The Connection Between the Japan Disaster & the US Budget Deficit

Now that we are almost a week away from the worst disaster to strike Japan since World War II, a disaster that continues to unfold as a complete meltdown at a Japanese nuclear facility is looking more and more likely, economists are already starting to figure out the impact on the global economy.

Lest any doubt exist, the impact will be enormous and it will be felt by every market in every corner of the globe. After all, one cannot expect an event that successfully stops the world's third largest economy dead in its tracks to not have some sort of impact, albeit temporarily. As expected in a disaster of this magnitude, the United States has pledged money, military personnel, and emergency aid to our friends in Japan. While a price tag has yet to be determined, it would be simply unthinkable for us to do nothing while a close ally and economic partner suffers.

It is unfortunate timing that such a disaster would strike while Congress is still wrestling with the particulars of the 2011 budget, not to mention the fact that they have not yet begun to discuss the 2012 budget.

Who Pays For the Deficit?

With the exception of the Federal Reserve's highly controversial Quantitative Easing program where the Federal Reserve buys US Treasury bonds out of its ability to create money from whole cloth, the rest of the Deficit is funded by individual investors who purchase long-term US Treasury Bonds. These investors include banks, insurance companies, pension funds, etc.

The “Reinsurance” Model – Insurance for Catastrophe

Re-insurance, refers to the sub-industry of insurance. In essence, a re-insurance company insures your insurance company. It works basically like this:

Level 1: Say you own a home on the Jersey Shore. You take out a homeowners insurance policy to protect it in case it gets destroyed by fire, wind, flood (separate coverage), vandalism, etc. You pay your insurance company some money each month in exchange for the promise that if the house is severely damaged or destroyed, they will pay you to repair or replace it.

Level 2: In the event that every home in the neighborhood is destroyed by a single event like a hurricane, tsunami, or similar event, there is no way your insurance company has enough cash on hand to cover your house and every other house in the neighborhood. Therefore, your insurance company buys a “re-insurance” policy where they pool your policy as well as the policies of hundreds or thousands of other homeowners into a single contract called a “treaty”. They take a portion of what you pay to your “primary” insurer, and give that to your “reinsurer” in exchange for the promise that should a really big catastrophic event occur, the reinsurer will provide the cash needed to replace all of the houses in the neighborhood.

Level 3: Catastrophic events don't happen every day. So in order to increase the income for the reinsurer and to keep the price of reinsurance affordable, they invest the premiums they collect – primarily in the bond market. In the event that they actually have to pay out a lot of cash in the event of a catastrophe, they sell the bonds, generate the cash, and pay the claims. Which bonds are considered the safest in the world? You guessed it – US Treasury bonds.

Japanese Reinsurers Sell US Treasury Bonds

While we are still a far cry from knowing exactly how many US Treasury bonds are being sold back to Uncle Sam right now, what we do know is that the process has already begun. What we already know is that for those bonds that are about to mature, the Japanese reinsurers have already indicated that they do not intend to re-purchase or “roll over” those bonds into new ones as they are anticipating that they will be needed large amounts of cash to pay for the multi-billion dollar claims they are anticipating.

What does this mean for Congress?

We already know that the Budget Deficit is too big for the current bond market. In other words, there are simply not enough investors to purchase all of the new debt that the US Government is generating. That is why the Federal Reserve had to step in to purchase $600 Billion of debt just to keep interest rates on the debt at a reasonable level, otherwise the US debt would become more toxic, and less attractive to the investors we still have. In fact, the PIMCO Total Return Fund, one of the most respected mutual funds on the market, just last week (prior to the earthquake) decided to sell off all of its US Treasury holdings in exchange for Corporate bonds.

Here's the bottom line:

  • Japanese reinsurers will have to sell off their old US Debt, and they will be unable to finance any new debt. This will likely cost the US Government hundreds of Billions of dollars.
  • The Fed's program of buying US Treasuries will end in June (so says Ben Bernake).
  • Yields on US Treasury are too low for our own Mutual Funds to consider them a sound investment, especially with the risk of inflation growing each day.

With nobody in the market to fund the Deficit, the Federal Government will have no choice but to cut hundreds of Billions of dollars from Federal Spending THIS YEAR. Unfortunately, bickering over such small line items such as the NEA, NPR, and other small items is not going to cut it. Where the money needs to be cut is from the largest line items such as Defense Spending and Entitlement Programs. Otherwise, the Government may run out of money THIS year.

Of course, there's always QE III, right?

Update: 3/18/2011 – This column by Michael Lewis was just published today on Bloomberg. The similarities between my article and his are striking. It appears that great minds think alike!  :)

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