Dave Pollard's chronicle of civilization's collapse, creative works and essays on our culture.
A trail of crumbs, runes and exclamations along my path in search of a better way to live and make a living, and a better understanding of how the world really works.

January 26, 2006

BLOG Why Republicans Want a Huge National Debt

Filed under: How the World Really Works — Dave Pollard @ 11:23
Warning: Long post with lots of financial terms. Before you bail and read something else, just remember that that’s what Bush is counting on — “don’t worry your pretty little head about all this economics stuff, we’ll take care of it”.

I mentioned last week that Warren Buffett, one of the world’s richest people, had expressed great alarm about the US trade deficit, expected to grow this year by another trillion dollars or so, to $10T, but he was unconcerned about the size of the US budget deficit, expected to increase this year by between $400 billion (if you believe the optimistic budget) and $900 billion (if deficits continue at the levels they have for the last four months), bringing the national debt to about $9T.

The reason he thinks this way is that, coming from a business background, he sees the federal accounts through a business lens, and assesses government finances as if government were just a giant corporation. In times of low interest rates, businesses are encouraged to borrow heavily, even if they don’t need the money, and to use the funds to establish new businesses, buy business assets, or acquire other companies.


The principle behind this is called leverage, and it holds that as long as the cost of borrowing (the interest rate on additional loans) is significantly less than the rate of return on the equity (‘ROE’) purchased with those loans (and ROEs of 15-25% are quite common among Fortune 500 companies), it makes sense to borrow at the low rate (especially since the interest is tax deductible) and invest it to yield the higher rate (especially since capital gains have been increasingly tax-sheltered under recent regimes).

The only caveat is to avoid getting over-leveraged, to the point that the ratio of debt to equity (equity being the accumulated investments and earnings that have not been paid out in dividends) gets so high that a company becomes vulnerable to sudden spikes in interest rates or a fall-off of revenue, and cannot meet its interest payments or dividend obligations.

Here’s an example to illustrate this. A typical corporate balance sheet and income statement for the past year might look like this (all amounts in billions of dollars):

Working capital (cash, inventory etc.) $3.0 Debts, bearing interest at 5% $4.0
Real estate and equipment 3.0 Equity 2.0
   Total $6.0    Total $6.0
Revenues $10.0
Expenses 8.8
Interest on Debts @ 5% 0.2
Pretax income 1.0
Income taxes 0.2
Net income (profit) 0.8
Dividends paid 0.4
Retained earnings $0.4

This company has a healthy 40% return on equity (ROE = 0.8/2.0) and a healthy 13% return on assets (ROA = 0.8/6.0), a comfortable debt/equity ratio of 2:1 (4.0/2.0) and income before interest (10.0 – 8.8 = 1.2) of six times the interest expense of 0.2.

Now suppose they decide they should leverage their company’s high returns by borrowing another $4B to acquire a competitor which they think would also, under their management, with massive layoffs on acquisition, attract a 13% ROA. Assuming they’re right, this is what the financial statements would look like a year later:

Working capital (cash, inventory etc.) $5.7       Debts, bearing interest at 5% $8.0
Real estate and equipment 5.0 Equity 2.7
   Total $10.7    Total $10.7
Revenues $13.0
Expenses 11.0
Interest on debts @5% 0.4
Pretax income 1.6
Income taxes 0.3
Net income (profit) 1.3
Dividends paid 0.6
Retained earnings $0.7

Thanks to leverage, profits are up 62%, the ROE is 48% (1.3/2.7), the ROA is 12% (1.3/10.7) and income before interest (13.0 – 11.0 = 2.0) is 5 times the interest expense of 0.4. The CEO who leveraged the debt and took over the other company looks like a genius. High fives, big management salary increases and share options all round.

But suppose in the third year of this example interest rates suddenly spike to 10% instead of 5%, and that causes customers to be stingy, so revenues of the company drop by 30%. Unless salaries are cut back as soon as the fall-off becomes apparent (and this rarely happens) profit would completely disappear. ROE and ROA would be zero, and times-interest-earned would fall from 5 to less than 1.

At this point, if they’re prudent, the company’s lenders would call some or all of their $8B loans. The company would then need to sell off or close half of their operations to reduce costs. If this is done at a loss (at less than book value) which is not uncommon in a forced sale situation, the company could end up insolvent, unable to pay its trade creditors, and forced into bankruptcy. The shareholders would be looking for blood. That’s the risk of leverage.

Now let’s go back to the US government and look at their accounts, this time in trillions of dollars rather than billions:

Working capital (cash, inventory etc.) $x       Debts, bearing interest at, say 3% $9.0
Real estate and equipment y Equity x+y-9
   Total $x+y    Total $x+y
Revenues $2.1
Expenses 2.8
Deficit $ -0.7

The accumulated debt of $9T, despite being four times annual government revenues, is currently manageable for three reasons:

  • Interest rates are low — despite recent increases by the Fed, the government only pays about 3% interest on its debt.
  • Most of the debt is denominated in US dollars, so the steady slide of the dollar against other currencies doesn’t affect the size of the debt or the interest on it.
  • While no one really knows what ‘y’ is (the liquidation value of all government-owned land and buildings) it is certainly a very large number, so the debt/equity ratio of the government, though rising rapidly, is probably still quite small.

