THE MATHEMATICAL CERTAINTY OF U.S. GOVERNMENT DEFAULT

The thing about finance is that it's not an opinion, ideology, or political debate—it's math. In conducting an analysis of an entity's solvency, there is a financial tipping point, after which there is no mathematical way out. The "way out” becomes default. The United States government reached that point at least 15 years ago. This is an update on the situation using the government's most recent financial statements (FY 2017).

THE PROPER ANALYTICAL METHOD

The correct way to financially value any individual, business, or government is net present value (NPV). This method is a standard in the financial industry, but since the general public lacks financial knowledge, you never hear about it. To perform the calculation we forecast the entity's expected future cash flows (both revenues and costs), net those cashflows against each other (hence the "N"), and apply a discount rate to give us a present value (hence the "PV")—the result tells us what the entity is worth today.

Once we have this cash flow model constructed, we can analyze the entity's financial situation, and see risks such as shortfalls—scenarios where the entity might not be able to meet scheduled negative cash flows.

One thing that makes applying this method to a government a bit different, is that governments can print/borrow money in ways that are not available to individuals and businesses. But this does not make the math irrelevant, it merely postpones the inevitable, and enables the eventual shortfall to grow.

A REVIEW OF THE CASH FLOWS

You might think constructing a model to analyze the solvency of a massive entity like the U.S. government (USG hereafter) would be enormously difficult, but it's actually a fairly simple business to analyze.

USG Positive Cash Flows, $3.4T

Source: Financial Report of the USG (2017)

The USG's positive cash flows are quite stable and come almost entirely from one source—individual income taxes. Since changes in the rates of economic growth and taxes happen slowly over decades, we can forecast these inflows with greater confidence than we could a volatile business like AAPL. It's difficult for the USG to increase their inflows because the country is past its growth stage, and into the maturity and decline stages. Thus GDP growth rates are expected to decline for the rest of this century (even per the USG's own optimistic model). Also, attempting to increase tax rates risks stalling GDP growth, thus leading to a bigger percentage of a smaller number. 

USG Negative Cash Flows, $4.5T

Source: Financial Report of the USG (2017)

The USG's negative cash flows come from an array of sources (defense, social insurance, interest payments, and endless small programs). However these tend to be fairly stable and locked-in because programs are "sticky," and because cuts to one bucket tend to be offset by additions to another. There are examples in history of a country increasing revenue, while not increasing spending, but they are rare. Besides, America has no recent history of financial responsibility—since 1970 outflows have exceeded inflows (avg 21% vs 18% of GDP respectively), except for a brief period around 2000. Generally citizens are not fond of cutbacks (see Greece's austerity), nor are corporations (who at this point have greater say), and so the path of least resistance is just to "keep spending until you hit the brick wall" (e.g., creditors cut you off, hyperinflation, etc).

So what were these cash flows for the most recent year? The United States government had revenues of $3.4T, and costs of $4.5T, for an operating loss of $1.2T, for the most recent full-year (2017). Total government spending was 23% of the country's $19.4T GDP, making it an above average year for spending.

ASSEMBLING THE CASH FLOWS

STEP 1: CURRENT ASSETS & LIABILITIES

As most know, many decades of these sustained operating losses have resulted in a sizable debt. The present value of that debt is simply the current value, which is negative $20.4T ($3.5T assets - $23.9T liabilities). On our spreadsheet timeline, we place this current amount at year zero (i.e., closing out this debt would cost $20T today).

STEP 2: EXPECTED FUTURE CASHFLOWS

Next we need to add the estimated future cash inflows/outflows to our timeline. We need to use a long timeline, because a government has known debts that extend many decades (generational debts). The USG uses a 75yr timeline in their own model, which is fine because calculating further out doesn't make a material difference due to the time value of money. Also, we need to assume the USG is an ongoing concern, meaning they can't liquidate assets required for operation. Here are their expected cash flows split into four categories...

A. Social Insurance Operations: 

Government actuaries have already modeled these cashflows out 75yrs, and their base case estimate is a present value of negative $49.0T (estimated future social security and medicare receipts - estimated future payouts). The government calls this "off-balance-sheet" debt. These debts to the citizens plus the "official" debt result in a subtotal—a negative $69.4T liability ($20.4 + $49.0), per their own financial statements (see pg1 executive summary).

