The media has been full of news and commentary about the debt ceiling and what would or would not happen in the event Congress and the White House couldn’t come to an agreement about raising the debt ceiling. Now we know. The Kabuki dance between the two political parties was simply theater—setting the stage for elections in 2012 and kicking the can down the road once again.
But there are long-term issues which will clearly impact the investment markets, so we’d like to help clients understand the concepts and implications to investors.
U.S. government debt is expected to reach 70% of our GDP (total economic production) by the end of this year. Importantly, deficits (income tax revenue minus government expenditures, not including Social Security and Medicare) are expected to continue for the next decade, adding to our debt. As John Mauldin, financial writer and best selling author, wrote last week, "No country save Britain at the height of its empire has ever recovered from a debt-to-GDP ratio of over 150% without a default. None. And the reason is simple arithmetic. Even a nominal interest rate of 6% means that it takes 10% of your national income just to pay the interest. Not 10% of tax revenues, mind you; 10% of your total domestic production." So the country must find a way to address the debt problem.
There are only four possible long-term solutions to the problem. We can increase tax revenues, cut government spending, inflate our way out of the problem, or default. True default (not just the temporary debt ceiling farce) is virtually incomprehensible and fraught with such massive adverse consequences that it’s not a realistic path to addressing the problem. Historically, most governments have used inflation as the solution of choice.
How does inflation solve the problem? If the cost of living doubles over some period of time, the value of our debt obligations falls in half. Inflation is simply a decline in the purchasing power of the dollar, which means that owners of U.S. debt will be paid back with cheaper dollars. To put that simply, an individual who is hoping to cash in his $25,000 Treasury note in 10 years to buy a car, will find out he no longer has enough dollars when the note matures because the price of the car is now $50,000. Using inflationary monetary policy, however, is very problematic today. The bond market quickly senses the declining value of a nation’s currency and demands an inflation premium be added to interest rates to compensate. Remember in 1983 the U. S. Treasury paid 15% interest on its 10-year note. Interest on our current debt alone comes to $414 billion per year and that’s at today’s historically low interest rates! If interest rates were to go up by only 2 percentage points, interest on the debt would increase by $280 billion! Imagine the damage to our balance sheet if rates returned to levels we saw in the 80’s.
That only leaves increasing revenues or decreasing spending. It is obvious that, at this point, the two political parties are still very far apart on using these levers as the long-term solution. On the issue of raising tax revenue, the press has done a horrible job of articulating how that can be accomplished. One issue is sloppy language. Raising tax revenues and raising tax rates are two very different things with important consequences for economic growth. Other avenues will surely be explored including eliminating deductions for mortgage interest, and instituting a “value added tax”. Regardless, any attempt to increase revenues by higher marginal tax rates or additional new taxes will result in slower economic growth.
Finally, we could reduce spending. As Milton Freidman pointed out, the benefits of government spending are very concentrated, the costs are widely dispersed. Therefore the beneficiaries of government largess will fight tooth and nail to keep their privilege—witness the fight over ethanol subsidies. That’s why this option is so challenging, especially insofar as it involves reducing entitlement spending, which is the biggest contributor to growth in government spending. However, this option offers the best chance to maintain economic growth, and thus inflict the least damage on the prospects for long-term investment returns.
At this point, we don’t know how the long-term debt problem will be addressed, only that it must be corrected lest we descend to the level of Greece. We do know that the investment implications are very different depending on the approach chosen. For example, veering sharply to austerity could be deflationary while a loose monetary approach would likely be inflationary. As it becomes clearer what path will be taken to deal with the problem, we expect to be able to make whatever portfolio adjustments are appropriate. We continue to believe a broadly diversified portfolio that can be tweaked in response to observed conditions is far superior to using forecasting to make big allocation “bets” as a way to preserve your wealth.