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Dale Franks

Dale Franks’ QandO posts

The Tea Party downgrade

“Look at the history of this – the fact of the matter is that this is essentially a Tea Party downgrade. The Tea Party brought us to the brink of a default.” –David Axelrod, top political consultant to President Obama, in an appearance on “Face the Nation”, Sunday, 7 August, 2011

Damn those Tea Partiers, and their rigid insistence on slashing the Federal budget. If only they were more flexible on spending and increased taxes, we’d be just fine. Their demand that we substantially cut federal spending, balance the budget, and pay down the debt without significant tax increases has now caused S&P to conclude that we aren’t serious about getting debt under control.

That’s the Democrats’ argument anyway. And they’re sticking to it.

I will defer to Protein Wisdom’s Jeff Goldstein for his response:

For all those — both left and (establishment) right — inclined to excuse their own complicity and try to scapegoat the TEA Party, which remains the one faction who actively pushed for serious, actual debt reduction and a return to fiscal sanity, take note here: we recognize that it’s been your strategy since the downgrade to seize on the warnings against “political gridlock” in order to insist that a failure to “compromise” on the part of the TEA Party supporters is what led to the downgrade. We also recognize the dishonesty and cynicism of such a strategy: as has been noted time and again, Cut Cap and Balance was the compromise, with the vast majority of TEA Party supporters in the House voting for the bill, which gave the President his debt ceiling increase in exchange for both real cuts and a mechanism by which to control future deficit spending and debt.

Who didn’t compromise — and whose political intransigence is at the heart of the downgrade — is the Democrats, who refused to come up with their own plan, and who then refused to even allow CC&B come up for a vote. This faction — along with the go along/get along GOP establishment — is now looking to pass blame for their own willingness to block compromise onto the TEA Party.

It won’t work. 66% of the population backed CC&B; 75% backed a Balanced Budget Amendment. What they got instead was more spending (the single largest increase in history) for more empty promises of future cuts in the rate of spending.

This didn’t come anywhere near to what the credit agencies demanded, and it is not lost on us, no matter how feverishly you wish to spin it, that what is missing from any plan but those pushed by the TEA Party is any “‘stabilization and eventual decline’ of the federal debt as a share of the economy,” something that simply won’t happen without real cuts. Raising taxes on “millionaires and billionaires,” even were you to confiscate all their wealth by taxing them at 100%, would run this government for less than a year. And once you confiscated it all, you’d have to then look elsewhere for new “revenues” to keep the government running.

The political class is unwilling to accept a simple premise: They’ve looted the system.  And they’ve looted it to such an extent that some notional increase in revenues obtained by taxing the "rich" can never make up for the spending.

Blaming the downgrade—or anything else—on the only group in America who are willing to fix the problem, rather than kicking it down the road as far as they can, is just a non-starter.

Or, it would be, if there weren’t so many people who weren’t so desperate to believe the gravy train can roll forever.

Dale Franks
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The first post-downgrade business day

The yield on the 10-year note has dropped to 2.44%, down from 2.57% at Friday’s close. I’m thinking this is telling us the economy’s on the way into the toilet, as the standard reaction for a credit downgrade is rising interest rates, to cover the extra risk. The Dow’s long slide, which began on 22 July–and continues with a 250 point loss so far today–is probably telling us the same thing, as earning expectations slide. Since the downgrade was one agency only, and the downgrade only to AA+, economic factors are clearly weighing more on the bonds than the downgrade.  On the other hand, if you’re a gold investor, you’re probably a little happier today, as Gold hit $1,715/oz.

The key takeaway so far today is the continuing decline in yields, which isn’t good news. Thank goodness there’s no economic releases today. I’d hate to see what more bad news would bring.

So, back into recession, it looks like.

One of the more interesting things I’m wondering about, in a horrified kind of way, is what effect the downgrade has on corporate paper.  A number of institutions have investment rules that require they concentrate their investments in AAA-rated securities.  But, one of the general rating rules is that subsidiary corporate and government instruments cannot have a higher rating than their sovereign instruments. So if the US Government doesn’t have a AAA rating, no subsidiary US corporate or government paper should have a AAA rating either.

So, what does this mean for the handful of corporate and government instruments that were rated AAA prior to the downgrade? Do they get downgraded, too?  If so, where do the institutions with a AAA rating requirement go with their money?

I’m not at all sure how this works. As we’ve been saying a lot in the last week or so, we’re in uncharted territory.

END OF DAY WRAP-UP: Well, that could’ve been worse, I suppose.

Dow 10,810.83 -634.76 (-5.55%)
S&P 500 1,119.46 -79.92 (-6.66%)
NASDAQ 2,357,69 -174.72 (-6.90%)
10-Year Yield 2.34% -0.22%
Comex Gold $1,710.20/oz (+3.7%)

I’m not sure how much worse it could’ve been, though.

