Fiscal Disaster This Way Comes!

I was shocked to see this headline just minutes ago!

Let's do the math on that! $1 trillion for one month X 12 months equals $12 trillion of spending for the year!
Even the deficit looks like a coming disaster! $738 billion for one month X 12 months equals a prospective deficit of $8.856 trillion of new debt for one year! That's more than 6 times the previous annual record! That ensures an eventual disaster!
Is is any wonder that the Dow futures are down 650 points as I post this?
And yet House Democrats are expected to pass another stimulus package today for an additional $3 trillion of spending! It guarantees a fiscal calamity!

Why "Tax the Rich" Won't Work!

by Charles Hugh Smith at the Of Two Minds blog:


Will "Tax the Rich" Solve Our Deficit/Spending Crisis?   (December 28, 2011)
If we look at tax revenues and income in a practical way, we find "tax the rich" will not close the widening $1.5 trillion gap between Federal revenues and spending.
Clearly, $1.5 trillion annual Federal deficits to fund the Status Quo--fully 10% of the nation's GDP--is unsustainable. Eventually, the ad hoc "solutions" currently being pushed by the Federal Reserve--zero interest rates to keep borrowing costs artificially low and money-printing operations that buy Treasury debt--will encounter political and/or market pressures which will limit the marginal effectiveness of these interventions, and the real cost of these historically unprecedented deficits will trigger a host of unintended consequences--all negative.
Everyone knows there are only two ways to bring deficits back to sustainable levels: skim more tax revenues from the national income or cut spending on the massive Status Quo programs of Defense/National Security, Medicare/Medicaid and Social Security. The rest of the Federal programs so reviled by various constituencies are a relative drop in the bucket.
Everyone with a stake in the Status Quo Federal spending--and that is certainly in excess of 100 million residents of the U.S.--is vocally in favor of "taxing the rich" as the "obvious and just solution" to the widening gap between revenues and spending.
If there is one stance that can gather non-partisan support, it's "tax the rich." More knowledgeable observers refine this to "tax the super-rich," as the majority of the wealth and income of the top 1% is actually held by the top 1/10th of 1%.
We can break this idea down into two basic parts: the ethical case and the revenue case. Ethically, at least in a democracy, the idea that everyone with substantial wealth and income should pay at least as much (as a percentage of income) as wage-earning citizens is compelling.
Various studies have found that the extremely wealthy pay about 17% of their income in Federal taxes, which is less than half of what we self-employed people pay (15.6% self-employment + 25% Federal tax on all income above about $34,000 = 40.6%).
The merely well-off--typically professionals, managers and small business owners--pay the majority of Federal taxes, with the very wealthy paying a substantial share as well. Roughly half of all those filing tax returns pay no Federal tax other than the employees' 7.65% FICA (Social Security) tax.
In the larger scheme of things, the bottom 60% of the workforce pays relatively little of the total Federal tax revenues. (Check U.S. Census records or search my site for sources that break down the sources of Federal tax revenues.)
In other words, the "rich"--or those who the average person considers "rich"--already pay most of the Federal taxes.
How much additional tax could be raised were the super-wealthy to pay the same 40% rate that we self-employed people pay? It is tempting to estimate that another $1 trillion or so could be raised from the super-wealthy, largely from non-wage (unearned) income.
I have addressed this yawning gap between spending and revenues in the past, for example:
The Promises That Cannot Be Kept (July 6, 2011)
As noted in the above entry (the TrimTabs chart), Americans' after-tax income is around $5.3 trillion and $900 billion in income from "other sources." Additional taxes would of course come from current after tax-income. It's difficult to sort out all the various measures of income; the BEA, for example, includes "government transfers" as personal income--though those transfers come from tax revenues.
Including government transfers and arcane categories such as "inventory valuation adjustment (IVA) and capital consumption adjustment (CCAdj)", the BEA counts $12 trillion in earned income. But if strip out transfers and inventory adjustments etc., that number drops to around $8.4 trillion. (Two Americas: The Gap Between the Top 5% and the Bottom 95% Widens August 18, 2010)
Total Federal tax revenues are about $630 billion from Social Security taxes and $1.5 trillion from Federal income taxes, or a total of $2.1 trillion. To Fix Social Security, First Ask Why It Is Deep in the Red (January 18, 2011).
There are local and state taxes, too, of course, which leaves the $6.2 trillion in after-tax income noted earlier. Since the top 10% collect roughly half the income, we can guesstimate that the top 10% receives about $3 trillion. To balance the current budget, they would need to pay 50% of their after-tax income ($1.5 trillion)--on top of the substantial taxes they already pay. (maybe the top 1/10th of 1% pay 17%, but the merely wealthy pay much higher rates on earned income.)
Add this up and you get tax rates of around 65% on the top 10% (25% total income rate plus 50% of the remaining income).
We then have to ask whether these rates would ever be collected.
There are a number of factors that affect actual tax collections from theoretical calculations. One is that Congress is a collection of wealthy people who are seeking to increase their power while minimizing their taxes and those paid by their cronies and contributors. As long as this is the case, then the tax code will continue to be thousands of pages long with exclusions, taxbreaks and exemptions for the politically connected wealthy.
Another is that studies have found Federal tax collections have historically topped out around 21% of total income. Above that level, people make choices that reduce their tax burdens.
Just as a thought experiment, put yourself in the shoes of someone with $20 million in assets and an income of $1 million. First off, you have a tax attorney who works the complex tax code to put as much of your income as possible in lower-rate income--for example, long-term capital gains.
Wealthy individuals shelter their income and assets with corporations, which have many more options in terms of shifting income.
Secondly, you have overseas accounts, assets and options. Let's say you are ethical, and pay your legal taxes without resorting to questionable tax havens. Let's stipulate that you are just like any other taxpayer--you feel no obligation to pay more than your legal share.
International agreements mean that income need only be declared and taxes paid on it in one jurisdiction. So income declared in Switzerland is exempt from taxes in the U.S., as taxes have already been paid in Switzerland.
Though I am not that knowledgeable about tax law, anecdotally it seems total tax rates in Switzerland are around 25%. If rates in the U.S. were jacked to 50% or higher, then very wealthy individuals will shift income to places like Switzerland and pay the lower tax rates there--perfectly legally. They would also liquidate assets in states which attempted to raise taxes on real property or enterprises, and shift those assets to lower-tax states or nations.
This would not be perceived as "tax avoidance," but as rational money management. In this sense, the super-wealthy are simply doing what every household does--attempt to lower taxes by whatever legal means are available. The means available to those with income and assets that can be shifted around are simply more capacious.
In practical terms, collecting another $1.5 trillion annually is problematic on multiple levels. Practically speaking, it might be wise to align total U.S. tax burdens with those of Switzerland and similar developed-world tax havens, for those essentially set the top rate that very wealthy individuals will pay.
Such a system would flatten taxation rates and very likely increase total tax collections. But it is simply not practical to think that the Federal government can skim 45% of the nation's $8.4 trillion in income to fund the bloated, corrupt and inefficient $3.7 trillion Federal budget.
How about those soaring corporate profits? If we taxed 100% of the $1.5 trillion corporate profits, then we could close the $1.5 trillion budget deficit. But then Wall Street would have nothing to support those sky-high stock valuations.

Three Competing Economic Theories

By Lacy Hunt, Hoisington Asset Management
The three competing theories for economic contractions are: 1) the Keynesian, 2) the Friedmanite, and 3) the Fisherian. The Keynesian view is that normal economic contractions are caused by an insufficiency of aggregate demand (or total spending). This problem is to be solved by deficit spending. The Friedmanite view, one shared by our current Federal Reserve Chairman, is that protracted economic slumps are also caused by an insufficiency of aggregate demand, but are preventable or ameliorated by increasing the money stock. Both economic theories are consistent with the widely-held view that the economy experiences three to seven years of growth, followed by one to two years of decline. The slumps are worrisome, but not too daunting since two years lapse fairly quickly and then the economy is off to the races again. This normal business cycle framework has been the standard since World War II until now.
The Fisherian theory is that an excessive buildup of debt relative to GDP is the key factor in causing major contractions, as opposed to the typical business cycle slumps (Chart 1). Only a time consuming and difficult process of deleveraging corrects this economic circumstance. Symptoms of the excessive indebtedness are: weakness in aggregate demand; slow money growth; falling velocity; sustained underperformance of the labor markets; low levels of confidence; and possibly even a decline in the birth rate and household formation. In other words, the normal business cycle models of the Keynesian and Friedmanite theories are overwhelmed in such extreme, overindebted situations.

