newjerseynewsroom.com

BY GERALD J. ROBINSON

NEWJERSEYNEWSROOM.COM

(First in a series)

Maybe never.

But you wouldn't know it from recent headlines. "Federal Government Faces Balloon in Debt Payments," proclaimed the New York Times. "Gold Hits a Record as Dollar Sinks" announced the Wall Street Journal.

Just how bad is it – and what will happen if it explodes?

The numbers aren't encouraging. The national debt, pumped up by years of deficit spending, has climbed to over $12 trillion, headed toward equaling our annual gross national product. It's the highest percentage of the GDP since World War II.

Low interest rates have made financing this mountain of federal debt easier, but when interest rates rise the government will face a problem like homeowners faced when their adjustable rate mortgages spiked upward.

How much is the $500 billion increase in interest by 2019 in real terms? It's reported that it's more than the combined current federal outlays for education, energy, homeland security and the wars in Iraq and Afghanistan.

The climbing national debt is destined to keep climbing. Pump priming in 2009 caused the fiscal 2009 budget deficit to balloon to $1.4trillion, a post-war record and triple last year's deficit.

According to White House estimates, the cumulative deficit over the next decade will be $9 to $10 trillion. With the sacrosanct unfunded entitlements of Social Security, Medicare and Medicaid regarded as a political third rail, there's little likelihood of Congress bending the cost curve down anytime soon, especially in view of the imminent bulge in the retirement of the baby boomer population and anemic personal income growth.

This flood of red ink and the rapidly running dollar printing press have spooked many investors into believing that runaway inflation is inevitable because of depreciation in the value of our currency. Their belief is reinforced by the decline of the dollar against other currencies, notably the Euro that at one time was worth less than a dollar but now floats around $1.50.

While there is substantial evidence that inflation is not a serious current threat – a matter that we'll explore in the second article in this series – serious inflation, if it happens, can substantially erode wealth and produce a serious loss of confidence. That's why many with money have been buying gold, pushing its price to record levels.

That's how bad it is. What happens if the debt bomb blows up?

Serious damage: inflation gallops causing credit markets to freeze. We just received a wrenching preview of what happens when the home mortgage debt bomb exploded last year. It produced a credit freeze that drove the economy into a deep recession.

The freeze last year was caused by lenders' uncertainty about whether they would get repaid. If galloping inflation occurs, there will be another freeze, but for a different reason: lenders will not be fearful that they will not be repaid so much as they will be fearful that they will be repaid in dollars with substantially reduced purchasing power.

In other words, they will become fearful as to the value of the dollars they will be repaid in.

This fear causes lenders to either hesitate or refrain from lending or to charge increasing interest rates to make up for the decline in the purchasing power of the dollars they will be paid back in. Or both. Either consequence, carried far enough, will drastically crimp business activity; possibly tail spinning the economy into a recession or worse.

A harbinger of the reaction of lenders to serious inflation is illustrated by the behavior of the Chinese on President Obama's recent visit. Holding the largest portion of our $3.5 trillion in foreign debt, they made known their concern about our budget deficits, increasing national debt and the effect of the falling dollar on the real value of their loans to us and the huge dollar reserves they hold.

Their growing fears are compounded by our huge and chronic trade and current account deficits. What happens if their concern causes them to lose confidence in the dollar and reduce their purchases of our debt or to demand higher interest rates?

Some say not to worry, the Chinese have to export to us to hold their unemployment at bay and if they stopped lending to us we couldn't buy their exports. It's a comforting theory, but reminiscent of former Fed Chairman Alan Greenspan's thesis that proliferating exotic financial instruments of recent vintage had built-in safety features.

When the unexpected happens, like the housing meltdown, such reassuring theories move to the academic junk heap, leaving financial and economic wreckage behind.

Determining at precisely what point the growing debt will cause the debt bomb to explode is like trying to calculate how many more straws can be added to the camel's back before it breaks. Clearly, however, the danger of the growing debt is no longer negligible.

♦♦♦

The next article in this series explores how we can escape from the debt bomb and why runaway inflation is unlikely. In our third-and-final article we'll discuss an investment strategy – not based on gold – that can be a hedge against the possibility that the pessimists are right.

Gerald J. Robinson, Esq., formerly tax counsel to the New York City law firm of Carb, Luria, Cook & Kufeld, is a member of the New York and Maryland bars. He received his B.A. degree from Cornell University, an LL.B. from the University of Maryland and an LL.M. in Taxation from New York University. Prior to entering private practice he served in the Office of Chief Counsel, Internal Revenue Service. He is the author of the treatise, Federal Income Taxation of Real Estate, now in its sixth edition, and wrote the monthly newsletter, Real Estate Tax Ideas, both published by Warren, Gorham & Lamont. He is also a frequent lecturer and contributor to various professional journals.