Aftermath

by James Rickards

  Another tax-cut supporter claim is that the Trump tax bill changed the rules on U.S. taxation of global corporate offshore earnings. These changes allowed multitrillion-dollar bundles of offshore earnings to be brought back to the books of U.S. parent companies at highly favorable rates. Repatriated earnings would create a cash wave washing on U.S. shores, to be used for investment in plant and equipment and job creation to stimulate U.S. growth. This is nonsense. Almost all the cash from “offshore” earnings of U.S. global companies was already invested in U.S. markets and always had been. There was no rush to bring home the money; it was already here. The offshore money was held on the books of Irish and Cayman Islands’ subsidiaries for accounting purposes, yet was mostly invested in U.S. bond and money markets. The Trump tax law allowed that money to be recorded on the books of the head office, and allowed the reversal of deferred tax expense. This is an accounting entry, not a tsunami of cash washing ashore. The repatriation story was always a myth designed to induce the media, Congress, and everyday citizens to go along with what was really a huge accounting windfall for corporate donors to the Republican Party. It is true that the offshore cash previously invested in Treasury notes, corporate bonds, and bank deposits could be invested in plant and equipment. Still, that’s another myth, because the cash is mostly not being redeployed to new plant and equipment, it’s being used for dividends and stock buybacks, another windfall for shareholders that does little to support long-term growth and job creation. Global companies that wanted to invest in plant and equipment in the United States for the past ten years could have done so easily by taking a 2 percent bank loan secured by the offshore cash. As far as the Trump tax law is concerned, the growth and investment story is smoke and mirrors.

  The Trump corporate tax effects are even worse than the missing repatriation stimulus. One unintended consequence of the new tax law is that it creates incentives for U.S. corporations to move new investment offshore instead of onshore. This is because in exchange for a one-time reduced tax rate on the repatriation of offshore profits, U.S. companies got what they have wanted for fifty years—an exemption from all future taxation of offshore earnings.

  Until the Trump tax bill, the U.S. taxed global companies on their global profits, either immediately or upon repatriation, or as a deemed repatriation under certain highly technical rules. Now the United States taxes only domestic profits; offshore profits are exempt. Tax-bill supporters point to the U.S. corporate tax reduction from 35 percent to 22 percent as a reason for companies to invest at home. Still, 22 percent is higher than zero. As long as companies can find tax haven jurisdictions with zero tax rates, they prefer to invest there rather than in the United States. The United States now has no way to tax those profits currently or on a deferred basis. The profits, and associated jobs, stay offshore forever.

  Trump advisers insist they can avoid a debt crisis through higher than average growth. This is mathematically possible yet extremely unlikely. The debt-to-GDP ratio is a product of two parts—a numerator consisting of nominal debt and a denominator consisting of nominal GDP. Mathematically it’s true that if the denominator grows faster than the numerator, the debt ratio declines. The Trump team hopes for annual nominal deficits of 3 percent of GDP and nominal GDP growth of 6 percent, consisting of 4 percent real growth and 2 percent inflation. If that happens, the debt-to-GDP ratio will decline and a crisis will be averted.

  This forecast invites incredulity. Deficits are already approaching 5 percent of GDP according to Congressional Budget Office forecasts and are projected to go higher in the years ahead. These CBO estimates are almost certainly optimistic, because they project no recessions for the next twenty years. That projection is practically impossible considering that the current expansion is already the second longest since the Second World War. Economic expansions don’t die of old age, but they do die. If a recession were to begin in the next three years—a likely scenario—additional hundreds of billions of dollars would be added to the deficit due both to the automatic stabilizers and reduced tax collections from slower economic growth. A new recession will decimate growth and inflate deficits at the same time. Even without a recession, official CBO projections expect 2.4 percent real growth and 2.1 percent core inflation in fiscal 2019. That yields 4.5 percent nominal growth, not enough to match the 5 percent deficit projection. The debt-to-GDP ratio will rise even under CBO’s rosy scenarios.

