If we forget debt, we’re damaged

I have amnesia of sorts. I remember almost nothing of my distant past — a condition that at the brink of my 69th year is neither fatal nor debilitating but which leaves me anchorless. Actually, I do recall some things, but they are hazy, almost fairytale fantasies, filled with a lack of detail and usually bereft of emotional connections. I recall nothing specific of what parents, teachers or mentors said; no piece of advice; no life's lessons. I'm sure there must have been some — I just can't remember them. My life, therefore, reads like a storybook filled with innumerable chapters, but ones which I can't recall having read.

LOST ON MEMORY LANE

I had a family reunion of sorts a few weeks ago when my sister and I traveled to Sacramento to visit my failing brother — only 18 months my senior. After his health issues had been discussed, we talked about old times. Hadn't I known that Dad had never been home, that he had spent months at a time overseas on business in Africa and South America? “Sort of, but not really,” I answered — a strange retort for a near-adolescent child who should have remembered missing an absent father. Didn't I know that our parents were drinkers; that Mom's “gin fizzes” usually began in the early afternoon and ended as our high school homework was being put to bed? “I guess not,” I replied, “but perhaps after the Depression and World War II, they had a reason to have a highball or two, or three.”

My lack of personal memory, I've decided, may reflect minor damage, much like a series of concussions suffered by a football player. Somewhere inside of my still-intact protective helmet or skull, a physical or emotional collision may have occurred, rendering a scar which prohibited proper healing. Too bad. And yet we all suffer damage in one way or another, do we not? How could it be otherwise in an imperfect world filled with parents, siblings and friends with concerns of their own for a majority of the day's 24 hours? Sometimes the damage manifests itself in memory “loss” or repression, sometimes in self-flagellation or destructive behavior toward others. Sometimes it can be constructive, as when those with damaged goods try to help others even more damaged. Whatever the reason, there are 7 billion damaged human beings walking this earth.

ALWAYS A CLEAN START

For me, though, instead of losing my mind, I've simply lost my long-term memory. It's a damnable state of affairs for sure — losing a chance to write your autobiography and any semblance of recalling what seems to have been a rather productive life. But I must tell you — it has its benefits. Each and every day starts with a relatively clean page, a “magic slate” of sorts where you can just lift the cellophane cover and erase minor transgressions, slights or perceived sins of others upon humanity. I get over most things and move on rather quickly. So there are pluses and minuses to this memory thing, and like most of us, I add them up and move on. If that be the only disadvantage on my life's score card — and there cannot be many — I am a lucky man indeed.

DAMAGE OF THE FISCAL KIND

In last month's blog, I promised to write about damage of a financial kind — the potential debt peril — the long-term fiscal cliff that waits in the shadows of a New Normal U.S. economy, which many claim is not doing that badly. After all, despite approaching the edge of 2012's fiscal cliff with our 8% of GDP deficit, the U.S. is still considered the world's “cleanest dirty shirt.” It has federal debt/gross domestic product of less than 100%, triple-A/double-A-plus credit ratings, and the benefit of being the world's reserve currency — which means that most global financial transactions are denominated in dollars and that our interest rates are structurally lower than other triple-A countries because of it. We have world-class universities, a still relatively mobile labor force and apparently remain the beacon of technology — just witness the never-ending saga of Microsoft, Google and now Apple. Obviously, there are concerns, especially during election years, but are we still not sitting in the global economy's catbird seat? How could the U.S. still not be the first destination of global capital in search of safe (although historically low) prospective returns?

Well, Armageddon is not around the corner. I don't believe in the imminent demise of the U.S. economy and its financial markets. But I'm afraid for them. Apparently, so are many others, among them the [International Monetary Fund], the [Congressional Budget Office] and the [Bank of International Settlements]. I hold on my lap as I write this the recently published annual reports for each of these authoritative and mainly nonpolitical organizations, which describe the financial balance sheets and prospective budgets of a plethora of developed and developing nations.

When all of them speak, we should listen, and in the latest year, they're all speaking in unison. What they're saying is that when it comes to debt and to the prospects for future debt, the U.S. is no clean dirty shirt. The U.S., in fact, is a serial offender, an addict whose habit extends beyond weed or cocaine and who frequently indulges in budgetary crystal meth. Uncle Sam's habit, these respected agencies contend, will be a hard (and dangerous) one to break.