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Observations: The QandO Podcast for 07 Aug 11

In this podcast, Bruce, Michael, and Dale discuss concerns about Turkey, and the debt limit.

The direct link to the podcast can be found here.


As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.

Mark Steyn is brilliant—and grim

Mark Steyn, writing in Investors Business Daily, isn’t pulling any punches about what the near future holds for us if the Federal government keeps spending like there is no tomorrow. There won’t be.

[B]y 2020 just the interest payments on the debt will be larger than the U.S. military budget. That’s not paying down the debt, but merely staying current on the servicing — like when you get your MasterCard statement and you can’t afford to pay off any of what you borrowed but you can just about cover the monthly interest charge.

Except in this case the interest charge for U.S. taxpayers will be greater than the military budgets of China, Britain, France, Russia, Japan, Germany, Saudi Arabia, India, Italy, South Korea, Brazil, Canada, Australia, Spain, Turkey and Israel combined.

When interest payments consume about 20% of federal revenues, that means a fifth of your taxes are entirely wasted. Pious celebrities often simper that they’d be willing to pay more in taxes for better government services.

But a fifth of what you pay won’t be going to government services at all, unless by "government services" you mean the People’s Liberation Army of China, which will be entirely funded by U.S. taxpayers by about 2015…

And even those numbers presuppose interest rates will remain at their present historic low. Last week, the firm of Macroeconomic Advisors, one of the Obama administration’s favorite economic analysts, predicted that interest rates on 10-year U.S. Treasury notes would be just shy of 9% by 2021. If that number is right, there are two possibilities:

The Chinese will be able to quintuple the size of their armed forces and stick us with the tab. Or we’ll be living in a Mad Max theme park. I’d bet on the latter myself.

And we all know who’ll be running Bartertown.

Look, there’s no way to sugar-coat this. What’s coming isn’t gonna be pretty. Too many politically powerful groups have their fingers stuck too deeply into the DC pie to let it all just slip away without fighting tooth and nail. There are too many people who believe the gravy train of benefits coming out of DC should be endless to kiss that goodbye without a fight.

Look at what has been happening in Greece.  They’ve built up two generations of people who cannot and will not accept that they’re simply out of money.  Despite the fact that system has been thoroughly looted, they are adamant that the looting should continue.

If we don’t cut spending—and I mean real cuts, not cuts to some imaginary baseline that has $9 trillion is spending increases baked in—and some sort of serious tax reform that widens the tax base to raise more revenue, we’re done.

And don’t come back at me with some lame "Our GDP:Debt ratio was 120% at the end of WWII" silliness.  Yes it was. And you know how we fixed it? We cut Federal spending from $92 billion in 1945 to $38 billion in 1949. For 2011, 40% of the federal budget was financed with borrowed money: We’ll spend  $3.818 trillion, of which  $1.645 trillion is borrowed. If we funded only defense, Medicare/Medicaid, and Social Security, and interest on the debt, we’d still have a deficit of $673 billion. Just to balance the budget this year—forget paying off any debt—we’d have to cut an additional ~25% from Health, Defense, and Pensions. Follow the link and download the CSV file, open it up in Excel, and run the numbers yourself. The magic number to balance the budget this year is the revenue of $2.174 trillion.

There’s no big mystery as to why we got a downgrade from S&P. The mystery is why Fitch and Moody’s haven’t downgraded US debt yet.

To begin paying down the debt will require massive cuts in government spending, substantially widening the tax base, and some healthy economic growth—and good luck with that as we add another couple hundred k government workers to the unemployment roles, lay off 1/3 of government contractors to boot, and start asking the bottom 50% of taxpayers to actually, you know, pay taxes, along with everyone else.

If you’re under 50, and reach retirement age with any modicum of personal wealth, you can forget seeing a dime in Social Security or Medicare benefits when you retire. You’ll be means-tested right out of all that.

You think the debt ceiling battle was disruptive? Well, hold on to your hats, folks.

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S&P downgrade coming tonight? (Updated: Downgrade: AA+)

Well, this is encouraging:

U.S. government officials are bracing for the rating agency Standard & Poor’s to downgrade the country’s credit as early as this evening or take other possible action, according to someone familiar with the matter.

Open comment thread to answer the question: How screwed are we?

UPDATE: ABC news adds more:

A government official tells ABC News that the federal government is expecting and preparing for bond rating agency Standard & Poor’s to downgrade the rating of US debt from its current AAA value.

Officials reasons given will be the political confusion surrounding the process of raising the debt ceiling, and lack of confidence that the political system will be able to agree to more deficit reduction. A source says Republicans saying that they refuse to accept any tax increases as part of a larger deal will be part of the reason cited. [Emphasis added—Ed.]