  The CBO also makes no allowance for substantially higher interest rates. With $22 trillion in debt, most of it short term, a 2 percent increase in interest rates quickly adds $440 billion per year to the deficit in the form of increased interest expense in addition to currently projected spending. The United States is past the demographic sweet spot that Obama used to his budget advantage from 2012 to 2016. From now on, retiring baby boomers will make demands on Social Security, Medicare, Medicaid, disability payments, veterans’ benefits, and other programs that drive deficits higher.

  Finally, the CBO fails to consider groundbreaking research by Kenneth Rogoff and Carmen Reinhart on the impact of debt on growth. A 60-percent debt-to-GDP ratio is considered by economists a red line beyond which debt levels may become nonsustainable. The Reinhart-Rogoff research shows there is an even more dangerous threshold of 90 percent debt-to-GDP, where the debt itself causes reduced confidence in growth prospects partly due to fear of higher taxes or inflation, which results in a material decline in growth relative to long-term trends. This is where the debt death spiral begins. The United States is well past the 90 percent death spiral trigger level and the situation grows worse by the year.

  These headwinds insure Trump’s growth projections are unrealistic. With higher than expected deficits, and lower than projected real growth, there is one and only one way for the Trump administration to reduce the debt ratio before a crisis of confidence emerges—inflation. If inflation increases to 4 percent, and Federal Reserve financial repression can keep a cap on interest rates at around 2.5 percent, and if there is no recession, then it is barely possible to achieve 6 percent nominal growth with 5 percent deficits—just enough to keep the debt ratio under control and even reduce it slightly. Still, this scenario is unlikely. The Fed failed to generate more than 2 percent inflation for seven years. It’s not clear how it could create 4 percent inflation in the near term. Five percent deficit projections are also unrealistic because of the tax cut, sequester relief, student loan defaults, and other adverse factors. A U.S. debt death spiral is now likely.

  Conspiracy of Looters

  Recent vacillation between prudence and neglect on debt is nonpartisan. Administrations that greatly increased the debt-to-GDP ratio in the past forty years included three Republicans—Ronald Reagan, George W. Bush, and Donald Trump—and one Democrat, Barack Obama. Presidents who held the line and either maintained or reduced the debt-to-GDP ratio included one Republican, George H. W. Bush, and one Democrat, Bill Clinton. Neither party bears exclusive blame for out-of-control debt. Both parties bear some blame, while both parties have held the line at different times.

  The control variable on deficit spending is not the party in the White House, it’s the mood of Congress regardless of party control. Congress was supportive of Reagan’s tax cuts in response to 1981’s severe recession. Congress was also supportive of greatly increased defense spending under Reagan because defense had been neglected by Jimmy Carter, and because of the threat posed by the Soviet Union, which Reagan identified as the “evil empire.” Similarly, Congress cooperated in a bipartisan way to raise taxes and reduce spending in 1990 during the Bush 41 administration. By then, the Berlin Wall had fallen, the Soviet Union was disintegrating, and the United States was the sole hegemonic power. Conservative Republicans wanted to get spending under control, while Democrats insisted on tax increases as the price of their support for spending cuts. In 1990, Congress did both. Bill Clinton also raised taxes in 1993, but wanted more spending to go along with the new tax revenue. After losing control of the House of Repres
entatives to Newt Gingrich and the Republicans in the 1994 midterm elections, Clinton too had to go along with spending cuts. The result not only reduced the deficit, it ultimately produced budget surpluses in Clinton’s final years in office. Deficits are not so much a product of White House wish lists as of shared priorities between the White House and Congress.

  The increase in defense spending included in the February 2018 bipartisan budget deal that eliminated sequester caps on all discretionary spending is just a down payment. Defense spending cycles can run ten years or more, followed by equally long spending droughts as reaction sets in. As the military purchases existing weapons systems, develops new ones, upgrades capabilities, and replenishes depleted cruise missile stocks, that expanded capacity requires costly maintenance, training, and deployment. As long as Democrats insist on near dollar-for-dollar domestic spending as the price of military spending, the $300 billion deficit impact for 2018 is expected to grow to $400 billion per year or higher in 2019 and stretch for years beyond.