Economists are aware of Fisher’s views, but until the onset of the present economic circumstances they have been largely ignored, even though Friedman called Irving Fisher “America’s greatest economist.” Part of that oversight results from the fact that Fisher’s position was not spelled out in one complete work. The bulk of his ideas are reflected in an article and book written in 1933, but he made important revisions in a series of letters later written to FDR, which currently reside in the Presidential Library at Hyde Park. In 1933, Fisher held out some hope that fiscal policy might be helpful in dealing with excessive debt, but within several years he had completely rejected the Keynesian view. By 1940, Fisher had firmly stated to FDR in several letters that government spending of borrowed funds was counterproductive to stimulating economic growth. Significantly, by 2011, Fisher’s seven decade-old ideas have been supported by thorough, comprehensive and robust econometric and empirical analysis. It is now evident that the actions of monetary and fiscal authorities since 2008 have made economic conditions worse, just as Fisher suggested. In other words, we are painfully re-learning a lesson that a truly great economist gave us a road map to avoid.

High Dollar Policy Failures

If governmental financial transactions, advocated by following Keynesian and Friedmanite policies, were the keys to prosperity, the U.S. should be in an unparalleled boom. For instance, on the monetary side, since 2007 excess reserves of depository institutions have increased from $1.8 billion to more than $1.5 trillion, an amazing gain of more than 83,000%. The fiscal response is equally unparalleled. Combining 2009, 2010, and 2011 the U.S. budget deficit will total 28.3% of GDP, the highest three year total since World War II, and up from 6.3% of GDP in the three years ending 2008 (Chart 2). Importantly, the massive advance in the deficit was primarily due to a surge in outlays that was more than double the fall in revenues. In the current three years, spending was an astounding $2.2 trillion more than in the three years ending 2008. The fiscal and monetary actions combined have had no meaningful impact on improving the standard of living of the average American family (Chart 3).

Why Has Fiscal Policy Failed?

Four considerations, all drawn from contemporary economic analysis, explain the underlying cause of the fiscal policy failures and clearly show that continuing to repeat such programs will generate even more unsatisfactory results.
First, the government expenditure multiplier is zero, and quite possibly slightly negative. Depending on the initial conditions, deficit spending can increase economic activity, but only for a mere three to five quarters. Within twelve quarters these early gains are fully reversed. Thus, if the economy starts with $15 trillion in GDP and deficit spending is increased, then it will end with $15 trillion of GDP within three years. Reflecting the deficit spending, the government sector takes over a larger share of economic activity, reducing the private sector share while saddling the same-sized economy with a higher level of indebtedness. However, the resources to cover the interest expense associated with the rise in debt must be generated from a diminished private sector.
The problem is not the size or the timing of the actions, but the inherent flaws in the approach. Indeed, rigorous, independently produced statistical studies by Robert Barro of Harvard University in the United States and Roberto Perotti of Universita Bocconi in Italy were uncannily accurate in suggesting the path of failure that these programs would take. From 1955 to 2006, Dr. Barro estimates the expenditure multiplier at -0.1 (p. 206 Macroeconomics: A Modern Approach, Southwestern 2009). Perotti, a MIT Ph.D., found a low but positive multiplier in the U.S., U.K., Japan, Germany, Australia and Canada. Worsening the problem, most of those who took college economic courses assume that propositions learned decades ago are still valid. Unfortunately, new tests and the availability of more and longer streams of macroeconomic statistics have rendered many of the well-schooled propositions of the past five decades invalid.Second, temporary tax cuts enlarge budget deficits but they do not change behavior, providing no meaningful boost to economic activity. Transitory tax cuts have been enacted under Presidents Ford, Carter, Bush (41), Bush (43), and Obama. No meaningful difference in the outcome was observable, regardless of whether transitory tax cuts were in the form of rebate checks, earned income tax credits, or short-term changes in tax rates like the one year reduction in FICA taxes or the two year extension of the 2001/2003 tax cuts, both of which are currently in effect. Long run studies of consumer spending habits (the consumption function in academic circles), as well as detailed examinations of these separate episodes indicate that such efforts are a waste of borrowed funds. This is because while consumers will respond strongly to permanent or sustained increases in income, the response to transitory gains is insignificant. The cut in FICA taxes appears to have been a futile effort since there was no acceleration in economic growth, and the unfunded liabilities in the Social Security system are now even greater. Cutting payroll taxes for a year, as former Treasury Secretary Larry Summers advocates, would be no more successful, while further adding to the unfunded Social Security liability.
Third, when private sector tax rates are changed permanently behavior is altered, and according to the best evidence available, the response of the private sector is quite large. For permanent tax changes, the tax multiplier is between minus 2 and minus 3. If higher taxes are used to redress the deficit because of the seemingly rational need to have“shared sacrifice,” growth will be impaired even further. Thus, attempting to reduce the budget deficit by hiking marginal tax rates will be counterproductive since economic activity will deteriorate and revenues will be lost.
Fourth, existing programs suggest that more of the federal budget will go for basic income maintenance and interest expense; therefore the government expenditure multiplier may become more negative. Positive multiplier expenditures such as military hardware, space exploration and infrastructure programs will all become a smaller part of future budgets. Even the multiplier of such meritorious programs may be much less than anticipated since the expended funds for such programs have to come from somewhere, and it is never possible to identify precisely what private sector program will be sacrificed so that more funds would be available for federal spending. Clearly, some programs like the first-time home buyers program and cash for clunkers had highly negative side effects. Both programs only further exacerbated the problems in the auto and housing markets.

Permanent Fiscal Solutions Versus Quick Fixes

While the fiscal steps have been debilitating, new programs could improve business considerably over time. A federal tax code with rates of 15%, 20%, and 25% for both the household and corporate sectors, but without deductions, would serve several worthwhile purposes. Such measures would be revenue neutral, but at the same time they would lower the marginal tax rates permanently which, over time, would provide a considerable boost for economic growth. Moreover, the private sector would save $400-$500 billion of tax preparation expenses that could then be channeled to other uses. Admittedly, the path to such changes would entail a long and difficult political debate.
In the 2011 IMF working paper, “An Analysis of U.S. Fiscal and Generational Imbalances,” authored by Nicoletta Batini, Giovanni Callegari, and Julia Guerreiro, the options to correct the problem are identified thoroughly. These authors enumerate the ways to close the gaps under different scenarios in what they call “Menu of Pain.” Rather than lacking the knowledge to improve the economic situation, there may not be the political will to deal with the problems because of their enormity and the huge numbers of Americans who would be required to share in the sacrifices. If this assessment is correct, the U.S. government will not act until a major emergency arises.

The Debt Bomb

The two major U.S. government debt to GDP statistics commonly referred to in budget discussions are shown in Chart 4. The first is the ratio of U.S. debt held by the public to GDP, which excludes federal debt held in various government entities such as Social Security and the Federal Reserve banks. The second is the ratio of gross U.S. debt to GDP. Historically, the debt held by the public ratio was the more useful, but now the gross debt ratio is more relevant. By 2015, according to the CBO, debt held by the public will jump to more than 75% of GDP, while gross debt will exceed 104% of GDP. The CBO figures may be too optimistic. The IMF estimates that gross debt will amount to 110% of GDP by 2015, and others have even higher numbers. The gross debt ratio, however, does not capture the magnitude of the approaching problem.

