How much would the US government be worth if we valued it using a discounted cash flow (DCF) model like any other company? A new paper by Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh, and Mindy Z. Xiaolan addresses this question.
The exercise is simple and straightforward. Every American citizen and taxpayer in some way has a stake in the US government. The US government generates revenue through taxes and in return provides goods and services to its stakeholders. Meanwhile, the US government takes on a debt that it will have to pay in the future. It can raise debt to cover losses, but it cannot raise equity capital very easily.
The Congressional Budget Office (CBO) publishes long-term projections of government tax revenue, government spending, and debt through 2051 that can be used to estimate future cash flows.
But what about the discount rate? The authors correctly assume that the discount rate of future cash flows must be higher than the safe interest rate, or Treasury yield, for the corresponding maturity. Because? Because tax revenues are volatile and highly correlated with GDP growth. If the country goes into recession, tax revenues tend to drop off a cliff. Thus, the authors apply a discount rate that assumes there is a risk premium of 2.6% above Treasury yields. (Read the paper for more information on how the risk premium was derived.)
Putting these numbers into action, the authors conclude that the net present value of the government’s future primary surpluses—that is, government revenue minus government spending—is negative, amounting to $21.6 trillion. That’s a lot of money the government needs to raise to cover deficits between now and 2051.
But the government can raise debt, and the net present value of the debt on its balance sheet is about $31.7 trillion. So the total net present value of the US government is over $10 trillion. However, the total value of outstanding debt today is $23.5 trillion, or about $13.5 trillion more than the government is worth.
If the US government were a normal business, it would have had to file for bankruptcy long ago.
But the US government is no ordinary company. It has two distinct advantages. First, it can print money and generate income through the privilege of lordship. This lordship premium is estimated to add 0.6% to GDP each year through international demand for US Treasuries, given the US’s role as the world’s largest economy and the US dollar USA as the world’s dominant currency.
But even this royalty premium will add only about $3.7 trillion to the net present value of the US government, leaving a significant gap of more than $10 trillion.
This brings us to the second advantage. The US government can raise taxes and force its citizens to pay them. Of course, the government is more likely to raise taxes only after the economy hits a wall and it becomes more difficult to pay off existing debt and the interest on that debt. This means that the government will tend to raise taxes at the worst possible time, when GDP growth is low or negative, not when it is strong.
Therefore, if taxes are to cover public debt shortfalls, fiscal policy will have to become pro-cyclical and taxpayers will essentially be the insurance that covers the bankruptcy of the US government. In financial parlance, it’s as if US taxpayers had sold credit default swaps (CDS) to the US government.
And here’s a scarier thought: Not only have American citizens unwittingly insured the government against default, but the risk of default increases as interest rates climb higher. Because the US Congress, in its eternal wisdom, has decided to spend now and push additional revenue into the future, the duration of expenditures is much shorter than the duration of the revenue stream. Therefore, if interest rates rise, the increase in discount rates will cause the net present value of future income to decrease faster than the net present value of future costs.
That means the government needs to cut spending and raise revenue faster and more aggressively. The more interest rates rise, the more likely an insurance contract will be triggered and citizens will have to pay.
And government spending cuts won’t be enough to fix this mess either. They will cause GDP growth to decline and tax revenues to decline with it. Meanwhile, the risk premium on government cash flows will increase. This, in turn, makes the situation worse, as future income will be worth even less today, and the net present value of the US government will fall.
This is the quagmire the US government is in today. There’s only one way out of this as far as I can see: keep interest rates as low as possible for as long as possible. And that means negative real rates are likely here in the long run and may even get worse over time.
The faster interest rates rise today, the more financial repression will be necessary in the coming decades and the more America will look like Japan. I see no other way out of the current situation. All other paths lead to a US government default and with it a global economic crisis that will make the COVID-19 pandemic and the Great Depression look like child’s play.
For more information from Joachim Klement, CFA, don’t miss it Risk profile and tolerance i 7 mistakes every investor makes (and how to avoid them) and subscribe to his regular comment a Klement on investment.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Joachim Klement, CFA
