-$418
-$521
-$138
-$624
-$732
-$948
$69
$125
$236
$127
-$106
-$1,200 -$1,000 -$800 -$600 -$400 -$200
$0
$200
$400
1998 1999 2000 2001 2002 Q1 2002 Q2
$ bil.
official "surpluses"
actual deficits
Figure 8.1 The so-called federal budget surpluses of 1999, 2000, and 2001 were purely bogus, based on massive, overt accounting manipulations of the bud- get. Meanwhile, data provided by the Federal Reserve on the government’s actual borrowing of new funds demonstrate that the government was running increasingly larger deficits throughout this period.
Data: U.S. Treasury Department, Federal Reserve Flow of Funds,as illustrated in Table 8.1.
The Ballooning Budget Deficit 89
Reserve, just down the street on Constitution and 20th, is saying we have these huge deficits?”
“Exactly. But no one’s paying attention to the Fed’s numbers.
They’re poorly distributed, rarely talked about. It’s the Treasury’s numbers—the doctored-up numbers—that get all the press, get debated before Congress. Do you realize how big this is? Do you realize what the ultimate consequences could be?”
Johnston’s interest perked up, but he still wanted to know the mechanisms, how it actually worked. In response, Dulles ex- plained a long series of accounting manipulations routinely used by the government to make the federal deficit look better and more acceptable to voters—measures that were uncannily similar to the gimmicks that UCBS used in the 1990s to make their earnings look better to investors.
“In a nutshell,” said Dulles, “here’s how it’s done. First, the gov- ernment has a bunch of agencies—the Federal Home Bank, Freddie Mac, Sallie Mae, etc. These agencies are controlled by Congress.
They are guaranteed, backed, or at least sponsored by the U.S.
government. And, their debts are universally classified as U.S.
government securities. Yet their books are not consolidated with the government’s books for the purpose of budget accounting. So it’s a very convenient dumping ground for bad numbers that might otherwise be a huge embarrassment to a lot of people in and out- side the beltway.
“Second,” he continued, “there’s the Social Security fund. The fund has a surplus that it’s going to need in order to cover expected Social Security deficits down the road. That money belongs to the 45 million people that are retired or are going to retire. It has noth- ing whatsoever to do with the rest of the operations of the govern- ment. Yet they’re adding those surpluses into the federal budget to help cover up the deficit.”
Momentarily, Johnston’s thoughts flashed back to another place and time. Then he returned to the present with a new ques- tion. “That’s the Treasury’s numbers. But you said the Federal Reserve does it differently—how does the Fed calculate the deficit?”
“The Fed’s numbers show how much the government and gov- ernment agencies actually borrow in new money—over and above the refunding of old debt—each and every calendar year. In 2000,
For those who might disbelieve the statement made here that the federal deficit was running at a rate of close to $1 tril- lion,here is the proof: The Federal Reserve’s table F.4,available to the public at www.federalreserve.gov/releases /Z1/Current/zlr-3.pdf.This data clearly shows that the federal government borrowed funds at the annual rate of $731.8 billion and $948.4 billion in the first and second quarters of 2002,respectively.These borrowings had only one purpose: To finance a government deficit of equivalent magnitude.
Table 8.1
The Ballooning Budget Deficit 91
they borrowed the $137.6 billion I just told you about. In 2001, they borrowed the $623.8 billion. In 2002, they borrowed at the annual rate of $731.8 billion in the first quarter and an absolutely shocking
$948.4 billion in the second quarter!”
“Where is all that money going?”
“I can assure you, they’re not tucking it away under a mattress.
They’re borrowing it for one purpose only—to finance the deficit.
That’s why I say there numbers are the real deficit, my friend. Not the rigged numbers you hear debated in Congress or quoted in the press.”
Johnston had heard about these gimmicks before but had never realized, until now, how incredibly huge it was. My God,he thought to himself, In the second quarter of 2002, the government was borrowing new money at the annual rate of nearly $1 trillion! This is so much larger than the official budget deficit, it defies the imagination!