Note: it's important to mention that all the money that was loaned to the USG by the citizens, is gone. The so-called trust funds hold absolutely no real assets of any sort to back their liability. It is a Ponzi scheme where new members are expected to fund older members. We can see this illustrated by their projections that current participants in the scheme represent a $68.2T liability, while future participants are expected be a $19.2T asset (newbies pay for the oldies), which gives us our total used above (-68.2 + 19.2 = -49.0). Also, there are financial clues that lead me to believe their numbers are optimistic, but let's be generous and run with them.

B. Core Operations:

Since we already have the government's social insurance cash flows modeled as a large net outflow above, their "core operations" (defined as total inflows - outflows, not including social insurance and interest payments) would be running at a gain. If we assume core operations as a % of GDP remain the stable (perhaps a generous assumption), then our estimate for core operations is a prevent value of positive $27.9T.

C. Interest Payments:

The next component we need to model are the annual interest payments on the debt, projected out 75yrs. The current payment in this low interest rate environment was $0.3T (9% of their revenue). However the government estimates interest rates will average 5.1% over our time horizon, so increasing dramatically from the current 1.8% rate. And of course debt will need to increase to pay the unfunded baby boomer benefits as they continue to retire. Plugging this into our model we get a present value of future interest payments of negative $110.0T.

D. Terminal Value:

Finally, in the last year of our model (yr75) we need to place a terminal value. A terminal value represents cash flows into perpetuity. What should that be? Well, in yr0 the government starts with $3.5T in assets and $23.9T in liabilities. But by yr75 it has accumulated debt of $1.6 quadrillion (or "zillion", err I've never had to use this in finance until now!) from all the boomer payments and interest on the growing debt. Since at yr75 the USG is clearly not a continuable business, instead of using a perpetual model we will calculate a liquidation value, and plug it in here. Closing out their debt at yr75 (they have no assets) would have a present value of negative $38.8T.

At each step I have opted for somewhat generous assumptions. Next we put all this together to get a NPV...

STEP 3: CALCULATE NET PRESENT VALUE

ASSETS & LIABILITIES($20.4)
Assets$3.5
Debt held by the public($14.7)
Other debt($9.2)
SOCIAL INSURANCE OPS (PV)($49.0)
Participants at eligibility age($21.4)
Participants not at eligibility age($46.8)
Future participants$19.2
CORE OPS & INTEREST (PV)($120.2)
Future operating gain/loss$27.9
Future interest payments($110.0)
Terminal value($38.8)
NET PRESENT VALUE($189.6)

Now we just add up the prior calculated present values, which gives us a net present value of negative $189.6T. Note: for the calculation of the present values a discount rate of 5.1% has been used (the USG's cost of capital over the next 75yrs, per their own model's assumptions).

To provide a point of reference, Credit Suisse calculated total global wealth at $280T as of 2017. The world would have to sell 68% of its assets today, to close out the government's shortfall.

And so their financial model clearly melts down—as the USG tries to hold its core operations  together  -> large liabilities from social insurance come due -> net negative cashflow increases -> more loans have to be taken out to avoid default -> debt increases -> interest payments increase. It's the combination of rapidly increasing debt and increasing interest rates that sends negative cashflow hyperbolic, and breaks the model (default).

Of course this absurd shortfall would never be realized, because the $110T in interest payments would never be paid, because the government would be forced to default well before year 75 in the model (2092).

Let's look at points along the timeline where such a forced default could happen...

STEP 4: ANALYZE RISKS IN THE CASH FLOW STREAM

Year 2017—The baby boomer generation has already started retiring, and annual deficits are increasing. In 2017 the USG ran a $0.7T deficit, and had $20T in debt for a 75% debt-to-GDP ratio.

Year 2038—Government actuaries estimate that in 20yrs the negative cashflow from boomer payments will have peaked. At this point the USG would start running a $3.3T annual deficit for decades to finish paying the boomers. The USG would have $50T in debt for a 130% debt-to-GDP ratio. There is a good probability default would happen by this point, as it's hard to imagine who would buy $3T in treasuries annually, and regardless printing/borrowing 10% of GDP would have consequences (inflation, higher interest rates, etc).