According to a recent report in USA Today, the unfunded liabilities in the Social Security and Medicare programs now total $59.1 trillion. This amounts to almost four times current GDP. Modern accrual accounting requires corporations to record expenses at the time the liability is incurred, even when payment will be made later. But this is not the case for the federal government. By modern private sector accounting standards, gross federal debt is already 500% of GDP.

Federal Debt – the End Game

Economic research on U.S. Treasury credit worthiness is of significant interest to Hoisington Management because it is possible that if nothing is politically accomplished in reducing our long-term debt liabilities, a large risk premium could be established in Treasury securities. It is not possible to predict whether this will occur in five years, twenty years, or longer. However, John H. Cochrane of the University of Chicago, and currently President of the American Finance Association, spells out the end game if the deficits and debt are not contained. Dr. Cochrane observes that real, or inflation adjusted Federal government debt, plus the liabilities of the Federal Reserve (which are just another form of federal debt) must be equal to the present value of future government surpluses (Table 1). In plain language, you owe a certain amount of money so your income in the future should equal that figure on a present value basis. Federal Reserve liabilities are also known as high powered money (the sum of deposits at the Federal Reserve banks plus currency in circulation). This proposition is critical because it means that when the Fed buys government securities it has merely substituted one type of federal debt for another. In quantitative easing (QE), the Fed purchases Treasury securities with an average maturity of about four years and replaces it with federal obligations with zero maturity. Federal Reserve deposits and currency are due on demand, and as economists say, they are zero maturity money. Thus, QE shortens the maturity of the federal debt but, as Dr. Cochrane points out, the operation has merely substituted one type for another. The sum of the two different types of liabilities must equal the present value of future governmental surpluses since both the Treasury and Fed are components of the federal government.

Calculating the present value of the stream of future surpluses requires federal outlays and expenditures and the discount rate at which the dollar value of that stream is expressed in today’s real dollars. The formula where all future liabilities must equal future surpluses must always hold. At the point that investors lose confidence in the dollar stream of future surpluses, the interest rate, or discount rate on that stream, will soar in order to keep the present value equation in balance. The surge in the discount rate is likely to result in a severe crisis like those that occurred in the past and that currently exist in Europe. In such a crisis the U.S. will be forced to make extremely difficult decisions in a very short period of time, possibly without much input from the political will of American citizens. Dr. Cochrane does not believe this point is at hand, and observes that Japan has avoided this day of reckoning for two decades. The U.S. may also be able to avoid this, but not if the deficits and debt problem are not corrected. Our interpretation of Dr. Cochrane’s analysis is that, although the U.S. has time, not to urgently redress these imbalances is irresponsible and begs for an eventual crisis.

Monetary Policy’s Numerous Misadventures

Fed policy has aggravated, rather than ameliorated our basic problems because it has encouraged an unwise and debilitating buildup of debt, while also pursuing short term policies that have increased inflation, weakened economic growth, and decreased the standard of living. No objective evidence exists that QE has improved economic conditions. Even before the Japanese earthquake and weather related problems arose this spring, real economic growth was worse than prior to QE2. Some measures of nominal activity improved, but these gains were more than eroded by the higher commodity inflation. Clearly, the median standard of living has deteriorated.
When the Fed diverts attention with QE, it is possible to lose sight of the important deficit spending, tax and regulatory barriers that are restraining the economy’s ability to grow. Raising expectations that Fed actions can make things better is a disservice since these hopes are bound to be dashed. There is ample evidence that such a treadmill serves to make consumers even more cynical and depressed. To quote Dr. Cochrane, “Mostly, it is dangerous for the Fed to claim immense power, and for us to trust that power when it is basically helpless. If Bernanke had admitted to Congress, ‘There’s nothing the Fed can do. You’d better clean this mess up fast,’ he might have a much more salutary effect.” Instead, Bernanke wrote newspaper editorials, gave speeches, and appeared on national television taking credit for improved economic conditions. In all instances these claims about the Fed’s power were greatly exaggerated.

Summary and Outlook

In the broadest sense, monetary and fiscal policies have failed because government financial transactions are not the key to prosperity. Instead, the economic well-being of a country is determined by the creativity, inventiveness and hard work of its households and individuals.
A meaningful risk exists that the economy could turn down prior to the general election in 2012, even though this would be highly unusual for presidential election years. The econometric studies that indicate the government expenditure multiplier is zero are evidenced by the prevailing, dismal business conditions. In essence, the massive federal budget deficits have not produced economic gain, but have left the country with a massively inflated level of debt and the prospect of higher interest expense for decades to come. This will be the case even if interest rates remain extremely low for the foreseeable future. The flow of state and local tax revenues will be unreliable in an environment of weak labor markets that will produce little opportunity for full time employment. Thus, state and local governments will continue to constrain the pace of economic expansion. Unemployment will remain unacceptably high and further increases should not be ruled out. The weak labor markets could in turn force home prices lower, another problematic development in current circumstances. Inflationary forces should turn tranquil, thereby contributing to an elongated period of low bond yields. The Fed may resort to another round of quantitative easing, or some other untested gimmick with a new name. Such undertakings will be no more successful than previous efforts that increased over-indebtedness or raised transitory inflation, which in turn weakened the economy by directly, or indirectly, intensifying financial pressures on households of modest and moderate means.
While the massive budget deficits and the buildup of federal debt, if not addressed, may someday result in a substantial increase in interest rates, that day is not at hand. The U.S. economy is too fragile to sustain higher interest rates except for interim, transitory periods that have been recurring in recent years. As it stands, deflation is our largest concern, therefore we remain fully committed to the long end of the Treasury bond market.

John Mauldin: Hard Dose of Economic Reality

This week we are going to revisit some themes concerning the problems of the debt and the deficit. I am getting a number of questions, so while long-time readers may have read most of this in one letter or another, it is clearly time for a review, especially given the deficit/debt-ceiling debate. I will probably offend some cherished beliefs of most readers, but that is the nature of the times we live in. It is the time of the Endgame, where things are not as black and white as they have been in the past.
Let’s begin with a question that is representative of a lot of the questions I have been getting, from reader John:
“John, it appears that you're arguing that two contradictory things have the same effect: adding government spending doesn't help the economy, and reducing government spending hurts the economy. Which is it? At first, you say that adding government spending doesn't help, no new jobs are actually created, it fails the sharp pencil test, etc. So, we should reduce this waste, right? Well, yes, you say, but that will reduce GDP too. I just don't get it. You seem to have it both ways: increasing government spending is bad, and reducing it is bad. What is your point?”
Yes, I am saying both things, and they are not contradictory. We are coming to the end of the debt supercycle in the US, and have reached that point in much of Europe, and soon will in Japan. So while I am going to focus on the US, at least this week, the same principles apply to all the developed world.
For some 65-odd years, we have added to the national debt – individually, corporately, and as governments. But as Greece is finding out, there is a limit (more on that later). Eventually the bond market decides that loaning you more money is not a high-value proposition. If your home or your government is debt financed, you are forced to cut back. While the US is not there yet, we soon (as in a few years) will be.
One way or another, the budget deficits are going to come down. As we will see later, we can choose to proactively deal with the deficit problem or we can wait until there is a crisis and be forced to react. These choices result in entirely different outcomes.
In the US, the real question we must ask ourselves as a nation is, “How much health care do we want and how do we want to pay for it?” Everything else can be dealt with if we get that basic question answered. We can radically cut health care along with other discretionary budget items, or we can raise taxes, or some combination. Both have consequences. The polls say a large, bipartisan majority of people want to maintain Medicare and other health programs (perhaps reformed), and yet a large bipartisan majority does not want a tax increase. We can’t have it both ways, which means there is a major job of education to be done.
The point of the exercise is to reduce the deficit over 5-6 years to below the growth rate of nominal GDP (which includes inflation). A country can run a deficit below that rate forever, without endangering its economic survival. While it may be wiser to run some surpluses and pay down debt, if you keep your fiscal deficits lower than income growth, over time the debt becomes less of an issue.