He also never realized, until now, how uncannily similar the government’s manipulations were to the gimmicks he knew so well from his experience with UCBS. The exclusion of the government agencies from the budget sounded just like the subsidiary shell game they used to use to hide losses and debts. The tricks the gov- ernment was playing with America’s Social Security fund seemed virtually identical to the way they used to juggle UCBS’s employee pension fund.
For the average person, the threat was huge. Social Security funds could dry up. The government’s heavy borrowing could drive up the cost of money—that is, in the form of higher interest rates. Mortgage rates could go up when Americans could least afford them to. Investors in bonds could lose fortunes.
He tried to calm down, but couldn’t. Here he was, busting his butt to get some government agencies—like the SEC and the IRS—
to support his drive for a cleaner and more responsible corporate America. And there they were, pulling the exact same tricks in their ownaccounting, killing—utterly shattering—any semblance of credi- bility they might have to help bring sanity to the private sector.
Johnston could just hear the executives now. They’d be saying,
“Hey! The government’s doing it—so why can’t we?” On the other hand, if he buried this issue and just ignored it, he could never live with himself. He decided to recruit Dulles for the project and go forward.
92 Crash Profits: Make Money When Stocks SinkandSoar
Two days later, with some trepidation and anxiety, the commit- tee issued a press release without hyperbole or sensationalism.
Nevertheless, they felt the headline, “Government Fudges Deficit to the Tune of $500 Billion,” was sure to make it to the front pages.
The following morning, Johnston walked into the office of his new press secretary and asked, “What’s the response been like?
Positive, right? No? Don’t tell me it’s been negative! Geez, don’t keep me in suspense. What are they saying?”
“Nothing, sir.”
“Nothing? Whaddaya mean ‘nothing’?”
“I mean, sir, we’re just not getting a rise out of ’em. No response at all. The general press doesn’t seem to understand it. The financial press guys do sort of get the point, but they don’t seem to care. One financial markets reporter who called about an old UCBS question this morning tells me it’s ‘a nonissue.’ He goes, ‘So what if the gov- ernment cheats? So what else is new?’ Besides, he says that ‘it has never seemed to have a major impact on the bond market, so why worry?’ He said it’s old news and implied our press release was naive. That pretty much sums up the general attitude out there.”
Johnston was stunned. Why was it, he thought, that when he personally confessed to the accounting manipulations of his com- pany, it hit Wall Street like a bombshell . . . but when someone tried to bust open far more egregious trickery in Washington, it fell on deaf ears? For the next several weeks, he became obsessed with this question. He had his staff talk to economists, and they talked about economic cycles. He had them go to Wall Street government bond dealers, and they talked about government bonds. Step by step, piece by piece, they assembled a picture that Dulles then painted for Johnston in their next conversation.
“First of all,” said Dulles, “let’s set the record straight. We areon the right track. These accounting gimmicks that Washington uses are actually much worse than the ones Main Street or Wall Street got smacked for.”
“Worse? Why worse?”
The CPA took out his yellow legal pad from the desk drawer and placed it next to a tall glass of ice water he had just brought from the fridge. On the pad, as was his habit, he had jotted down four bullet points. “There are fourreasons I think it’s much worse,”
he said after a 15-second pause.
TE AM FL Y
Team-Fly®
The Ballooning Budget Deficit 93
“Reason number one. The shenanigans in Washington are clearly on a much, much bigger scale. Heck, how much in extra profits were we able to squeeze out of our little shell game with the subsidiaries—$1 billion? Or $1.5 billion at the peak? Well, the Trea- sury’s manipulations with the government agencies and the Social Security fund add up to nearly $2 trillionjust since 2000. And how many employees did we have in our pension fund? At most, 40 thousand. Well, the government’s tricks with the Social Security funds could result in cuts for 45 millioncitizens!
“Reason number two,” he continued. “They’re not just juggling numbers—it’s real money. Remember our very first meeting a few years ago? Remember how I explained to you that we were not actually raiding the employee pension fund?”
“Refresh my memory,” Johnston requested.
“We weren’t taking actual cash from the pension fund. We were just moving numbers around in the accounting.”
“Ah, yes. Now I remember.”
“Well, guess what! The government actually doesraid the Social Security funds. They take that hard cash that’s supposed to be ear- marked for future Social Security checks, that belongs to tens of millions of citizens, and . . . theyspendit.”