Year 2058—The government would be running $5.8T annual deficits (same boomer payments as in 2038 but now more interest on the debt), with $110T in debt for a 210% debt-to-GDP ratio. So if they were not cut off by 2038, it would surely end by 2058. Full-payment to the boomers would result in catastrophic debt, and a default felt across the planet as the biggest debt bubble in history popped. It would be much better for everyone if the bubble popped around 2038. 

Year 2092—The government would be running $14.1T annual deficits with debt of $1.6 zillion ($330T in today's dollars) and the debt-to-GPD ratio of 300%. But, they will never make it this far.

Note: all figures above are in today's dollars, unless otherwise noted.

THE MODELS

For additional confidence we can triangulate using three models, 1) Gokhale and Smetters model that has been running for 15+ years with great accuracy, 2) my own independent model which was presented above, and 3) the government's current model. 

MODEL #1: Gokhale, Smetters & Kotlikoff

In 2003 Gokhale and Smetters calculated the USG's NPV at negative $44.2T in this study "Fiscal and Generational Imbalances" (this was the first instance of proper math on the topic, to my knowledge). Treasury Secretary Paul O’Neill commissioned this year long analysis and recruited Jagadeesh Gokhale (Senior Economic Adviser to the Federal Reserve Bank of Cleveland) and Kent Smetters (Deputy Assistant Secretary of Economic Policy at the Treasury). So these were insiders, and as such they had better data than we on the outside. Essentially this was the USG's own quantification of their grim situation! What happened? The Treasury Security was fired, the study censored, and it was not presented to then president W. Bush.

In 2005 Gokhale and Smetters released an updated report "Measuring Social Security's Financial Problems" and calculated NPV at negative $65.9T.

We find that a lot has changed in just a few years...the nation’s fiscal imbalance has grown from around $44 trillion dollars as of 2002 to about $63 trillion, mostly due to the prescription drug bill. The imbalance also grows by more than $1.5 trillion each year that action is not taken. —Gokhale and Smetters Aug2005

In 2006 Laurence Kotlikoff (currently a Boston University professor, who sat on the Council of Economic Advisers during the Reagan years) published what is still the best paper ever on the topic, "Is the United States Bankrupt?" which is based on Gokhale and Smetters' math.

One way to wrap one’s head around $65.9 trillion is to ask what fiscal adjustments are needed to eliminate this red hole. The answers are terrifying. One solution is an immediate and permanent doubling of personal and corporate income taxes. Another is an immediate and permanent two-thirds cut in Social Security and Medicare benefits. A third alternative, were it feasible, would be to immediately and permanently cut all federal discretionary spending by 143 percent. —Laurence Kotlikoff Jul2006

USG, Net Present Value ($Trillions)

In 2015 Kotlikoff presented an updated estimate of negative $210T in his testimony to congress "America’s Fiscal Insolvency and Its Generational Consequences". The gap grows so quickly because 1) each year the bulk of the baby boomer generation gets closer to retirement, and 2) new irresponsible spending schemes are launched. Per Kotlikoff's report, it would now require an immediate and permanent 58% hike in federal taxes, or 38% cut in all spending. Kotlikoff also presented this handy chart, with values back to 2003 recalculated using the current refined methodology.

Note: Kotlikoff's recent model is based on the Congressional Budget Office's Alternative Fiscal Scenario projections. He argues this is a more realistic base case to use, and I agree. Below I run my own model using the USG's "base case" presented in their own financial statements, which is more of an optimistic scenario. I am aware their numbers have been "massaged," but I wanted to reproduce their math, and show what their own optimistic assumptions (and questionable math) reveals. Obviously there's no point in running a pessimistic scenario.

MODEL #2: My own independent model

My model, which I updated with their 2017 financial statements, puts the USG's NPV at negative $189.6T. I’ve been modeling complex financial instruments and venture capital funds for a decades, and studying this growing gap since 2006.

For my model, I plugged in the government's own optimistic assumptions. The point of doing so is simple, if under their own best-case assumptions they are still insolvent, then it's game over. So borrowing from their annual report I plugged in the following: 1) GPD grows at 2.9% for now, but quickly comes down to 2.1% for the remainder of the 75 year period, 2) revenue grows from 18% of GDP to 21% due to tax hikes, 3) core spending (not counting social insurance and interest) stays flat, 4) interest rates increase quickly and average 5.1% over the period, 5) the applicable discount rate is the government’s own cost of capital (which is this same 5.1%), and 6) inflation averages 2.3%. 