  Republicans are mostly to blame for the Trump tax-bill fiasco. Democrats are mostly to blame for the domestic spending pig-out. The White House went along with all of it. The two major political parties are in this debt debacle together at the expense of everyday citizens who suffer the consequences of slower growth and higher interest rates. America’s solvency is now threatened.

  In addition to tax cuts, budget cap riddance, and other drivers of increased debt, one must consider an 800-pound gorilla in the room no one in Washington, D.C., wants to acknowledge—student loan debt. Total student loans outstanding in 2019 are over $1.6 trillion. To put that in perspective, the total amount of subprime and other high-risk mortgages outstanding in 2007 at the start of the mortgage meltdown was $1 trillion. The student loan debt pile is more than 50 percent larger than the junk mortgage pile in the last financial crisis. The $1.6 trillion figure is not a static amount. It will grow to $1.7 trillion by 2020 and continue growing after that. Student loans are a greater financial threat than mortgages, because default rates are higher. At the height of the 2007–2008 mortgage crisis, default rates on all mortgages were just over 5 percent. That’s historically high for mortgages, yet manageable. Student loan default rates are in excess of 15 percent and growing rapidly.

  Reasons for this high default rate are diverse. Student loans are given out to part-time and full-time students in qualified schools regardless of income, assets, or credit history. Many borrowers lack basic financial literacy. Borrowers don’t realize how much debt they are taking on relative to their earnings prospects. Students graduate from school a hundred thousand dollars in debt only to discover they can’t get jobs paying more than minimum wage. They move back into their parents’ homes and hope for the best. Within months the student borrowers are in arrears on debt payments. Interest and penalties accrue, and soon the outstanding debt has grown by 50 percent because of the compounding effects.

  Student-loan defaults impact the budget deficit because approximately 90 percent of all student loans are guaranteed by the U.S. Treasury. These guaranteed loans are originated by banks and serviced by banks or specialist loan-servicing companies. Treasury guarantees are off the books from a federal budget perspective as long as the loans are performing. When the loans first go into arrears, lenders and servicers work with borrowers to resolve the case. Grace periods on late payments are allowed. Certain types of public service can result in loan-payment deferrals or forgiveness. In some cases, consolidation refinancings can be used to stretch out maturities and lower monthly payments. As long as these workout processes are ongoing, the bad debt does not hit the Treasury’s books. This extend-and-pretend charade has been going on for years. Increasingly banks are hitting the end of the line with borrowers and demanding payment from the Treasury. At a certain point, the Treasury pays off the bank lender and assumes ownership of the loan file sitting with the servicer.

  Arrears were exacerbated by 2016 presidential election rhetoric. Candidates Hillary Clinton and Bernie Sanders understood that younger voters were distressed about their student loan debt loads. Both proposed various forms of relief, including loan forgiveness and free tuition for new students. Millennials heard the campaign promises and some simply stopped paying their loans in anticipation of a Clinton victory and a debt jubilee. The Clinton victory never came; a wave of debt defaults did. This campaign promise bait and switch will be more pronounced in the 2020 presidential election cycle as Democratic candidates polish their debt relief proposals. Another spike in defaults based on false hopes is coming.

  The student loan fiasco has negative economic effects that go beyond the deficit. When young adults go into arrears on their student loans, their credit ratings take a hit. A poor credit rating makes it more difficult to get a job, rent an apartment, qualify for a mortgage, or get a car loan. Student loan arrears and bad credit ratings are standing in the way of household formation and consumption that comes with it from purchases of furniture, appliances, linens, and the like. The student loan headwind hits the denominator of the debt-to-GDP ratio through slower growth and hits the numerator through higher deficits; it’s a double whammy in terms of U.S. capacity to sustain its national debt. A microburst of student loan losses is about to hit the U.S. Treasury. Losses will be $200 billion per year or higher based on current default rates. This default wave is not properly accounted for in official budget deficit estimates, yet defaults will increase the deficit by additional hundreds of billions of dollars in 2019 and beyond. Failure to address this issue intelligently with financial counseling and better loan underwriting is another example of bipartisan neglect.

