Is It So Farfetched?

One factor that contributed to the near-unraveling of the financial system in the fall of 2008, and which played a role in the LTCM blow-up and other financial crises through the ages, is the human response to Knightian uncertainty, or "unknown unknowns."

When people find themselves in a situation where they feel they don't have a decent grip on the risks they face, or where a great deal of critical information is hidden from view, emotions can easily overwhelm rational decision-making.

In some respects, this phenomenon helps explain the market's reaction to the Greece-inspired sovereign debt crisis, where there are many questions about the extent of the nation's outstanding obligations, as well as which countries and companies might be left holding the bag.

Based on the following CNNMoney.com report, "America's Hidden Debt Bombs," is it so farfetched to think that a sudden loss of confidence in the United States' ability to manage its finances could evoke similar fears about just how large and widespread the fallout might be?

America's total debt load is on pace to top $13 trillion this year, and $22 trillion by 2020 -- and that's just the debt we're counting.

What's not being counted: potential debt bombs that don't get factored into most budget analysis.

When anyone talks about U.S. debt, they typically refer to two numbers.

The first is the debt held by the public. That's money owed to those who have bought U.S. Treasurys, most notably big bond mutual funds and foreign governments. Debt held by the public today is roughly $8 trillion and rising.

The second number is the money the federal government owes to government trust funds, such as those for Medicare and Social Security. The government has used revenue collected for those programs to cover other outlays. Currently, the debt to the trust funds is approaching $5 trillion.

The two combined is the total gross debt that's accounted for. But deficit hawks also worry about what's not on the books.

Here is just a sampling of the unseen or underplayed obligations that could worsen the debt outlook:

Losses from Fannie Mae and Freddie Mac

Mortgage giants Fannie Mae and Freddie Mac are private companies that for years had the implicit backing of the federal government. That backing assured investors that if anything went seriously south for the companies Uncle Sam likely -- although not absolutely -- would step in.

Well, things did go south, and now both are run by the federal government.

While the implicit guarantee has become explicit for Fannie and Freddie, its treatment in the budget is up in the air.

"Our budget doesn't have Fannie Mae and Freddie Mac on it, even though it's owned lock, stock and barrel by the American taxpayer," said Rudolph Penner, a former director of the Congressional Budget Office (CBO) during a conference held by the Peterson-Pew Commission on Budget Reform.

Last year, the CBO did start to account for both companies as if they were federal agencies on the budget. But the White House Budget Office only includes some potential costs because the future of the two companies is still under consideration. Last week, a Republican congressman introduced a bill that would require the two agencies be put on the budget.

It's still not clear what the companies' total hit to the federal budget will be. Amherst Securities, a broker-dealer in residential mortgage-backed securities, estimated that the total loss on the mortgages backed by the companies could reach $448 billion, with a portion of that covered by reserves or assumed by outside parties. The CBO estimated the net costs to the government could top $370 billion by 2020.

These are just estimates. But what's clear is that Fannie and Freddie are not cheap dependents.

That's why some argue that lawmakers should assess the potential costs of implicit government guarantees well before things go to pot.

"Their costs are largely unmeasured, unrecognized in the budget and unmanaged," federal budget expert Marvin Phaup wrote in a recent paper. "A troubling aspect of current policy aimed at restarting the financial markets is the likely expansion of implied guarantees to include the obligations of additional private financial institutions."

Unfunded promises

The governments' accrued debt to the Social Security and Medicare trust funds is known. And making those payments -- which begin in earnest this decade --won't be easy given the drop in federal revenue and the surge in government spending.

"[Lawmakers] need to acknowledge they have no way of funding them right now," said tax expert Len Burman, a professor of public administration and economics at Syracuse University.

But the piece of future entitlement debt that's not reflected under current budget protocols is what the government will have to pay into the system after its payments to the trust funds end -- which will happen by 2037 for Social Security and within the next decade for Medicare.

At that point, the programs will only be collecting enough in taxes to pay a portion of the benefits currently promised. There will be enormous pressure on the government to make up the difference, and Uncle Sam would have to borrow a lot of money to do so.

Some budget experts like Stuart Butler, vice president for domestic and economic policy at the conservative Heritage Foundation, would like to see the long-term obligations to Medicare and Social Security included in lawmakers' annual consideration of the federal budget.

Right now, money allocated to both entitlement programs is considered "mandatory" spending and therefore the spending increases for the programs are on autopilot and the financial commitment is uncapped in future years.

True cost of tax breaks

Everybody loves tax breaks. And there's more than a trillion dollars of them to love.

That's the amount of money the Treasury foregoes in annual revenue as a result of the many breaks in the tax code. And that effectively increases the government's need to borrow.

But that trillion-plus isn't really up for consideration during annual budget discussions. "Tax expenditures are basically hidden," Burman said.

No one advocates abolishing tax breaks altogether. But Burman and others believe tax breaks should be treated as discretionary spending. The idea is to bring them into the open so lawmakers can make a conscious decision annually about what they spend on tax breaks and recognize the costs associated with that decision.

Long-term costs of new rules

This year is the first year in which high-income investors with traditional IRAs or 401(k)s -- both of which let savings grow tax-deferred until withdrawn -- will have a chance to convert their accounts into Roth IRAs, where investments grow tax-free.

The new conversion rule is scored as a revenue raiser on the federal budget over the next decade because those who convert must pay the tax owed on their traditional IRA savings the year they convert.

But long-term it's a different story. Since investments in the converted accounts will grow tax-free, Uncle Sam will collect less revenue than he otherwise might have had the investors kept their ever-larger savings in a traditional IRA and paid taxes on them in retirement.

"It will cost federal coffers a lot beyond the 10-year window," Burman said.

Comments

[roger]

owned lock, stock and barrel by the American taxpayer,"
this is crap and bull,the tax payer owns nothing,Nada,
the tax payer owes period!as in pay your taxes and shut up.
And when did anybody involved in financial matters make a rational decision?

[Steve]

It would be great if our debt was only $13 trillion. However, the actual debt, including social security and medicare obligations, is $56 trillion. For more on this, visit the Pete Peterson Foundation website.

[Kevin@OutOfYourRut]

What seems to be at least as significant as the size of the known debt is the complication surrounding it. What is included? What isn't included? What do the components mean? How relevant are unfunded liabilities? Etc, etc, etc.

Is seems that complication has become the cloak behind which it's all hidden. The public are blinded not only by the enormous numbers involved, but also by the unfathomable complication. We can't even know with any certainty what we're talking about when we talk about the national debt.

And add to that, it's the state of affairs in probably most countries in the world. It would be convenient to blame this all on government, but the public has done it's bit by a) demanding ever more benefits, ever more fires be put out, and b) by turning a blind eye to true costs.