HOW BIG IS THE GAP?

What standards or guidelines do their reports use, and how best to explain them? Well, the three of them all try to compute what is called a “fiscal gap,” a deficit that must be closed either with spending cuts, tax hikes or a combination of both that keeps a country's debt/GDP ratio under control. The fiscal gap differs from the “deficit” in that it includes future estimated entitlements such as Social Security, Medicare and Medicaid that may not show up in current expenditures. Each of the three reports targets different debt/GDP ratios over varying periods of time, and each has different assumptions as to a country's real growth rate and real interest rate in future years.

A reader can get confused trying to conflate the three of them into a homogeneous “fiscal gap” number. The important thing, though, from the standpoint of assessing the fiscal “damage” and a country's relative addiction, is to view the U.S. in comparison with other countries, to view its apparently clean dirty shirt in the absence of its reserve-currency status and its current financial advantages, and to point to a more distant future 10 to 20 years down the road, at which time its debt addiction may be life-, or certainly debt-threatening.

To keep our debt/GDP ratio below the metaphorical combustion point of 212 degrees Fahrenheit, these studies (when averaged) suggest that we need to cut spending or raise taxes by 11% of GDP and rather quickly — over the next five to 10 years. An 11% “fiscal gap” in terms of today's economy speaks to a combination of spending cuts and taxes of $1.6 trillion per year. To put that into perspective, the CBO has calculated that the expiration of the Bush tax cuts and other provisions would reduce the deficit by only a little more than $200 billion. As well, the failed attempt at a budget compromise by Congress and the president — the so-called Supercommittee “Grand Bargain” — was a $4 trillion battle plan over 10 years worth $400 billion a year. These studies suggests that close to four times that amount will be needed in order to douse the inferno.

And look at who's in that ring of fire alongside the U.S. There's Japan, Greece, the U.K., Spain and France, sort of a rogues' gallery of debtors. Look as well at which countries have their budgets and fiscal gaps under relative control: Canada, Italy, Brazil, Mexico, China and a host of other developing — as opposed to developed — countries. As a rule of thumb, developing countries have less debt and more underdeveloped financial systems. The U.S. and its fellow serial abusers have been inhaling the meth crystals of debt for some time now, and kicking the habit appears incredibly difficult.

America's abusive tendencies can be described in more ways than an 11% fiscal gap and a $1.6 trillion current-dollar hole which needs to be filled. It's well-publicized that the U.S. has $16 trillion of outstanding debt, but its future liabilities in terms of Social Security, Medicare and Medicaid are less tangible and more difficult to comprehend. Suppose, though, that when paying payroll or income taxes for any of the above benefits, Americans were issued a bond that they could cash in when required to pay those future bills. The bond would be worth more than the taxes paid because the benefits are increasing faster than inflation. The fact is that those bonds today would total nearly $60 trillion, a disparity that is four times our publicized outstanding debt. We owe, in other words, not only $16 trillion in outstanding Treasury bonds and bills but $60 trillion more. In my example, it just so happens that the $60 trillion comes not in the form of promises to pay bonds or bills at maturity but the present value of future Social Security benefits, Medicaid expenses and expected costs for Medicare. Altogether, that's a whopping total of 500% of GDP.

So how can the U.S. not be considered the first destination of global capital in search of safe (although historically low) returns? Easy answer: It will not be if we don't address our fiscal gap.

DISMAL FISCAL FUTURE

If we continue to close our eyes to existing 8%-of-GDP deficits, which, when including Social Security, Medicaid and Medicare liabilities, composes an average estimated 11% annual fiscal gap, we will resemble Greece before the turn of the next decade. Unless we begin to close this gap, our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation will follow and the dollar will inevitably decline. Bonds would be burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive.

If that be the case, the U.S. will no longer be in the catbird's seat of global finance and there will be damage aplenty, not just to the U.S. but to the global financial system itself, a system that for 40 years has depended on the U.S. economy as the world's consummate consumer and the dollar as the global medium of exchange.

Bill Gross is the founder and managing director of Pacific Investment Management Co. LLC. This commentary originally appeared on the firm's website.