GDP = C + I + G + Net Exports

But either raising taxes or cutting spending has side effects that cannot be ignored. Either one or both will make it more difficult for the economy to grow. Let’s quickly look at a few basic economic equations. The first is GDP = C + I + G + net exports, or GDP is equal to Consumption (Consumer and Business) + Investment + Government Spending + Net Exports (Exports – Imports). This is true for all times and countries.
Now, what typically happens in a business-cycle recession is that, as businesses produce too many goods and start to cut back, consumption falls; and the Keynesian response is to increase government spending in order to assist the economy to start buying and spending; and the theory is that when the economy recovers you can reduce government spending as a percentage of the economy – except that has not happened for a long time. Government spending just kept going up. In response to the Great Recession, government (both parties) increased spending massively. And it did have an effect. But it wasn’t just the cost of the stimulus, it was the absolute size of government that increased as well.
And now massive deficits are projected for a very long time, unless we make changes. The problem is that taking away that deficit spending is going to be the reverse of the stimulus – a negative stimulus if you will. Why? Because the economy is not growing fast enough to overcome the loss of that stimulus. We will notice it. This is a short-term effect, which most economists agree will last 4-5 quarters; and then the economy may be better, with lower deficits and smaller government.
However, in order to get the deficit under control, we are talking on the order of reducing the deficit by 1% of GDP every year for 5-6 years. That is a very large headwind on growth, if you reduce potential nominal GDP by 1% a year in a world of a 2% Muddle Through economy. (And GDP for the US came in at an anemic 1.75% yesterday, with very weak final demand.)
Further, tax increases reduce GDP by anywhere from 1 to 3 times the size of the increase, depending on which academic study you choose. Large tax increases will reduce GDP and potential GDP. That may be the price we want to pay as a country, but we need to recognize that there is a hit to growth and employment. Those who argue that taking away the Bush tax cuts will have no effect on the economy are simply not dealing with either the facts or the well-established research. (Now, that is different from the argument that says we should allow them to expire anyway.)

Increasing Productivity

There are only two ways to grow an economy. Just two. You can increase the working-age population or you can increase productivity. That’s it. No secret sauce. The key is for us to figure out how to increase productivity. Let’s refer again to our equation:
GDP = C + I + G + net exports
The I in the equation is investments. That is what produces the tools and businesses that make “stuff” and buy and sell services. Increasing government spending, G, does not increase productivity. It transfers taxes taken from one sector of the economy and to another, with a cost of transfer, of course. While the people who get the transfer payments and services certainly feel better off, those who pay taxes are left with less to invest in private businesses that actually increase productivity. As I have shown elsewhere, over the last two decades, the net new jobs in the US have come from business start-ups. Not large businesses (they are a net drag) and not even small businesses. Understand, some of those start-ups became Google and Apple, etc.; but many just become good small businesses, hiring 5-10-50-100 people. But the cumulative effect is growth in productivity and the economy.
Now, if you mess with our equation, what you find is that Investments = Savings.
If the government “dis-saves” or runs deficits, it takes away potential savings from private investments. That money has to come from somewhere. Of late, it has come from QE2, but that is going away soon. And again, let’s be very clear. It is private investment that increases productivity, which allows for growth, which produces jobs. Yes, if the government takes money from one group and employs another, those are real jobs; but that is money that could have been put to use in private business investment. It is the government saying we know how to create jobs better than the taxpayers and businesses we take the taxes from.
This is not to argue against government and taxes. There are true roles for government. The discussion we must now have is how much government we want, and recognize that there are costs to large government involvement in the economy. How large a drag can government be? Let’s look at a few charts. The first two are from my friend Louis Gave, of GaveKal. This first one reveals the correlation between the growth of GDP in France and the size of government. It shows the rate of growth in GDP and the ratio of the size of the public sector in relation to the private sector. The larger the percentage of government in the ratio, the lower the growth.

I know, you think this is just the French. We all know their government is too involved in everything, don’t we. But it works in the US as well. The chart below shows the combined US federal, state, and local expenditures as a percentage of GDP (left-hand scale, which is inverted) versus the 7-year structural growth rate, shown on the right-hand side. And you see a very clear correlation between the size of total government and structural growth. This chart and others like it can be done for countries all over the world.

Now let’s review a graph from Rob Arnott of Research Affiliates. The chart needs a little setup. It shows the contributions of the private sector and the public sector to GDP. Remember, the C in our equation was private and business consumption. The G is government. And G makes up a rather large portion of overall GDP.
The top line (in dark blue) is real GDP per capita. The next line (yellow) shows what GDP would have been without borrowing. So a very real portion of GDP the last few years has come from government debt. Now, the green line below that is private-sector GDP. This is sad, because it shows that the private sector, per capita, is roughly where it was in 1998. The growth of the “economy” has been limited to government.

Notice that real GDP without government spending or deficits has been flat for 15 years (which, as a sidebar, also explains why real wages for private individuals are flat as well, but that’s a topic for another letter). Now, here is what to pay attention to. For the last several years, the real growth in GDP has come from the US government borrowing money. Without that growth in debt, we would be in what most would characterize as a depression.
This is why Paul Krugman and his fellow neo-Keynesians argue that we need larger deficits, not smaller ones. For them the issue is final aggregate consumer demand, and they believe you can stimulate that by giving people money to spend and letting future generations pay for that spending. And sine WW2 they have been right, kind of. When the US has gone into a recession, the government has embarked on deficit spending and the economy has recovered. The Keynesians see cause and effect. And thus they argue we now need more “hair of the dog” to prompt the recovery, which is clearly starting to lag behind what they think of as normal growth.
But others (and I am in this camp) argue that business-cycle recessions are normal and that recoveries would come anyway, and are not caused by increased government debt and spending but by businesses adjusting and entrepreneurs creating new companies. Correlation is not causation. Just because recoveries happened when the government ran deficits does not mean that they were the result of government spending. This is not to argue that the government should not step in with a safety net for the unemployed – again, a subject for another letter.
Let’s see what Rob Arnott says about this conundrum:
“GDP is consumer spending, plus government outlays, plus gross investments, plus exports, minus imports. With the exception of exports, GDP measures spending. The problem is, GDP makes no distinction between debt-financed spending and spending that we can cover out of current income.
“Consumption is not prosperity. The credit-addicted family measures its success by how much it is able to spend, applauding any new source of credit, regardless of the family income or ability to repay. The credit-addicted family enjoys a rising “family GDP” – consumption – as long as they can find new lenders, and suffers a family “recession” when they prudently cut up their credit cards.
“In much the same way, the current definition of GDP causes us to ignore the fact that we are mortgaging our future to feed current consumption. Worse, like the credit-addicted family, we can consciously game our GDP and GDP growth rates – our consumption and consumption growth – at any levels our creditors will permit!
“Consider a simple thought experiment. Let’s suppose the government wants to dazzle us with 5% growth next quarter (equivalent to 20% annualized growth!). If they borrow an additional 5% of GDP in new additional debt and spend it immediately, this magnificent GDP growth is achieved! We would all see it as phony growth, sabotaging our national balance sheet – right? Maybe not. We are already borrowing and spending 2% to 3% each quarter, equivalent to 10% to 12% of GDP, and yet few observers have decried this as artificial GDP growth because we’re not accustomed to looking at the underlying GDP before deficit spending!
“From this perspective, real GDP seems unreal, at best. GDP that stems from new debt – mainly deficit spending – is phony: it is debt-financed consumption, not prosperity. Isn’t GDP after excluding net new debt obligations a more relevant measure? Deficit spending is supposed to trigger growth in the remainder of the economy, net of deficit-financed spending, which we can call our “Structural GDP.” If Structural GDP fails to grow as a consequence of our deficits, then deficit spending has failed in its sole and singular purpose.
“Of course, even Structural GDP offers a misleading picture. Our Structural GDP has grown nearly 100-fold in the last 70 years. Most of that growth is due to inflation and population growth; a truer measure of the prosperity of the average citizen must adjust for these effects.”
And thus the graph above showing private GDP and the difference in the GDP numbers that are reported in the media. I used Rob’s entire (and brilliant) piece as an Outside the Box last May. If you missed it, you can go to http://www.johnmauldin.com/outsidethebox/does-unreal-gdp-drive-our-policy-choices/

 

and review it.

