Deep Space

I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market – James Carville 

The night sky has been alluring to man for centuries.  Planets, constellations and nebulae crisscross the black canvas of the night sky illuminating the secrets of the universe…..for those intelligent enough to interpret them.  

Astronomy is a science that few understand well.  Parts geology, physics, and chemistry with a healthy underlying foundation of math (think of calculating light years) it is certainly not a pure discipline.  

Amongst the most aesthetically pleasing nocturnal sights can be vast clouds of gasses called nebula.  The night sky is not all fun and games; however, as there are exploding stars, asteroid belts and ….the infamous black holes.  

Black holes are amongst the most fearful creations in the universe.  Let go to Wikipedia for the definition: 

A black hole, according to the general theory of relativity, is a region of space from which nothing, including light, can escape. It is the result of the deformation of spacetime caused by a very compact mass. Around a black hole there is an undetectable surface which marks the point of no return, called an event horizon 

The defining feature of a black hole is the appearance of an event horizon—a boundary in spacetime through which matter and light can only pass inward towards the mass of the black hole. Nothing, including light, can escape from inside the event horizon. 

Alright …alright…fine…we’ll get right to it.  

Most people are obsessed with the stock market as it’s fairly easy to understand.  “I buy a share of ownership in a company and I get either a slice of the profits or the value of my share goes up, or hopefully both. 

As much attention as the stock market receives; however, it never comes close to having the degree of impact on a society that the bond market does. 

Similar to astronomy, the credit markets are an area of economic activity that is poorly understood my most.  Pricing in the bond market is based on things most people have never heard of, let alone think about.  Factors such as credit risk, funding risk, collateral risk, etc determine pricing.  

Regular readers of the Recon know that debt is a subject we have discussed at length.  There have been various points where we have noted the danger of too much debt and some of the associated consequences.  

What we haven’t done is explained how continual use of debt compounds on itself to create the much feared “death spiral” often discussed in the worldwide credit markets. 

 When a country spends more than it collects in taxes it has to borrow the difference.  When a country continually spends more than it collects in taxes it must borrow the difference and roll over the previous debt as well.  

This causes the total amount of debt to increase exponentially as the country must borrow to pay its current year expenditures, borrow to refinance its prior years expenditures and borrow to pay the interest on all of its debt.  

The death spiral occurs when investors lose faith in the country’s economy or leadership.  The bond traders then demand a higher rate of interest.  The higher interest payments raise overall government expenditures causing a budget gap that must be filled with more borrowing.  The greater amount of borrowing further worries the bond traders who then demand even higher interest rates to compensate them for this risk.  

In addition, according to economists Carmen Reinhart and Kenneth Rogoff when a nation’s gross debt reaches 90% of its economy, it often loses about one percentage point of growth a year.  Of course slower growth means less tax revenue which means more borrowings.  

Where does the good old USA stand?  Well, Reuters reports: 

The U.S. debt will top $13.6 trillion this year and climb to an estimated $19.6 trillion by 2015, according to a Treasury Department report to Congress. 

And so the country loiters at the event horizon of the black hole…waiting to be sucked away into oblivion.    

Have a great weekend, 

Michael Bechara, CPA

Managing Director

Granite Consulting Group Inc.

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