Off Topic :: The Big Short:: What is the lesson?

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Hi all, last week I watched the movie “The Big Short”. It is both entertaining and somehow concerning. One of the lessons is that if people are incentivized to see a certain picture they will ignore the underlying fundamentals and stick to a false reality.

One of the topics that really bothers me is the National Debt. It is now more than 18.2 Trillion dollars that is:
18.2 x 10^12.
This debt is in terms of Treasury bonds that are sold to investors.
Who are these investors?
Mostly Pension Funds, The public, some of it is held by China and other countries that we have trade deficit with.
Means that the US is paying interest on this debt. I assume that this days the interest paid is about 2.5% (That is the 10 years Treasury interest rate).

So we pay 2.5 x 10^-2 * 18.2 10^12 which is about 45 10^10 = 450 Billion dollars.
The Federal budget is 2 Trillion dollars, so 22% of our Federal budget is going to service this debt.

What is going to happens when the interest rate is going to hit 6%?

USA will have to pay 8% or more on new issues bonds. So within a few years the annual interest will be about.

6 x10^-2 x 18.2 x 10^12 which is about 1 Trillion dollars.
With more than 1/2 of the budget going to be paid for just the interest it is not sustainable.

US, will default on its debt… (like Greece).
Of course Greece couldn’t print Euros but the USA can (and did) print as many US dollars as they want.

Politicians always choose to kick down the can, they will choose to print more dollars to pay the debt.

This is a likely scenario, the only question is when this will happen…
Peter Schiff has been calling for that for years (at least five). With current low inflation the interest rate can stay low for a prolonged time.

What does it mean for us?
A crisis is looming, it may take years to materialize. The most likely result is high inflation in the US.
For me the lesson is to avoid long term fixed return vehicles like annuities, one can get caught in it while inflation is sky rocketing.
There are more potential bad news there (like an Austerity period, the collapse of Social Security and Medicare and the list goes on).

Happy New Year All!
Shuki

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Shuki,

Thou didst violate Saul’s 10 Commandments by bowing thyself down unto irrelevant discussions, see http://discussion.fool.com/sauls-10-commandments-32044783.aspx?s….

In the past, Saul has specifically asked that posts like yours be posted on boards like Macro Economic Trends and Risks, http://discussion.fool.com/macro-economic-trends-and-risks-11490… , or Free For All Economics, http://discussion.fool.com/free-for-all-economics-117500.aspx.

While I agree with you that our National Debt is a problem that warrants discussion (it should also include that our prodigal lifestyle is financed by many developing nations who are forced to back up their own currencies with USD), this post does not by any stretch of the imagination conform to Saul’s guidelines for his board.

Should we perhaps have a rule that posts that do not belong here be removed?

im

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What is going to happens when the interest rate is going to hit 6%?

That is going to take a long time to happen, probably not within the next decade.

USA will have to pay 8% or more on new issues bonds. So within a few years the annual interest will be about.

Why do you think that the US would have to pay 8% or more on newly issued bonds?
And the average maturity of US treasuries right now is 63.9 months, so it’ll take more than a few years for treasury interest rates to increase to that level.

I predict that it’s very unlikely that the US will at any point during the next 20 years pay more than a 6% interest rate on its debt overall.
And that will only happen in the presence of substantial growth (3%?) AND normalized inflation (2%).
As a result, economic growth and inflation will absorb the increased interest rate burden.

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Shuki,

It is an interesting post and an interesting thing to think about. I think this topic and this discussion is relevant to this board.

Let’s analyze this a little more.

Ok, assuming your numbers are correct, servicing the debt currently consumes 22% of the Federal budget. I don’t think that this number is necessarily alarming. It’s not how I would run my personal finances, but the system is currently dependent on people working for money so they can pay taxes. If everyone ran their personal finances like I did then there wouldn’t be a huge work force and the system would cease to function. I digress.

OK, for interest rates to rise, there will have to be additional economic growth and inflation of 2-2.5%. If growth and inflation are absent then interest rates will remain low. Now if we can get 3% economic growth (reasonable assumption) then the GDP increases. GDP is about $18 trillion. In 10 years with 3% growth and a similar tax code, the GDP will reach around $24 trillion and the tax revenue will also increase by about 25%. When the growth rate exceeds the interest rate then we see improving finances (assuming spending increases are in line or less than additional revenue).

So to say that the federal debt is a big problem and that we are doomed is not certain. It really depends on a number of factors including the economic growth rate, interest rates (which are influenced by the growth rate), changes in Federal spending, and some other factors.

One of the lessons is that if people are incentivized to see a certain picture they will ignore the underlying fundamentals and stick to a false reality

Perhaps part of the false reality is the assumption that the current debt burden is a huge problem.

Chris

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Loved the film by the way. Everyone who remembers 2008 should see it. And if you are too young to remember 2008 you probably should see it to know what everyone else is talking about. And it’s fun besides. What more could you ask.

Saul

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I think this topic and this discussion is relevant to this board.

There is a perspective which will allow any topic to be relevant to any board … especially if someone else has already posted on it and one has a different point of view.

I suggest, however, that the whole point of having thousands of different boards is so that one can focus discussions for those interested in the topic. Some here are undoubtedly interested in the topic and have opinions about it … but that is not why they follow this board.

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Perhaps part of the false reality is the assumption that the current debt burden is a huge problem.
You are assuming that there will be no inflation ever…
And staying in an interest rate close to zero is the norm, even though the Federal bank already started raising in fear of possible inflation…
They actually stated that the low inflation is due to transitory conditions (Low commodity prices mainly OIL).
And that the National Debt (it was 16 Trillions just two years ago) will stop increasing…

If all the above assumptions remain in tact, you are right. I think this is a lot to assume. The false reality is that we can keep on spending while writing IOU’s and taking lawns. I think this is going to implode in our lifetime.

Sorry to be so realistic.
Anyhow, Happy New Year All!
Shuki

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Hi Shuki,

I think a more likely scenario is a yield curve inversion rather than interest rates on US debt reaching 6-8%. The fed can only set a target for the short end of the yield curve. Investors set the interest rates by the price they are willing to pay for the bonds. The US still has comparatively high interest rates compared to the rest of the developed world, and commodity prices are showing more deflation than inflation.

The US can’t default, as the fed can just print money to fund the payments… at least until people stop buying the bonds. That is the only way long term rates will rise.

I think that technology trends have really disrupted the way classical economists view inflation. It is going to take some time for them to catch up, but they are usually wrong anyway. It’s kinda like the quote “In theory, theories should work in reality”

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"a yield curve inversion "

Any significant yield curve inversion (sometimes hard to define ,which specific yields are you talking about) will be a signal for me to gradually start some stock selling, building cash. This bull market is already old,. And the S&P 500 may be starting to form the right shoulder of a head and shoulders top, but it is too soon to be sure
.
At this stage of this bull market conserving capital for the next bear market bottom has become more important to me than trying for a few extra dollars,. Even though none of my “bear market has started” signals are flashing yet. And the interventionist Fed Reserve may have short circuited some classical signals.

Economist look backward and use old sometimes flawed data. You will not get much of an idea about future markets listening to them.