The Trillion Dollar Question

Now, in our review, let’s get back to reader John’s question. I have used this chart before, but it bears another quick look. This is from the Heritage Foundation. It is a year old, and one can quibble about the specifics. That is not the point of today’s issue. The point is that, whatever the deficit is, it is huge. This is a chart of something that will not happen, as the bond market will simply not finance a deficit as large as the one that looms in our future. Long before we get to 2019, we will have our own Greek (or Irish or Portuguese or Japanese, etc.) moment. (Or Spanish or Italian or Belgian – so many countries, so much debt!)

For the sake of the argument and our thought experiment, let’s split the difference on that chart. Somehow we must then find about $1.2 trillion in cuts or taxes to get the deficit down to below the growth rate of nominal GDP. And another few hundred billion if we actually want to balance the budget.
And that, gentle reader, is no small hill to climb. Let’s say we cut spending and/or raise taxes by $200 billion a year for 6 years. That is more than 1% of GDP each and every year! Go back to the first chart. That means that potential GDP growth will be reduced by over 1% a year! Every year. We would need to rely upon private GDP growth, which Rob’s chart shows has been flat for almost 15 years! The growth of the last 11 years has been a government-financed illusion.
There are no good choices. The time for good choices was years ago. I was and still am a fan of the Bush tax cuts. They were not the problem; a few years after the cuts, tax revenues were up considerably. The problem was a profligate Republican Congress which allowed spending to rise even more. And you can’t just blame it on the wars. That contributed, but it was not even close to the lion’s share. If we had held the line on spending, we would have paid off the entire debt and been in good shape when the crisis hit in 2008. The following graph is from today’s Wall Street Journal editorial page. They use it to show how much Democrats allowed the budget in terms of GDP to rise and spin out of control.
I would point out that in the 8 previous years, under Bush/Hastert/Delay et al., there was also a rise in the growth of government, as the chart shows. While it was not as large, it was clearly there. The drop in the previous period was the Bill Clinton/Newt Gingrich years. How many people are nostalgic for that pairing? Say what you will about them, their collaboration was a good era for growth in the private sector – the last we have had.

And that is the crux of the problem. Either we willingly cut the deficit by a far more significant amount than anyone is discussing, or we hit the wall at some point and become Greece. $4 trillion? No, let’s talk about 10 or 12.
And that, John, is the problem. We have painted ourselves into the corner of no good choices. We are left with difficult and disastrous choices. We have condemned ourselves to a slow-growth, Muddle Through Economy for another 5-6 years, at best, as we are forced to right-size government. If we raise taxes to partially solve the problem, we have to recognize that higher taxes will result in slower private growth. That’s just the rules. There are no easy buttons to push.
So, we must cut spending and the deficit, and yes, it is going to slow the economy for a period of time. The economic literature suggests that a spending cut will have 4-5 quarters of effect and then be neutral going forward. But we are going to have to make those cuts year after year after year.
I know the Tea Party types want to do it all at once, but that would guarantee a decade-long depression. You just really don’t want to go there. It MUST be a slower, controlled “glide-path” approach. I wrote about this back in 2009, along with all the other options. Nothing has changed: http://www.johnmauldin.com/frontlinethoughts/the-glide-path-option-mwo110609/

 

. The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is determined by the choices we make.
It is getting time to close, so a few quick observations. While choosing a President and Congress next year will be a referendum of sorts, I would like to see a real, non-binding referendum appear on our primary ballots. How much Medicare do we want? Should we raise taxes? How do we get to $10 trillion in cuts? You would have to confirm you have read a 20-page document outlining the choices and consequences, and that should be posted everywhere and mailed to everyone. We need to have a real national conversation.p>
If Obama says he wants $4 trillion in cuts, then let him give us details rather than asking Congress to give him a plan, as he did today. He has his brain trust; surely they can come up with some details. The problem is that if he offers specifics he will have to show his supporters what he is willing to cut. And those cuts will not be without pain.
The real issue, as I have said, will boil down to how much Medicare we want and how we want to pay for it. Congressman Ryan’s cuts don’t get us even halfway there.

A Summer of Ultimatums

In closing, this from my friends at GaveKal:
“ In the past 24 hours, we have seen the Greek deputy finance minister announce that Athens would fall far short of planned asset sales (this can only come as a surprise to investors born yesterday) and the Greek prime minister publish an open letter to Eurogroup Chairman Juncker warning that Greece has done all that it could. Mr Panandreaou went on to say that the onus is now on European policymakers to meet in a closed forum, with no damaging press leaks, and emerge with a strong, unambiguous message – we have to assume that the irony of asking for more secrecy through an open letter to the general media was perhaps lost on the Greek PM. Diplomacy aside, it seems that Greece is placing an ultimatum on Europe and this for a very simple reason: the end game for the EMU is approaching much faster than most investors had expected. Indeed, the choice between fiscal union or disintegration may well have to be faced this very summer.
“In his eloquent letter, Papandreou boldly stated that, in essence, Greece is no longer prepared to make further concessions and will thus blow up Europe's financial system if it is subjected to any more pressure. In other words, it is now time for all additional concessions to come from the side of Germany, the ECB and the EU. The willingness of Papandreou to speak so boldly is hugely important since it marks a recognition by the debtors that they now have the whip-hand in these negotiations. The Greeks (and Irish) for some reason failed to realize their power last year, but they do now. This transforms the balance of power in the negotiations. As a result, Germany and the ECB have reached the moment of truth – either they comply with the debtor countries' demands or they abandon the euro. This ultimatum probably helps explain why the euro has been so weak and why it should be heading even lower.”
There will be yet another emergency meeting next Thursday. The crisis is coming to the final innings. Will Germany and the ECB finance Greece? Print money in a fashion that would make Bernanke and Krugman envious? But if we in the US do not get our own act together, in the not-too-distant future we will face our own moment of truth as the bond market forces us to choose between disastrous and worse. The cuts we will have to make under pressure will be far worse than those we can make now.

Mauldin: Headwinds to Economic Growth Over the Next Five Years

Enemy of Spain

Second, Endgame continues to do well, so thanks to those who have purchased it, and if you haven’t already got your copy you should go to www.amazon.com

 

and do so! And quick kudos to my co-author, Jonathan Tepper, brilliant young Rhodes scholar and head analyst at Variant Perception. Apparently, he’s on a small but prestigious list of enemies of Spain, according to El Mundo, one of the biggest Spanish newspapers, for the sin of pointing out that Spain is in a crisis (we have a whole chapter on Spain on the book). Their article appeared in print in the weekly finance edition, but is not online. Other papers have been called by government officials and asked not to quote him. Oddly, the people who helped inflate the enormous construction bubble and the incompetent government officials who denied for years there were any problems are not enemies of Spain. Go figure. I guess if you have to be on an enemies list, you could do worse than Spain (where, oddly enough, Jonathan spent most of his childhood growing up in a drug-rehab facility). Congratulations, young man! (Oh, and a publisher in Korea picked up the Endgame Korean-language rights, so we will soon be in bookstores in Seoul.) And now to the second part of the Endgame. And for those who want to review the first part, you can read it here

 

.

