The Hindu Business Line : The bankrupt superpower

Similar to the Ponzi insurance company reporting surplus cash positions, it may be possible for the US Government to report a balanced budget while running the biggest Ponzi scheme in history. The fact that it is not, shows the depth of the problem.

Is this just another oxymoron or an inevitable outcome, as is being proclaimed by some financial commentators? Before going any further, bankruptcy needs to be defined: It is the situation in which the current and future liabilities of a person or business entity exceed the expected earnings and assets owned.

This definition, though simple, is often misunderstood. Bankruptcy is often equated with the absence of cash-on-hand. While this could be true for a majority of situations, under certain conditions the "cash-on-hand" test fails. For example, when the timelines for income and expenses are different, as in the case of insurance companies. One pays insurance premiums for the first 10, 15 or 20 years and the service from the insurance company comes much later. So, it is possible for an insurance company to be flush with cash and still be bankrupt.

Broke Insurance Company

Assume a firm with only one client. The firm receives Rs 100 at the beginning of every year for the first five years. It then has to pay back Rs 200 for the years 6 to 10. Assume further that the firm is able to invest the earnings and get a net return of 12 per cent. The cash flow position of the firm would be as given in Table 1.

The present value of the firm, as can be inferred, is negative and the firm is therefore bankrupt. Notice that the firm doesn't actually run out of cash till the very end though it has been "financially bankrupt" all along. The point is that cash-on-hand is not necessarily a good indicator of whether a company is bankrupt is or not.

Lest one thinks the above situation is hypothetical, there are many real-life examples, the most prominent being the troubled auto-makers of the US. For instance, it may be argued that with $19 billion in cash, GM cannot be bankrupt. But this $19 billion is dwarfed by the $64 billion in unfunded liabilities that GM owes to its retirees. So, in financial terms, GM has no money today (as indeed has been the situation for several years now).

The actual filing for bankruptcy itself is another matter altogether. Similar to the broke insurance company, the US auto-makers can delay the actual filing for bankruptcy till the very last stage in which it actually runs out of cash. The reason is that the managements of companies are usually more than optimistic about future outcomes (as in better future earnings compared to current assumptions, reduction of benefits through trade union negotiations, etc.) and they delay the inevitable till there is no other alternative.

Ponzi Insurance Company

Let us take an example of another insurance firm. In this case, the company does not invest the original premiums received, but provides the returns from incomes derived from future clients. Also assume that the company has other expenses of Rs 50 and that it is able to find three new subscribers to its policy from year 6 onwards. So the P & L statement would be as shown in Table 2.

The firm has been showing an increasing cash position all along. However, as should be clear, the liability for the years 11 to 15 would be Rs 600 and the firm can continue to show the (phantom) profits only if it is able to find seven new subscribers for its policy from the 11th year. Thus, the system will work only if it is able to find an ever-increasing base of subscribers. By definition, the business practices of this insurance firm would not be sustainable and such an arrangement would be called a "Ponzi Scheme".

In the first case, the broke insurance firm was indeed following the correct practices though the earnings were not sufficient to cover the guaranteed returns. In the second case, the entire scheme was dubious to start with. The firm can, however, continue to run operations normally as long as it is able to find an increasing subscriber base. The question is not "if" such a scheme would fail, but "when".

How does this apply to US?

The biggest spending programmes in the US today — social security and Medicare that account for more than 35 per cent of the federal outlays — are for the most part unfunded. They are not provided by savings from a trust of the earlier incomes, but by contemporaneous transfers of new subscribers.

The approaching "demographic transition" of having a higher proportion of retirees to workers would make this system unsustainable before long. Some influential thinkers have argued as to how allowing for more immigration would solve this. But that is a completely specious argument — the pay-as-you-go-along system was broke to start with.

The way to estimate the financial imbalance of such a scheme would be through the following:

FI(t) = PVE(t) - PVR(t) - A(t)

This definition is simply understood as the excess of total expenditure over available resources in present value. Here, PVE(t) stands for the present value of projected expenditures under current policies at the end of period t. PVR(t) stands for the present value of projected receipts under current policies, and A(t) represents assets on hand at the end of period t.

By the estimates of a study commissioned by the former Treasury Secretary, Mr Paul O'Neill, this imbalance could be to the tune of $65 trillion (more than five times the current GDP of the US). Similar to the Ponzi insurance company reporting surplus cash positions, it would in fact be possible for the US Government to report a balanced budget while running the biggest Ponzi scheme in history. The fact that it is not, shows the depth of the problem.

Likely outcome

Measures such as additional taxes and cut-back in spending have been suggested to eliminate the imbalances. But such a policy is unlikely in a democracy and all evidence indicate that Presidents (whether Republican or Democrat) will spend as fast as central bankers can print.

The likely way forward would be for the US to massively inflate (inflation defined as creation of excess money supply) its way out of the mess. That is, in nominal terms the payments will still be made by printing more money. However, this would debase the currency so much so that the real value of the payments would be worth a fraction of what it is today.

(The author is a Chennai-based financial advisor.)

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