ECONOMIC

ARMAGEDDON
“Over the last four years, Congress’ solution to our budget crisis has been a temporary patchwork
of fiscal Band-Aids, passed at the stroke of midnight before critical deadlines,” said Delaware
Congressman John Carney.
Congressman Daniel Webster of Florida added that “American taxpayers deserve to have a full and
transparent accounting of the financial situation of our country.”
The thing is, taxpayers already have access to this information. It’s just not coming from the government.
Academic researchers such as James D. Hamilton, professor of economics at University of California,
San Diego, have spent years trying to figure out just how far into debt the U.S. government has fallen.
Now, the on-the-books figure most often cited when people discuss U.S. government debt is about
$18 trillion. This is an astounding, nearly inconceivable amount of money. In terms that are easier to
understand, the U.S. federal debt doubled as a percentage of GDP between 2007 and 2013.
But as Hamilton and others have shown, this is only a fraction of the true debt burden.
You see, the government’s accounting methods favor “off-balance-sheet liabilities” that keep the total
debt number from ballooning to even more atmospheric heights. An accurate picture of the total debt
would include these off-balance-sheet liabilities, which, according to Hamilton, amount to an incredible
$70 trillion as of 2012. This means the total debt is at least $88 trillion, nearly five times higher than what
appears on the balance sheet.
If you’re wondering how any government could possibly pay back such an enormous sum, you’re not
alone.
A 2015 Government Accountability Office report states that, over the next several decades, we should
expect huge growth in government liabilities that aren’t included in the officially reported numbers.
The biggest category of off-balance-sheet liabilities comes from the additional funds needed to fulfill
commitments to Social Security and Medicare participants.
The situation is so dire that if the U.S. federal government was an American company operating to
Financial Accounting Board Standards, it would’ve already filed for bankruptcy protection.
Thus, it’s worth wondering how much longer the government can maintain its fiscal facade.
Let’s first take a closer look at James Hamilton’s report, which provides a clear-eyed picture of the
government’s debt disaster. Then, Wall Street Daily’s Chief Income Analyst, Alan Gula, will provide an
economic outlook for 2016 so we can see where the greatest short-term risks lie.
THE HAMILTON REPORT
In 2014, James D. Hamilton, a professor of economics at University of California, San Diego,
published a paper on off-balance-sheet liabilities.

Specifically, he wanted to see just how much the government could be on the hook for in terms of
“implicit or explicit government guarantees and commitments.” His survey covered housing, other
loan guarantees (such as student debt), deposit insurance, Federal Reserve actions, and government
trust funds.

What he found was astonishing.

As the following chart shows, the government’s off-balance-sheet liabilities come to a whopping
$70 trillion – even accounting for a positive return from Federal Reserve activities!

According to Truth in Accounting,

the “accumulation of off-balance-
sheet obligations and related
accounting chicanery have played
an important role in historically
significant financial meltdowns in
the private sector.”

And now, it’s happening in the

public sector, as well.

Basically, there are five parts to the

equation: housing, other federal loan
guarantees such as post-high school
education, federal deposit insurance,
the Federal Reserve, and federal
government trust funds (such as
Social Security).

Interestingly, Hamilton calculates

that the Federal Reserve was actually
a net positive for the balance sheet,
to the tune of about $1.13 trillion.