So, it’s all your fault, Republicans.

UPDATE II: Politico’s Ben White (@morningmoneyben) tweets, "Senior govt official tells me S&P had planned to downgrade 2nite. And now may not. Weirder and weirder".

UPDATE III: Jake Tapper updated the ABC story above with new developments:

A third official says that S&P made a "serious mistake" in its analysis, "based on flawed math and assumptions," so the Obama administration is pushing back. But even though "S&P has acknowledged its numbers are wrong, it’s unclear what they’re going to do.," the official said.

S&P refused to comment.

What a strange set of developments.

Update IV: The Wall Street Journal provides a clearer look at what’s happening:

A mathematical error discovered late Friday by Treasury Department officials threw into limbo, at least temporarily, plans by ratings firm Standard & Poor’s to downgrade the top-notch AAA credit rating the U.S. has held for 70 years, people familiar with the matter said…

S&P officials notified the Treasury Department early Friday afternoon it was planning to downgrade the debt, a government official said, and the firm presented its report to the White House. S&P has previously warned such a downgrade might come if Washington didn’t move to comprehensively tackle its long-term fiscal woes.

After two hours of analysis, Treasury officials discovered that S&P officials had miscalculated future deficit projections by close to $2 trillion. It immediately notified the company of the mistakes.

S&P officials later called administration officials back to say they agreed about the mistakes, though they didn’t say whether it would affect the rating. White House officials remained waiting Friday evening to see what the company would do.

That’s an enormous mistake for S&P. If you’re about to issue a downgrade to the United States, you’d better check yourself, son.  After this, the Treasury Department will go to the wall on S&P if they try to downgrade.

Big black eye for Standard & Poor.

UPDATE V: Holy crap! CBS White House reporter Mark Knoller (@markknoller) just tweeted: “S&P has downgraded US Treasury securities from AAA to AA+. S&P bills downgrade as an ‘unsolicited rating.’" Oh, it’s on now. S&P has got big brass ones, because the Treasury Department and White House will now go 10-8 on their ass, after finding that $2 trillion math error.

UPDATE VI: Well, the first responses for the downgrade are in at Reuters. They seem pretty measured. Optimistic even.

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Nobel Prize-winning economist endorses my economic analysis

Well, this is interesting.  Paul Krugman finally agrees with me:

[W]e already know what isn’t working: the economic policy of the past two years — and the millions of Americans who should have jobs, but don’t."

I’d just like to point out that I knew those economic policies wouldn’t work back in 2009, writing about them here. Since then, I’ve just been watching the kangaroo. So It’s nice to see Krugman joining me in declaring "fail"—though he does so with the advantage of 20/20 hindsight.

I eagerly anticipate my upcoming invitation to Sweden.

Where we diverge is in providing solutions. As always, Krugman’s solution is more spending, and more debt.  But with debt already at 100% of GDP, we’re really in uncharted waters, and I have no confidence that more debt is the answer, if the problem is the existing debt overhang.

The real question I’m concentrating on is, "At what point do the markets recognize not only that the debt path we’re on is unsustainable, but that it is going to be impossible to pay it back?"  Is that 120% of GDP? 150%?  I don’t know.  But I fear that we’re going to learn the answer.

On the bright side, I’ll be able to pay off the remaining 19 years of my mortgage for the cost of a nice hat. On the down side, a new Astros baseball cap will cost $200,000. On the bright side, again, the $100,000 from my Nobel will cover half of that, so it’s all good.

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Gloomy Goldman-Sachs

James Pethokoukis writes, "Goldman Sachs drops this H-bomb on the Obama campaign:

We have lowered our forecast for US real GDP growth further and now expect real GDP to grow just 2%-2½% through the end of 2012.  Our forecast for annual average GDP growth has fallen to 1.7% in 2011 (from 1.8%) and to 2.1% in 2012 (from 3.0%).  Since this pace is slightly below the US economy’s potential, we now expect the unemployment rate to be at 9¼% by the end of 2012, slightly above the current level.

Even our new forecast is subject to meaningful downside risk.

So, we got that goin’ for us.

Dale Franks
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Unemployment situation for July

The headline numbers for the the July employment situation show that 117,000 new non-farm payroll jobs were added last month, while the unemployment rate dropped to 9.1%. But, the true story is—as we’ve come to expect—more complicated when you delve below the fold.

Private payrolls rose by 154,000 jobs, while government payrolls declined by 37,000. Average weekly hours were unchanged at 34.3, while hourly earning rose slightly to $23.13.