Johnston’s forehead began twitching again. He could feel his blood pressure rising as Dulles continued.
“Reason number three. Did you ever wonder why the govern- ment let us and other big companies go hog-wild in the 1990s with- out so much as a faint word of caution? Did you ever wonder why the Fed suddenly stopped warning about ‘irrational exuberance’
and actually started encouraging the tech boom?”
“No. Why?”
“Because the government was raking it in too, and it didn’t want to do anything that might upset the applecart. Never forget—the tax man is the silent, ever-present partner behind every single company in America. When businesses make more money, the government takes in more tax money. Never forget that the government is also the silent partner of every company that exag- geratesits taxable profits. The more the companies exaggerate, the more they have to pay the government in taxes. The result: While corporate America was enjoying the 1990s superboom in profits, the U.S. Treasury Department was having its own superboom in
94 Crash Profits: Make Money When Stocks SinkandSoar
tax revenues. Just in corporate income taxes, the Treasury col- lected $204 billion in 1998, $213 billion in 1999 and $224 billion in 2000—despite the fact that many companies were finding new ways to avoid taxes, all ‘perfectly legal,’ of course.”
“Of course.”
“It was a windfall for the Treasury—a huge, unprecedented windfall. It was like sitting under a bulging money tree, shaking it gently and just letting all the money come pouring down into your baskets. Think about that for a moment. If you were managing the government’s cash flow in that environment, wouldn’t you have had the common sense to know that the boom could not go on for- ever? Wouldn’t you set aside some of the money for leaner times?
Unfortunately, they did exactly the opposite.”
“Why’s that?”
“They were listening to the government’s economists, of course.
The economists said the music would never stop and the party would never end.”
Dulles was out of breath and took a sip of water, but Johnston was just warming up. “You said there were four reasons the federal deficits could be even more dangerous than the private sector dis- aster,” he said. “What’s the fourth?”
“The fourth reason ties back directly to the nonresponse we got when we tried to issue that press release on the budget a couple of weeks ago.”
“I don’t get it.”
“I’m talking about the fact that the world is totally ignoring it!
Let me explain. When you confessed the troubles at UCBS, investors reacted right away, right? That was actually good. It meant they got the message. They absorbed it. Anyone who didn’t like the truth sold their stock, and that was the rational thing to do.
But that ended it. From then on, the stock stabilized. Not so in this case! The truth is not out yet. The government and the people are still living a pack of lies.”
“Yes, but . . .”
“Don’t you see? It’s the bubble psychology all over again. Back in the 1990s, if you talked about accounting problems or earnings exaggerations at major U.S. companies, people would throw you out on your rear end. Or worse, they’d simply ignore you. That
The Ballooning Budget Deficit 95
was the stock market bubble. Now, what we have is another kind of bubble, a far more dangerous bubble.”
“Which is . . . ?”
“The bond market bubble! If you thought the stock market crash was bad, wait till you see what a bond market crash feels like!
And remember: When bonds crash, interest rates—and mortgage rates—go up. So think of what that could do to American families in debt.”
P
aul Johnston was so deeply troubled by the federal deficits that he wanted to find out for him- self what the impact might be. He asked his staff for the contact info for one of the veteran government bond dealers in New York and gave the man a call. He prefaced the conversation with a brief apology for his general ignorance of bonds and interest rates. Then he asked what the future consequences might be of a ballooning federal deficit.The bond dealer was reticent at first but soon loosened up.
“Never mind what might be. It’s already happening! It seems like just a few months ago the folks in Congress and the White House were talking about $200 billion surpluses, stumbling over each other to see who could spend it the fastest. Now they’re talking about $200 billion deficits! Never in my 30 years in this business have I seen the deficit swing that far that fast!”
Johnston was going to mention the $1 trillion deficits Dulles had just told him about, but then decided not to. “What will that do to interest rates, to bond prices?” he queried.
“There’s only one way the government can continue to exist with a deficit—by borrowing. And there’s only one way it can bor- row—by selling bonds and other government securities to the pub- lic. The bigger the deficit, the more bonds they have to sell. It’s that
96