year ($10K per month) now trying to carry a mortgage of $854K. So….let’s see what happens to the mortgage payment calculations for this household if only interest rates change, but not the 30 year maturity:
Interest Rate Monthly Payment
3.5% $3,835
7.0% $5,682
10.5% $7,812

Just to blow everything out of the water, look what happens if the mortgage maturity is reduced to 15 years:

Interest Rate Monthly Payment
3.5% $6,105
7.0% $7,676
10.5% $9,440

Even at the lowest interest rate of 3.5%, the household’s monthly income after paying the mortgage and withholding taxes is $1,400. Such a household—even if it were comprised of just two people—can’t possibly make it on $1,400 per month for all expenses of living (exclusive of housing). And of course, at a 7% interest rate or anything higher, the household has nothing left after paying the mortgage and withholding taxes, and in fact can’t even pay both of them in full. This is a bankrupt household.

  1. The household, of course, can’t go to its employer and demand a raise to cover the debt obligations; the household does not have the power of the gun to make any such demand. And to cover his mortgage under the old 3 to 1 rule of thumb, he’d need to demand a raise to $284K per year for the same work he has been doing for $120K. The employer would laugh at such a demand, and then say ‘no’, and ‘hell, no’. (At the federal level, the ‘employer’ is the US taxpayer, who is being asked to pay for this raise from $120K to $284K. And it is a surprise that the taxpayer says ‘no’ and ‘hell, no’?)

The household in reality would never have gotten the $854K mortgage—no sane lender would have made the loan based on the calculations described above. But if by hook or crook (read: Fannie Mae), the mortgage loan was made, the household would soon be in default, and the lender would not loan any more money to this household, would foreclose on the mortgage and take the house, and would likely never lend again to this household except under circumstances that give the lender full compensation for the risk taken. Translated, that means the lender would lend again, if at all, in small amounts with short maturities at high rates of interest.

  1. At the federal level, people know the Laffer Curve is fundamentally true—which is to say that an increase in tax rates will not produce more ‘total direct revenue’. Taxpayers will find ways to shelter income or simply won’t bother to earn it. That’s why leftists soon turn to outright confiscation of net worth as a way to raise ‘total direct revenue’. But that of course only works a few times until no one has anything left to confiscate.

So this is why the national debt ceiling debate is in some sense superfluous. It’s like arguing whether the household should be able to borrow another $100K on top of the $854K mortgage it already cannot pay. The household is broke—bankrupt—and until it can cut that mortgage back to $360K or so (at the federal level, primarily by radically restructuring the entitlements which give rise to the need to borrow so heavily), any discussion of the appropriate increase of the ‘debt ceiling’ for this household is ridiculous. The ‘full faith and credit’ of this household is already toast.

It also points out what is already happening in terms of attempts by the federal government to find lenders (a/k/a the Chinese) to fund the federal government’s debt. Just as in the household case, at some point the lenders say, ‘are you crazy?’—but until they get to that point they are only willing to lend smaller amounts for shorter durations and at higher interest rates in order to compensate for the risk being taken.

These are the reasons why you hear the word ‘unsustainable’ applied to the federal government’s spending and borrowing activities. They cannot be funded; demagoguery cannot alter math, and the math will not work. The spending activities which give rise to the borrowing needs must be cut. Now.

Paul Gable

July 19, 2011