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He admits that the Fed’s assets are greatly
expanded relative to historic levels, but he
found in his calculation that most of these
Recently, I sat down with former U.S.
new assets were already liabilities of the Treasury advisor and global merchant
broader government. banker, Martin Hutchinson, to discuss
the impending crash – likely to occur
Unfortunately, the Fed’s net positives within the next year – that’s the
hardly made a dent in the total debt inevitable result of ultra-low interest
figure. rates, extreme confidence, and
overbuilding.
In housing, Fannie Mae and Freddie
Mac were responsible for the majority According to Martin, one of the biggest
signs of an impending crunch is when
of the government’s liabilities. Hamilton
corporate and consumer debt levels
notes, “Because both Fannie Mae and are rising faster than the rate of GDP
Freddie Mac were originally created by growth.
an act of Congress, they are referred to
as ‘government-sponsored enterprises’ Martin also indicates that the junk
(GSEs).” And after Fannie and Freddie bond market is beginning to fall apart,
were placed into conservatorship in 2008, which is a potential catalyst for a series
of events like we saw during the 2007
their debts became the debts of the federal
through 2009 Great Financial Crisis.
government (if they hadn’t already been). Finally, Martin sees reckless monetary
policy, with relatively cheap and easy
In total, the off-balance-sheet debt burden money, leading to a misallocation of
from housing totaled more than $7.5 resources and overbuilding.
trillion in 2012.
The end result likely won’t be pretty.
Next we have federal loan guarantees,
specifically student debt. By now, most
people are aware that the student debt
bubble has reached historic proportions.
According to the White House, roughly
70% of bachelor’s degree recipients are
leaving college with student loan debt.
In total, these students have accumulated
about $1.2 trillion worth of debt, the
second-highest level of consumer debt
behind only mortgages. CLICK HERE TO VIEW THIS VIDEO >>
Worst of all, it’s become apparent that

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students aren’t prepared to pay back their debt. According to the Consumer Financial Protection
Bureau, one in four student borrowers is either in delinquency or default – and that number is
trending upward quickly. With so much inertia in favor of simply forgiving large student debts, it
seems to be only a matter of time before this bubble bursts.

Next up is federal deposit insurance. The Federal Deposit Insurance Corporation (FDIC) was
created as part of the 1933 Banking Act to insure small depositors in the event that their banks
became insolvent. During the financial crisis, the number of insured deposits rose swiftly, and
the FDIC also increased the limit on deposit insurance from $100,000 to $250,000. At the time
Hamilton’s report was published, FDIC-insured deposits totaled $5.9 trillion.

Finally, we have federal government trust funds. According to Hamilton, the budget impact
associated with an aging population and other challenges could turn out to have much more
significant fiscal consequences than even the mountain of on-balance-sheet debt already
accumulated.

Basically, Medicare and Social Security are a massive anchor threatening to drag the U.S.
government under. And the problem is only getting worse as the population ages and as interest
rates begin to normalize.

Most projections call for interest rates to rise back to more usual historical levels over the next
several years. For example, the consensus Blue Chip Financial Forecast anticipates a yield on 10-
year Treasury bonds of 4.7% by 2017 (Bernanke 2013).

Returning to those levels of interest rates – or the even higher rates seen on average during the
1990s – would mean a doubling or tripling of the government’s current annual interest expense,
even without further increases in federal debt from now on. Worse yet, the only way to stem the
bleeding is for the government to start spending way less and start taxing way more – immediately.
I’ll let you guess what the odds of that happening are.

Indeed, things are likely going to get worse before they get better. Regarding the short-term risks
to the economy, our Chief Income Analyst, Alan Gula, has provided the following 2016 economic
outlook. It’s an insightful look at a very precarious situation.

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ECONOMIC OUTLOOK 2016
By Alan Gula, Chief Income Analyst

Economic growth is much slower than economists have predicted. In December 2014, the Fed
governors expected the economy to expand at a pace of 2.6% to 3.0% (central tendency of real GDP
growth).

Actual 2015 growth wound up around 2.1%. That’s below even the 2.5% expansion posted in 2014, as
I warned it would be in last year’s economic outlook. Yet, in spite of flagging GDP growth and sub-
2% inflation, the Fed decided to raise short-term interest rates.

Meanwhile, collapsing crude oil and natural gas prices have turned the energy sector into an
anchor around the neck of the U.S. economy. According to Goldman Sachs, 30% of total S&P 500
capital expenditures (capex) came from the energy sector in the last 12 months. That’s still the
highest percentage of any sector.

Add on the materials and industrials sectors, and we’re talking about 45% of total U.S. capex. Don’t
let anyone tell you these sectors don’t matter anymore in our “technology- and services-driven
economy.” In 2015, capex – which serves as a powerful economic stimulus – likely experienced its
first annual decline since 2009. As I
see it, lower corporate spending is
still an underappreciated economic
headwind.