  The Point of No Return

  A venerable dictum in economics is that if something can’t go on forever it won’t. The U.S. debt-to-GDP ratio is approaching the point at which it cannot expand much further without inducing a crisis of confidence. The United States will never default on its debt because the Fed can print the money to pay it off. Inflation is an all-purpose remedy for excess debt. The issue is how the inflation is catalyzed, since central banks seem incapable. Major U.S. creditors such as foreign central banks, sovereign wealth funds, and large institutions won’t wait for the other shoe to drop. They’ll look at trends, see that inflation is the only way out from under the debt, and shift assets from dollars in anticipation. This dollar dumping will depress the dollar’s exchange value, increase Treasury borrowing costs, and catalyze a debt death spiral. It is this shift in investor perceptions, a psychological phenomenon, that triggers inflation more than central bank policies. The difficulty for policymakers and bankers is that the shift can happen almost overnight. Inflation can emerge seemingly from nowhere.

  Critics of this debt-bomb scenario have a simple rebuttal. Unlike Greece or Argentina, U.S. debt is denominated in a currency the United States can print. No matter how high the debt is or how high interest rates go, the Treasury can simply sell the debt to the Fed directly or indirectly through bank primary dealers. The Fed prints the money to pay for the debt and stows the debt away on the Fed’s balance sheet until maturity. The flaw in this reasoning is the assumption of unlimited confidence in the dollar’s value. In this view, no amount of money printing or borrowing can shake confidence in the dollar, in part because of legal tender laws, and in part the necessity of citizens to acquire and hold dollars to pay their taxes. Yet this view ignores history, psychology, and common sense. Confidence in money is fragile, easily lost, and impossible to regain.

  Even if dollars can be created in unlimited quantities (they can), and required in payment of taxes (they are), this does not mean that citizens can be forced to hold dollars beyond what is needed for tax payments. Citizens can allocate after-tax funds to other assets such as land, natural resources, fine art, or private equity. Citizens can also dump their dollars for food on the shelf, gas in the car, new clothes, other necessities, and even luxuries, vacations, and costly gifts. As citizens race to dump dollars for readily available alternatives, the result
is a higher velocity of money on top of a bloated money supply. The quantity theory of money shows that expansion in money supply and an increase in money velocity together in excess of the economy’s potential growth rate must result in inflation.

  Central banks have failed to achieve desired inflation levels in the past ten years, not for want of trying. The Fed expanded the money supply with ease while assuming velocity would follow. It hasn’t. Velocity plunged for the past twenty years. The Fed does not grasp that velocity is a behavioral variable rather than a constant or linear function. Psychologically driven behavior can change instantaneously once a critical threshold is exceeded. Physicists call this a phase transition. Mathematicians call it hypersynchronicity. Wall Street analysts call it a black swan without necessarily understanding the dynamics behind it.

  Whatever the name, the result is the same—an instantaneous loss of confidence in the dollar and a sustained desire to dump dollars in favor of other currencies, hard assets, or goods and services. Higher inflation, even hyperinflation, is the inevitable result.

  Investment Secret #2: Prepare for slow growth and periodic recessions for decades to come.

  Even the most generous forecasts, including those of the Congressional Budget Office, show a steady increase in the U.S. debt-to-GDP ratio over the next five years and an exponential increase beyond that as baby boomers retire in increasing numbers and the prime-age workforce shrinks. These forecasts most likely overestimate growth and revenues due to persistent model error. More realistic models show the U.S. debt-to-GDP ratio will surpass 115 percent by 2023.