This is why Buffett isn’t worried about the national debt. However, if the trade deficit (which Buffett is worried about) isn’t reduced, confidence in the US dollar will continue to fall and, as is happening now, creditors (like China and Saudi Arabia) will not be able to sustain the foreign exchange losses (which could wipe out their profits). They will insist that the US buy in euros, or yuan, or some ‘basket’ of currencies with fundamentals stronger than the US dollar. That will produce a double-whammy:

  • The US deficit, and debt, will jump in proportion to the decline in the US dollar, and
  • US interest rates will spike as investors flee US dollar investments in favour of those of countries with more responsible fiscal and monetary policies.

If the US had to pay, say, 9% interest on its debt (spikes like that are not unprecedented) instead of 3%, that would add over $0.5 trillion in annual interest expense, nearly doubling the annual deficit. And since the interest rate spike and inflationary price increases will cut into corporate and individual earnings, it will also lower government revenues to the point they are only half of expenses, a rate of debt accumulation that, as in Argentina a few years ago, could make the US dollar virtually worthless and produce an economic collapse that will be felt around the world.

There are two ways to prevent this. The first is to double tax rates, and you know no Republican regime will do that. The second is to sell off large amounts of public property to private interests at a greatly accelerated rate. This second alternative fits precisely with the Norquist/neocon “weaken government until you can drown it in a bathtub” agenda. They would then be doing exactly what corporations do — treat the entire country’s public property, the Commons, as an enterprise in liquidation, as economist Herman Daly has described. Until they’re sold off to private developers, they’re ‘worth’ nothing because they generate little or no cash revenues.

So now you know why Bush is not only unworried but actually pleased with skyrocketing deficits. They give him the excuse to cut government services and programs (if you read the harsh rhetoric of his annual budget he makes no bones about the fact he sees only defense and ‘homeland security’ expenses as essential), and to sell off ‘priceless’ parks, national forests and other public lands inexpensively to Republican campaign donors.

By this analogy, the ‘shareholders’ of the US are its taxpayers. They should be outraged that their assets are being given away, and their ‘investments’ (taxes paid) so badly mismanaged. Imagine if Google or Microsoft were to do this: Their shareholders would not be happy to learn that to pay off their huge debts it would be necessary to sell off priceless corporate assets at fire-sale prices to friends of management. If this was tried in the private sector there would be a hastily-convened special general meeting of shareholders and directors, and the managers would be fired and possibly charged with negligence and imprisoned.

But because no one knows what ‘y’ is (the real, rapidly-increasing value of all public holdings), we can’t audit Bush’s sell-offs to discover how cheaply these assets are being sold off — though the discounts will eventually have to be made up by the next generation’s taxpayers. And as a result we can’t tell either how much is left to “drown in the bathtub”. And that means we don’t know how necessary it is, and will be, to cancel or privatize all government social services and programs to reduce the need for even more fire-sale sell-offs of taxpayers’ property.

So no wonder Buffett isn’t worried about the size of the debt. His companies stand to benefit both from the huge Bush tax cuts to the rich (though I give Buffett credit — he does pay his taxes and is scornful of the many corporations that don’t), and fire-sale divestiture of public assets to private corporations. Through his lens of government-as-corporation (rather than government as steward of public assets, standard-setter for social services and sustenance provider to those unable to help themselves), the private sector can always manage any ‘business’ better than government can. In the US, as a result, private enterprises are slowly taking over the provision of essential services (education, health, transportation etc.) and studies indicate they are more bureaucratic, more expensive and less efficient than the government agencies they replace (the bureaucracy and waste in the privatized US health care sector chews up half of every health care dollar it receives in administration costs).

No matter that private companies, in taking on these essential-for-all services, are only really interested in serving ‘customers’ who have lots of money to pay for higher-margin, premium services. No matter that priceless public assets are being virtually gifted to private corporations who see value only in ‘developing’ them for the crassest purposes. No matter that trillions of dollars are being wasted on ‘defense’ and ‘security’ boondoggles like Star Wars, ludicrous spying and other invasions of privacy and abrogations of human rights and the law, and imperialistic wars in the Mideast — all designed to fatten the wallets of private ‘defense contractors’ while making life for Americans much less safe. The plan is clearly to liquidate the people’s assets and leave nothing for the next, more liberal, government to borrow against, so that government will be unable to restart essential public service programs.

It’s too bad that America’s starved and broken education system doesn’t teach economics programs that show this theft for what it really is. By the time most Americans wake up to what the neocons have done with their assets and tax dollars, and the bankrupt legacy the neocons are leaving for future generations, it will be too late. Americans will then have to do what so many countries have had to do when their public purses have been completely pillaged by corrupt political opportunists — nationalize the industries that are not serving the majority of citizens, and reappropriate the lands that were sold to private interests at a fraction of their real value. And the cycle of seizure and theft will start all over again.

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