These seem like semi-reasonable assumptions, but also a bit optimistic. For example they say taxes will increase slowly across this period, yet GDP will not take a hit, and spending will remain flat—resulting in core operation surpluses (even though this has never happened before, for a sustained period of time). Also their estimates on social insurance are a "black box" and highly questionable, I ran into problems trying to reconcile their math, and so suspect they have cooked the books (I've been doing this a long time and recognize the signs when someone is trying to hide something). And finally there are large numbers they seem to be excluding such as government employee benefits and medicaid (which oddly does not seem to be included in their $49.0T number).

And yet, optimistic as this model is—as social insurance payments come due, debt must be taken on, and the whole thing breaks. Every time. I’ve tried endless other combinations over the last decade I’ve been studying this problem, and talked to many financial professionals, and in every scenario default or hyperinflation is the outcome (which are not necessarily so different).

MODEL #3: The U.S. Government's model

Let's look at their own model. Again, since I based my model on theirs, this is similar to what we just discussed.

Their model has improved over the years, because the Gokhale and Smetters methodology was correct, and has massive support in the finance/economics community. And so I assume they have been pressured to integrate this NPV thinking (aka "fiscal gap") into their annual financial statements presentation.

However despite the appearance of transparency and improving financial methodology, when it comes time for the punchline the government report is evasive, and spins the bottom line in a less frightening (and less true) manner. On p. 56 they add up NPV, except they ignore interest payments, exclude terminal value, and seem to inflate revenue—resulting in a preposterous answer of negative $16.2T. This of course doesn't agree with their own statement (below) that "current policy is unsustainable," if the NPV truly were -16.2T, that would be sustainable. 

The debt-to-GDP ratio rises continuously despite flat primary deficits mainly because higher levels of debt lead to higher net interest expenditures, which lead to higher deficits and debt. The continuous rise of the debt-to-GDP ratio after 2026 indicates that current fiscal policy is unsustainable.
The longer policy action to close the fiscal gap is delayed, the larger the post reform primary surpluses must be to achieve the target debt-to-GDP ratio at the end of the 75-year period. —USG Financials, 2017

The above statements are true, and mirror what our other two models have told us. Their fiscal policy is not sustainable and there is a 100% probability this ends in default of some sort. And the longer the delay, the larger the default will be.

But notice they don't use the D-word (default) but "post-reform surpluses." They spin it as if there is still time to start running a surplus and turn things around. Even though we can use any of these three models to calculate the required changes, and see it is clearly impossible.

The other trick they pull is that despite now understanding that NPV is the correct metric, they continue to cling to the somewhat irrelevant old debt-to-GDP metric (which historically has been used to hide the problem). They choose an arbitrary debt-to-GDP target, and then say if they run a surplus of 2% of GDP things can be fixed. Well, of course they phrase it that way, because "2% of GDP" sounds doable, unlike closing a $200 trillion shortfall! But it's not doable, because GDP $19.4T x .02 = a $390B surplus. Since current revenue is $3.4T that means per their own analysis they would need to cut spending from $4.5T to $3.0T starting right now, into perpetuity, not even to close the NPV gap to zero, but just to hold the GDP ratio down to a sustainable and "reasonable" level. And so that is checkmate—there is no combination of cuts that could achieve a $1.5T reduction in spending, and hold it across the boomer retirement window, without defaulting on obligations to "the oldies".

And if they don't make the cuts (they mathematically can't), they also admit that the interest on the debt shoots out of control, hitting 300% of GDP by 2090 (see p. 160). So by the U.S. government's own most calculation, even using their unrealistically optimistic model, they are insolvent.

HOW DOES THIS END?

Badly. Again, it's just basic finance math. People always say "oh, there is hope, they will think of something, we have survived worse," but there's no such thing as magic. NPV math is simple and authoritative—either revenues need to be increased, or costs need to be decreased.

But the amount revenue would need to be increased is impossible—no reasonable increase in GDP or taxes could ever provide the needed revenue to close a $200T gap. Similarly the cutbacks in spending necessary are unrealistic—per their own model they would have to cut spending by $1.5T into perpetuity, yet turning off the entire Department of Defense forever wouldn't even get halfway there! There's simply no amount of revenue increases and spending cuts that can make their broken model work, without default.