The Endgame, Part 2

There is an argument that the US should pursue a strong growth and jobs policy as its #1 goal and that growth, along with spending cuts and/or tax increases (depending on your views), will bring us out of the current doldrums and help us solve the budget deficit. I set the table in both the book and last week’s letter that the US is going to be growth challenged for years to come. Let me review a few items in brief and add a few more, then we will get to my predictions of what the next five years will look like. Don’t jump ahead. Without understanding the elements that are lining up to retard growth, the forecast will not make much sense.
First, job #1 MUST be to reduce the deficit below the nominal growth rate of GDP. Period. The level of debt threatens to overwhelm everything else, and at some point can produce a crisis like those evolving in Europe and Japan. I have outlined the reasons for this in depth, so here I merely make the assertion.
As I explained at length, if you increase government spending it will increase GDP IN THE SHORT TERM. The economic literature suggests this effect lasts about 4-5 quarters. Further, tax cuts will produce a growth in GDP of roughly 1 to 3 times the total amount of the cut over the next few years (depending on whose research you read, but the consensus is clearly that tax cuts make a difference). It sadly follows that increasing taxes will have a negative effect of roughly the same amount.
Now, basic economic accounting shows that if you reduce government spending you are going to reduce GDP over the short term by a rough equivalent (GDP = Consumption (C) + Investments (I) + Government Spending (G) + (Net exports)).
Therefore, the first headwind to economic growth over the next five years is the reduction of the deficit. While there is a longer-term difference between tax cuts and tax increases, in the short term (4-5 quarters) there is a simple drag effect. And we are going to need to cut government spending by about 1.5% of GDP per year every year for five years (allowing for some growth) to get the deficit to a manageable level.
Below is a chart I used last week that is from my friend Rob Arnott at Research Affiliates (and to whose annual conference I am flying to as I write this letter), but it bears looking at again. The chart needs a little set-up. It shows the contribution of the private sector and the public sector to GDP. Remember, the C in the equation is private and business consumption. The G is government. And G makes up a rather large portion of overall GDP.
The top line (in dark blue) is real GDP per capita. The next line (yellow) shows what GDP would have been without borrowing. So a very real portion of GDP the last few years has come from government debt. Now, the green line below that is private sector GDP. This is sad, because it shows that the private sector, per capita, is roughly where it was in 1998. The growth of the “economy” has come from government spending. Private-sector spending is where it was almost 13 years ago, accompanied by no growth in median real income and no growth since 2000 in the actual number of jobs, even as population grew by 30 million.

As we bring government spending down, unless it is accompanied by private-sector growth, we will see overall real GDP shrink. That is just the how it works. Now, in the fullness of time (or a few years), the smaller government expenditures and deficit will mean more money for private-sector investment and productivity growth, but the process of simply getting the deficit under control is going to mean slower growth. Wrap your head around that. While Republicans (including me) want to control Congress and the presidency in 2012, the policy choices made in 2013 will not be met with a robust return to 4% growth and immediate jumps in employment levels. It is going to take a lot of education to convince voters that there is no magic in spending cuts (or even tax increases) and that we will need to stay the course, even while there is a general malaise in the economy. My advice to my fellow Republicans? Do not sell the concept that voting Republican will provide a quick fix. It will get you slaughtered in 2014. More on why below, in the conclusions.
Let’s quickly list other headwinds.
· The next headwind we will face, in 2012, is a tax increase of about 2% for almost everyone, as we lose the reduction in Social Security taxes that was passed to 2011 as part of the Bush tax cut extension. This means less money in the pockets of everyone making below about $100,000, which is significant in terms of the drag on GDP.
· The stimulus package of 2009 is fading from view. There is little reason to think any of it will come back. Look at that graph again and see how much worse GDP would have been without it. But for all that, we are watching growth soften of late, with the economy now down to 1.8%. We didn’t get the organic growth in the economy that the Keynesians promised. Where is that multiplier effect? It actually seemed to be a negative multiplier, which Austrian economics suggested it would be. Score one for von Mises and Hayek.
· QE2 is stopping in June. The hope at the Fed is that the economy can take over from there. But the last time QE was stopped, in 2010, the results were not impressive; and now we can look across the pond to England to see what is happening as they are about 6 months further along in their ending of QE. It is hard to get encouraged from the data, as it looks like growth in England has slowed. And the real effects of their new austerity pursuits have not really been felt. Can the Fed start up again? Or more apropos might be the question, “Will the Fed start another round of QE?” My answer is that, when they see the economy slip into recession, they will use the only real tool they have left, and that is to inject liquidity into the economy.
· A McKinsey study on the aftereffects of debt crises (in numerous countries) that require deleveraging in one form or another, is that for the first two years there is a significant slowing of GDP, and the slower growth does not dissipate for 4-6 years. We have not started deleveraging as a nation. The real work now looks like it will be done in 2013; and thus the real pain, the study suggests, is in our future.
· Unemployment is back at 9%, rising this morning another 0.2%. The real level is easily above 10% if you count people who were in the work force as recently as 2008. Five percent of the nation’s workers are not paying income, Social Security or Medicare taxes. Many of them are on food stamps and unemployment, which are driving deficits at the federal and state levels higher. It is hard to imagine a robust economy that does not somehow figure out how to drive the unemployment level down, yet economic growth of 3% or more is required. We are simply not there.
· I noted above that private-sector jobs have gone nowhere for 11 years. But transfer payments as a percentage of private-sector income and wages have risen inexorably for the past 50 years. Below is a chart from Madeline Schnapp, the chief economist of Trimtabs. Let me quote from the email she sent me along with the chart:
“Here is the graph which generated a HUGE amount of controversy when published awhile back. For lack of a better term, I called the ratio the "TrimTabs Dependency Ratio." What it is, using BEA data, is a ratio of ‘BEA's government social benefits to persons’ divided by ‘BEA's wages and salaries.’
“While wages and salaries are about 50% of total personal income (other sources of personal income are benefits, interest, dividends, etc.), it is the largest bucket of income that produces revenue for the government via our tax structure. Therefore wages and salaries are currently the engine of support for the government’s social programs.
“FYI, the BEA's definition of government ‘Social Benefits to Persons’ includes Social Security, Medicare, Medicaid (the biggies), unemployment insurance, supplemental nutrition (SNAP, formerly food stamps), veteran's benefits, etc.
“For the ratio to go back to something sustainable, e.g. 20%, either wages and salaries need to rise, benefits need to be trimmed, or taxes need to go up.
“Be careful not to confuse ratio with proportion. In this chart, I am comparing the size of one thing to the size of another (backpacker analogy); it is not a proportion, e.g. one thing as a part of another.
“Another useful analogy is:
“There is the engine (wages and salaries) pulling rail cars up a hill. In those cars are the Defense Department, the EPA, government social benefits to persons, etc. Since 1960, the size of the social benefits rail car has grown from 10% the size of the engine, to now 35%. The ‘Little Engine that Could’ is rapidly becoming the ‘Little Engine that Couldn't.’”

· I showed two charts and research last week that clearly demonstrates that at some point the size of government becomes a drag on the economy. That may seem contradictory to my first point in this letter (reducing government spending will reduce GDP), but it is not. The first point was a short-term effect, and the size of government is a longer-term effect. We now have a government that is too large, and it acts as a headwind to growth.
· The research of Rogoff and Reinhart clearly shows that, as the debt-to-GDP level of a country approaches 90%, there seems to be a slowing of potential GDP growth by about 1%. This is an observation of the data, not a theory. And this graph from David Walker suggests we are getting there. Notice it does not include state and local debt, which it should. We are very close to this level, if not there already.

Muddle Through, or Crisis?