Here are a few more issues that

should concern economists and
investors in 2016.

1) EXCESS INVENTORIES
The following chart shows the
total inventory-to-sales ratio for
U.S. retailers, manufacturers, and
wholesalers:

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 The ratio experienced a dramatic decline in the 1990s and early 2000s, likely due to improving
supply chain efficiencies. Then, as sales plummeted during the Great Recession, there was
a massive spike in the ratio. The excess inventory of unsold goods was worked off fairly
quickly, but there was a lot of pain associated with that process.

Now, relative inventory levels are slowly inching their way back up. By digging a bit further,
we can see that declining sales is a big part of the problem:

Every single month in 2015 has

seen lower total business sales
on a year-over-year basis. In
fact, the data appear downright
recessionary when compared with
the declines in the shaded areas.
And the Fed is hiking rates!

Businesses are dreaming if they

think a burst of sales is imminent.
If you build it, they may not come.
Inventory levels will need to
be rightsized, likely through a
combination of slower production
rates and inventory liquidation.
Headline GDP growth figures will
suffer as a result.

2) RISING HEALTHCARE AND RENT COSTS

According to the Centers for Medicare & Medicaid Services, U.S. healthcare expenditures
amounted to $9,523 per person in 2014. That’s up 5.3% over the previous year. Astoundingly,
the cost of prescription drugs surged 12.2% in 2014.

Insurance companies are passing these costs along to consumers in the form of higher
health insurance premia and deductibles.

Ironically, the Affordable Care Act (Obamacare) is helping to make healthcare less
affordable. And according to the White House, the cost of a benchmark Obamacare plan will
increase by an average of 7.5% in 2016.

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 Naturally, if you spend more on health insurance and out-of-pocket healthcare expenses
each month, then you have less money for discretionary purchases – like eating out or
buying a car. Also, if you save on gasoline but spend more on healthcare, then that’s a wash.

By this same logic, rising rents are crimping discretionary spending, as well.

The U.S. homeownership rate is at its lowest level since the 1960s. More and more people
are renting, and rental costs are rising far faster than stagnating wages. Average rents have
increased by 3.6% over the past year and have surged 12.7% since the beginning of 2012.

According to a study conducted by Zillow, renters can now expect to put around 30% of
their monthly income towards rent. That’s the highest percentage ever. The rent (and health
insurance) is too damn high.

3) IMPENDING CREDIT CRUNCH

According to Standard & Poor’s, the trailing 12-month high-yield corporate bond default rate
was 2.8% in November 2015. The high-yield default rate reached over 10% in 1991, 2001, and
2009. Thus, we have a long way to go before the default rate peaks.

Credit distress will spread over the next couple of years because a feedback loop has
begun. An increasing default frequency will lead to falling asset prices, tightening lending
standards, and even more defaults. Basically, the credit cycle has turned, and we’re now
going to have a credit crunch (a crunch is somewhere between a pinch and a crisis).

An abundance of credit is necessary for our overly indebted economy to grow. Companies
and individuals will increasingly find it harder to borrow money, and this impending credit
contraction will deprive the economy of its lifeblood.

One final note: Many economists are missing this nascent economic downturn because
they’re on the lookout for the next Great Recession. But the next recession won’t look
anything like the last one.

The U.S. banking system is in much better shape than it was during the last recession.
However, even though there may be less contagion risk in the financial system, this doesn’t
mean we shouldn’t be worried. The probability of a U.S. recession continues to rise against
the backdrop of a weak global economy.

Consumer spending comprises around 70% of the U.S. economy, and consumer spending

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growth peaked in January 2015. At that time, the year-over-year increase in real personal
consumption expenditures (PCE) was 3.8%. As of November, real PCE growth has moderated
to 2.5%.

A vicious cycle has started. Lower consumer spending will result in lower production, which
will translate into fewer jobs being created. Slowing employment growth will negatively
impact consumer spending, and so on and so forth. Based on the risks and headwinds I’ve
discussed, I believe we’ll see real PCE growth slow to below 2.0% in 2016. At that point, a
bona fide recession will be at the doorstep.

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