The decline in the unemployment rate to 9.1 was not a reflection of the increase in non-farm payrolls, but a decline of 193,000 in the labor force, as workers dropped out of the labor market. As a result, the labor force participation rate continued to decline to 63.9%.  In addition, the total number of employed persons declined from 139,334,000 to 139,296,000, meaning that 38,000 fewer people were actually working last month, compared to June.

The U-4 unemployment rate, which includes discouraged workers, held steady at 9.8%, while the broadest measure of unemployment/underemployment, the U-6, which includes workers who have part-time jobs for economic reasons, dropped 0.1% to 16.1%.

Overall, the report is not positive. At best, it can be said that we’re about the same last month as we were in June.  The trend over the last few months is not good, however, as the table below illustrates.


  Mar 2011 July 2011
U-4 9.4% 9.8%
U-6 15.7% 16.1%


Finally, if we go back to the historical average of labor force participation prior to the recession, which was 66.2%, the proper size of the labor force should be 158,662,000, rather than 153,228,000. Use that figure to calculate the employment rate with the 139,334,000 persons actually employed, and you get an actual unemployment rate of 12.2% for July. The caveat here, of course, is that with the first tranche of Baby Boomers so close to retirement, some number have just retired early and are out of the labor force permanently, so that historical participation rate may no longer be valid.

In any event, once you add in the workers who’ve gotten discouraged, and workers who have part-time jobs because full-time employment isn’t available, this month’s employment report makes it clear that real unemployment is actually back on the rise.

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The tyranny of numbers (Updated)

Let me see if I can quantify the current and future budget situation.  It’s actually quite simple, and doesn’t require knowledge of anything other than elementary mathematics. The most recent analysis of the Federal government’s unfunded liabilities, to include the national debt, debt financing, Social Security, and Medicare, showed total unfunded liabilities of $61.6 trillion. I’ve seen substantially higher numbers in other analyses—up to $75 trillion, depending on how you score it—but let’s take this fairly conservative one.  What are the practical implications of this number?

Let’s see what we’d have to do to pay all that back in 30 years. I picked that length of time because a) it covers the entire span of Baby Boomer retirements, and b) it equals the longest maturity of any Federal debt instrument,  the 30-Year Note.

Let’s look at the rounded numbers, derived from the Statistical Abstract of the United States. In fiscal 2010, GDP was $14.63 trillion.  Of that $2.165 trillion was collected in Federal revenue, or 14.8% of GDP. $61.6 trillion, paid over 30 years, will require equal installments of $2.05 trillion every year.

Now we’ll make some assumptions.  Let’s assume that we get 2% growth this year, and that for the next 29 years, we get an average of 3% growth in both GDP and in tax revenues collected. We also have to assume that the US Government doesn’t run a deficit, or add and more to the national debt between now and 2041. And let’s even assume that the current 14.8% of GDP we’re currently collecting in revenues doesn’t rise to the the historical 17.8% average, and that we can fund the government on just revenues of 14.8% of GDP.

Finally, let’s remember that most revenue that has ever been collected in all of American history, as a percentage of GDP, was 20.6% in 1999, after a substantial economic boom. Prior to that was 1945’s 20.4%.

In order to pay off this year’s share of the $61.6 trillion in unfunded liabilities, the government will have to collect $4.261 trillion in revenues.  With an estimated 2011 GDP of $14.922 trillion, that comes to 28.6% of GDP. If we assume government revenues rise to the historical average, the we’ll need the government to take 31.6% of GDP in tax revenues. Happily, because we’re assuming a 3% rise in GDP and revenues for every year over the next 30 years, that percentage will decline slightly every year, until, in 2041, we’ll only need to collect 20.5% of GDP in tax revenues to pay off the last installment, assuming, again, 14.8% of GDP covers the operation of government.  If we go back to the 17.8% figure, then we’ll have to collect 23.5% of GDP in revenues.

Either way, for the next 30 years, we need to collect substantially higher tax revenues than we have collected at any time in the nation’s history, and we have to do it every year for 30 years.

Quite frankly, I doubt that this is even physically possible, much less politically possible. Quite apart from anything else, I have no confidence whatsoever that we will even have 3% GDP growth under a regime where more than one-quarter of national income is given to the government for the next decade.

If you want to see the year-by-year numbers, my Excel worksheet is here.

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UPDATE: A commenter points out that shows a total unfunded liability of $114 trillion. I believe that figure goes out to the year 2087, however. But, those calculations wouldn’t look that much different for individual years. We’d just have to support unsustainable taxes for 70 years instead of 30. Not that it matters, ‘cause we won’t do it anyway.

BTW, keep in mind that these numbers are just a simple back-of-the-envelope calculation to wrap our heads around the basic scope of the problem, not a precise model of government expenditures and revenues for the next 30 years. I wasn’t really interested in doing 20 hours of math for a 15-paragraph blog post, after all.