Betting against the power of the free-market economy in the US is generally a bad idea. Yet when I suggested back in 2003 that we would see a slow-growth Muddle Through Economy for the remainder of the decade, it turns out I was right. We only grew at 1.9% last decade, which was the worst performance since the Depression. Ugh.
So where are we for the next five years?
I think we have two choices as a country. We can elect to deal with the deficit proactively, or wait until there is a crisis and react. And make no mistake, there is a an approaching Endgame, with regard to how much debt the market will let us have. We don’t know that point now, but if it happens it will be quite a “surprise!”
What happens if we make the choice to get the deficit under control? What that really means is that we have to decide how much health care we want and how we want to pay for it. Let’s forget for the moment how that happens. Let’s just be optimistic and say we do make those decisions.
For me, that is the best-case scenario. But it means a slow-growth, Muddle Through Economy for quite some time, perhaps as long as 5-6 years, though getting better as time goes on. It also means it is highly likely we will have at least one recession during that period, as growth will be close to “stall speed” and any exogenous shock could tip us into recession. Recessions mean higher unemployment, lower tax revenues, and an even deeper hole that will require more fiscal discipline and work. It will make maintaining corporate earnings growth at today’s expected levels more difficult, which puts a headwind to the US-based equity markets. Of course, a recession will mean (on average) a 40% retrenchment of US equities. It will also mean another deflation scare and a likely QE3. Bernanke can bring back and polish his “helicopter” speech, but this time he will be able to tell us what happened.
Then there is the crisis scenario. Let’s assume we do not deal with the deficit in any meaningful way. Eventually the debt will rise to epic, Greek proportions. The bond vigilantes arise from the dead and start to push up interest rates. Interest as a percentage of government spending rises, crowding out other government expenses or increasing the debt still further.
Then we have a crisis. We are FORCED by the bond market to get the deficits under control, but now we are doing so in a crisis. Health care will have to be slashed by far more than it would in a more controlled scenario. Tax increases will be brutal. You think Social Security is untouchable? Not in this crisis world. Means testing and spending freezes will be the rule of the day. Military cuts will seem draconian. Our allies who depend on us for a defense shield will not be happy. Education? On the chopping block. The economy will not be Muddle Through, but Depression 2.0. Unemployment will go north of 15%.
What’s my basis for this? History. This movie has played over and over again in various countries in modern history. While we may be the world’s superpower, we are not immune from the laws of economic reality.
In such a scenario, I expect QE 3-4-5-6. Could the Fed literally monetize the debt and then “poof” it? When our backa are against the wall, don’t assume that what has been seen as normal will be the reigning paradigm.
Let me jump out on a real limb. I was having dinner last Monday with Christian Menegatti, the #2 economist at friend Nouriel Roubini’s economic analysis shop. We were comparing notes (imagine that), and he said their opinion is that the US has until 2015 before the bond market really calls the deficit hand. Knowing that Nouriel is seen as the ultimate bear, it makes me nervous to put out my own even more bearish analysis.
I think the crucial point will be reached in late 2013. If the bond market sees a serious move to control the deficit, I think they let us “skate.” Then we Muddle Through. But if not, I think we begin to see some real push-back on rates then.
Why so early? Because bond investors are going to be watching the slow-motion train wreck that is happening in Europe and especially Japan. It is one thing for Greece to default (which they will in one form or another, with lots of rumors flying this morning), yet another for Japan to do so. Japan is big and makes a difference. Japan could start to go as early as the middle of 2013. As I have said, Japan is a bug in search of a windshield. Whenever this happens, 2013 or a year or so later, it is going to spook the bond market. The normal indulgence that a superpower and reserve-currency country would be accorded will become much more strained. It will seemingly happen overnight. Think Lehman Brothers on steroids.
I think the chances we will deal with this potential crisis are about 75%. Not doing so is such a horrific outcome that I think politicians will do the right thing. See, I am an optimist. (What was it Winston Churchill said? “You can always depend on the Americans to do the right thing, after they have exhausted all the other possibilities.”)
And let me note that I have had some rather at-length, high-level (but very off-the-record) discussions with politicians on the right in recent weeks. More and more of them are really getting it. But as one said to me, “John, I can’t run on that platform.” And that is the reason that I give it a 25% chance that we’ll wait until a crisis hits us. If the “good guys” (my view, not yours, gentle reader – I know many of you are of the more liberal persuasion) need a real push to act correctly, we are not in good shape.
I totally recognize it will not be easy to fix it. It will probably mean tax increases, which will not be good for the economy. And spending cuts that will be painful. I get all the consequences. I have written about them. But the goal is to get rid of the cancer of the deficit. It could truly destroy our economic body. Sometimes, if you have cancer, you take very ugly chemicals into your body, which have very serious side effects. The prospect does not make me happy at all, but we have made bad choices as a country for decades, and now we have to pay the price.
Just a few more thoughts. Republicans should demand a total restructuring of the tax code in return for any tax increase. I would opt for lower corporate rates to help make us competitive (say 10-15%) and include all foreign corporate income, and get rid of the mass of exemptions. Lower personal rates and a consumption tax would suit me just fine, as both an economist and a businessman; but I know that’s not some people’s cup of tea. Just saying. I like David’s Walker’s thoughts about $3 of spending cuts for every $1 of tax increases. And can we get rid of some of the “tax expenditures,” like mortgage interest deductions? We all pay 4% in income tax so that a minority can have interest-rate deductions. (I have written about efforts we need to undertake that would more than offset any hit to real estate.) At least reduce it for mortgages over $1 million. If you can afford a mortgage that big, you don’t need the deduction.
Every one of those tax expenditures is someone’s else tax break that is vital to the future of the Republic, but if we got rid of all tax expenditures in one massive move (or over time) we could simplify the tax code and come within a few hundred billion of balancing the budget. Walker says the breaks total $1.2 billion. Basically, these are goodies that Congress hands out to get votes. Get rid of them all, I say. It will be politically difficult, but we need drastic action.
And I might suggest that Democrats should come to the table this year rather than waiting until 2013. If unemployment is north of 8% next election, as I think likely, you will lose more seats and (probably) the White House, given today’s polls. Why not negotiate now when you have the Senate and can get what you can? Maybe “my guys” are being obstinate, but the sooner we do this the sooner we get through it.
And that is my point. We do get through it, either as adults or forced to do so by the bond market. One way or another, by the latter part of this decade, in the fullness of time, this too shall pass.
The eternal optimist in me wants to quickly point out that neither scenario is the end of the world. Yes, we may have to tighten our belts, some more than others, but life goes on. We all figure out our own paths. While investing has been more difficult the last five years, we are all still alive, celebrating birthdays and grandchildren. New businesses that will dramatically change our lives are being formed every day. There are lots of opportunities for business and investment, perhaps just not the traditional ones we are used to. Maybe gold goes to $5,000, but I hope it goes to $500. Either way I will still buy some physical gold every month as insurance, with the dream that I’ll give it to my great-great grandchildren as a novelty from the days when we thought gold had value. But I will still buy, just in case. I simply don’t completely or naively trust the &*%@^&’s who are running the place.
Seriously, I expect that, beginning later this decade we will see the secular bear crawl back into hibernation and a roaring secular bull market cycle come charging out. We will all get to once again be geniuses.
The book I am starting to write this month (finally!) will be called The Millennium Wave, in which we’ll look at what our world may be in 2032. The journey there will be bumpy, but what a world it will be! So, over the next few months and quarters, we will keep our eye on the politicians and see what happens. I will be looking for good hedges and places to invest that don’t depend on Washington DC or the other capitals of the world. And I will keep on writing to you, gentle reader, every week.
Last thought: I encourage you to get involved in the process in whatever way you deem correct. This is going to be the most important national conversation we have had in a long time, and you should be a part of it. Make your voice and vote count!

Is Reality Beginning to Set In?

Not based upon stock market futures this morning.


From Peter Tchir oF TF Market Advisors
Budget Deficits, Rating Agencies And IBGYBG
Never have so many, said so much, that's so wrong.  It seems like a combination of deficits and rating agency action have sparked a myriad of comments, many of which are just plain wrong.

First, on the deficit.  NEITHER party is reducing the existing cumulative deficit nor amount of debt outstanding.  They are NOT creating surpluses anytime in the next few years (decades)!  They are cutting the projected deficit.  Yes, we will run annual deficits, just less than the currently projected annual deficits.  The fact that S&P could figure this out, makes it clear how easy it is to see through the semantics and games politicians are playing.  Yet, most of the popular press is treating the government plans as though they were creating surpluses.  We have to stop hiding behind words.  The reality is we have a large amount of debt.  Over the next few years we have big projected deficits that will add to that debt burden.  So far, no one has proposed a plan that gives up surpluses, just less additional debt.  Lets stop fooling ourselves and address the real issue.  No more celebrations over just making the future problem less bad.

Secondly, after getting wrong what the deficit reduction really is, they get wrong the likelihood.  Talks about 2030 being balanced.  Excuse me???? In November the talking heads thought we might see tax cuts expire.  They didn't see new spending.  In December, we got both!   So within a month of mid-term elections the pundits and government couldn't get anything right.  Why do we assume things will be better 15 years from now when we can't predict a few months out very well?  Probably, the obvious reason.  IBGYBG.  I'll Be Gone, You'll Be Gone.  That is the only way to explain why we want to argue about details 10 years from now and basically ignore the immediate problem.