And so let's explore that...

DEFAULT AND/OR HYPERINFLATION

Default on whom? Well, default on their creditors. Who are their creditors? Their creditors fall into two categories 1) holders of public debt ("public" consists of individuals, corporations, state governments, Federal Reserve Banks, foreign governments), and 2) their own citizens, specifically the old people. We have determined default is the only way out, and those are the only two creditors. So which do they choose? Let's logic thru it...

If they do not default on the oldies, and pile up insane amounts of debt to loyally pay them benefits, then they will get cut off along the way by global creditors anyhow, and eventually be forced to default on a significant portion of their debt (as the interest payments would eat them alive). And it's not just enough to somehow strategically default just on China, they would also need to default on their own institutional investors, which would collapse global markets, and shoot up their own borrowing rates. But when has the USG ever prioritized citizens over investors?

Defaulting on financial investors would be catastrophic, so that just leaves defaulting on the oldies, and thus never accumulating the coming $100T+ debt by 2058. Like a strategic default on a mortgage, why keep paying the debt when your house is underwater, if you're just going to have to default later anyhow? So I think this is the most probable scenario. Also I think they will do it by a combination of smaller moves, to try to sneak thru it and avoid outrage. For example, 1) increasing the retirement age, 2) only paying say 70% of social security, 3) inventing excuses not to pay for medical care, 4) trying to raise the required cash by "we are too big to fail, you better loan us money," and 5) inflation. But the shortfall is so large, it seems improbable they succeed in quietly closing the gap with a perfectly-timed series of "mini-defaults," especially since they are so disorganized, and this would require adherence to a long-term plan across the decades. These are loans the citizens made to the government, and they expect to get their money back; there's no way to sneak around the widespread financial hardship and health problems which would result.

Of course someone always naively says "they'll just print their way out," but hyperinflating is the same as defaulting. It's not like the whole world doesn't already know this is what America is doing with their various printing and economic statistic fictions (for example their calculation of inflation is questionable). But this strategy is checkmated by the fact that we're talking about printing $1.6 zillion dollars over the next 75 years (not a typo), to satisfy this -$190T present value. And that's assuming the gap doesn't grow, which of course it will (see 2018 tax cuts and spending increases). Printing alone won't work because the amounts needed become ludicrous by 2038, and then get even worse. They would cause catastrophic hyperinflation and a collapse of the dollar, ending American hegemony.

CONCLUSION

To resolve the financial imbalance I expect the U.S. government will delay some more, before eventually trying a desperate combination of—strategic default on old people, borrowing/printing, financial trickery, and possibly war—and just hope they squeeze thru the century without 1) defaulting on treasury securities, and 2) revolution brought about by the default on the citizens. And I expect they will fail.

The takeaway—this is the largest Ponzi scheme in human history, and as the bubble pops during our lifetimes, it's going to get very ugly. Like all Ponzi schemes, the longer they are able to hold their disastrous financial situation together due to people's trust in them and their special access (world's largest economy + reserve currency), the greater the eventual damage will be when the bubble pops.


FURTHER READING

Financial Statements:

U.S. Government. (2018). Financial Report of the United States Government (2017 FY)

Professional Papers:

Gokhale, J., & Smetters, K. (2003). Fiscal and Generational Imbalances. Federal Reserve Bank of Cleveland, Policy Discussion Paper.

Gokhale, J., & Smetters, K. (2005). Measuring Social Security's Financial Problems. National Bureau of Economic Research, Working Paper Series. 

Gokhale, J., & Smetters, K. (2006). Fiscal and Generational Imbalances: An Update. National Bureau of Economic Research, Tax Policy and the Economy. 

Kotlikoff, L. (2006). Is the United States Bankrupt?. Federal Reserve Bank of St. Louis, Review.

Kotlikoff, L. (2015). America’s Fiscal Insolvency and Its Generational Consequences. Testimony to the Senate Budget Committee.

Press Coverage:

Kotlikoff, L. (2011). Deficit Accounting is a Generational Ponzi Scheme. The Fiscal Times.

Kotlikoff, L. (2014). America’s Ponzi scheme: Why Social Security needs to retire. PBS News Hour.