After being forced to read and listen to so much just plain wrong about the deficit, we are subject to the same thing on the rating agencies.  Is AAA versus AAA on negative watch materially different? NO!  From a 'probability' of default perspective it means nothing.  Is the outlook change surprising?  Not to anyone who has been watching the deficit grow, stimulus and spending being applied at every opportunity, with minimal results.  So it shoudn't be shocking, its not stating anything near term about likelihood of default.  Watching people turning red in the face arguing that we are not close to default is mildly humorous as the rating change does not imply anything that bad.

Then why is the rating action causing the market to go down?  The simplistic, and likely wrong answer, is that some entities cannot hold anything less that AAA.  That is too far away.  One question that we should be asking ourselves for about the 1000th time, is why do regulators based risk capital on the rating agencies?  They have a track record that is not particularly impressive (to say the least).  They get blamed by congress for their ratings, and then are guaranteed future existence by being made an integral part of future regulations.  Insane, yes, but not the real problem here.

Stocks have rallied from 900's to 1,300 as the smart money bet on unwavering and unlimited government support.  Tepper was spot on.  He called it for what is was.  Now, smart money may be realizing that game is over.  There was already concern about the ability to continue the QE franchise, but this adds another obstacle to including it.  There was always the hope of another round of stimulus on any economic weakness, this also just took a little hit.  Today's market reaction is a direct result of a growing realization that the fed/government put may not be there, or may be struck lower than we realized.  The pundits can continue to be wrong about their budget commentary, can scream til they are blue in the face that the rating agencies don't get it, but we have moved one more step towards that slippery slope where government support for stock prices is getting more difficult to implement.

The realization is probably helped by the timely realization that Greece is basically done.  Greece has realized its time to haircut the existing lenders, and move on with a manageable debt load and a budget that makes sense without creating too much pain for its citizens.                        

What the Too-Big-To-Fails Think

Is it any wonder that the beneficiaries of Fed monetary mayhem would shrug off the news of the day? It puts their livelihoods at risk, so shrug away, imbeciles!

By Matt Phillips @ WSJ:

The commentary keeps coming, with every market watcher and their aunt Sally offering their two thoughts on what S&P surprise cut of its outlook for the U.S. debt rating from “stable” to “negative.” (The credit rater left Uncle Sam’s AAA rating intact.)

• Barclays Capital: It is important to be clear on this. If the U.S. government were to default on its obligations, a very large financial panic is what we’d get. But as the saying goes, once they’ve exhausted all the other alternatives, US politicians can usually be relied on to do the right thing – and S&P’s move might actually serve as a reminder of what that right thing is. Just as it took two attempts for the US legislature to pass the TARP and save the world, so now we may need to be braced for a prolonged period of brinkmanship before a budget deal gets done.
• George Goncalves, Nomura Securities: We believe that although this news does bring to the forefront the longer-term profligacy of the US, this is something we’ve highlighted several times as a concern and is widely acknowledged by the market. To that extent, aside from the knee jerk reaction, this downgrade contains little new info. The most salient issue for Treasuries currently is the extension of the debt ceiling in the next few months and that is likely to have a greater impact in the near-term than 2012-2013 budget discussions. We had mentioned in the past that fiscal austerity measures needed to be passed, but that these weren’t pressing concerns, given the reserve currency status of the USD. We believe it will be a slow and drawn out process before foreign central banks can start investing their trade surplus reserves in any other currency. Until we reach that point (which is many years away, even by conservative estimates), sponsorship for USTs will continue to be strong from this demand segment.
• Lena Komileva, Brown Brothers Harriman: The S&P move to revise the U.S.’s AAA outlook from stable to negative has been a shot across the bow of market complacency about the U.S.’s medium-term debt outlook. The U.S. will have no problem in financing its deficit, but the role of U.S. government securities as the primary reserve asset in global public sector balance sheets and as the primary liquidity and capital risk hedge in financial balance sheets, means that a fallout from a potential U.S. debt re-rating would reach far outside U.S. borders. It is a low-probability event with high impact. If the AAA backbone of the global financial system is at risk of being lost, what happens to the rest of the credit structure?
• Societe Generale Cross Asset Research: While a credit warning for the U.S. was somewhat expected by the market, it was not anticipated to be so soon. The early threat of a downgrade may help U.S. policy leaders to make progress on agreeing to substantial budget cuts. The Washington Post reports that a deal on Medicare is at hand. It also provides the doves at the Fed further reasons to maintain accommodative monetary policy and hence reinforces the inflation/EM trade.
• Paul Ashworth, Capital Economics: S&P’s biggest concern seems to be that the Democrats and Republicans will struggle to agree on a comprehensive plan to address the medium-term fiscal problems before the Presidential election in late 2012. S&P now puts the odds of a downgrade within the next two years as high as one-in-three. With the Republicans controlling the House and the Democrats controlling the Senate, and both sides proposing radically different plans to cut the deficit, this is a concern we would share. Things could get even messier after the election, if Obama is re-elected but the Republicans capture control of the Senate.
• Goldman Sachs Economics: A rating outlook change has no immediate implications—in particular, it does not make a difference in terms of current bond mandates. It does flag the possibility of an outright ratings downgrade within the next few years, which would have material market implications for investors required to invest a specific portion of their holdings in AAA securities. According to S&P, the negative outlook “signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years.” (Historically, the frequency of ratings downgrades for AAA sovereigns on negative watch is actually much lower than 1 in 3 over this horizon, although there is of course no guarantee that will remain true in the future.)

S&P's U.S. Debt "Wake-Up Call" -- Eric Cantor

WASHINGTON (Reuters) – House of Representatives Republican leader Eric Cantor on Monday called the Standard & Poor's downgrade of U.S. credit outlook "a wake-up call" against those seeking to "blindly increase" the U.S. debt limit.

Cantor said the S&P action makes clear that any increase in the debt limit must be accompanied by "meaningful fiscal reforms that immediately reduce federal spending and stop our nation from digging itself further into debt."

Budget Symbols, Not Substance!

Today’s quote du jour comes courtesy of Don Boudreaux, author of the Cafe Hayek blog.

“Suppose that in a mere three years your family’s spending – spending, mind you, not income – jumps from $80,000 to $101,600. You’re now understandably worried about the debt you’re piling up as a result of this 27 percent hike in spending.

“So mom and dad, with much drama and angst and finger-pointing about each other’s irresponsibility and insensitivity, stage marathon sessions of dinner-table talks to solve the problem. They finally agree to reduce the family’s annual spending from $101,600 to $100,584.

“For this 1 percent cut in their spending, mom and dad congratulate each other. And to emphasize that this spending cut shows that they are responsible stewards of the family’s assets, they approvingly quote Sen. Harry Reid, who was party to similar negotiations that concluded last night on Capitol Hill – negotiations in which Congress agreed to cut 1 percent from a budget that rose 27 percent in just the past three years. Said Sen. Reid: ‘Both sides have had to make tough choices. But tough choices is what this job’s all about.’

“What a joke.”

Source: Don Boudreaux, Cafe Hayek, April 9, 2011.

What Happens If Japan Must Sell U.S. Debt to Rebuild?

from Washington Times:

Some lawmakers and market analysts are expressing rising concerns that a demand for capital by earthquake-ravaged Japan could lead it to sell off some of its huge holdings of U.S.-issued debt, leaving the federal government in an even tighter financial pinch.
Others say a major debt sell-off by Tokyo is unlikely, but noted that the mere fact that questions are being raised speaks volumes about the risks involved in relying so heavily on foreign investors to fund U.S. debt.
“This natural disaster in Japan concerns me that it could speed up what’s coming, because they are the second leading buyer of our debt,” Sen. Rand Paul, Kentucky Republican, told The Washington Times. “Small degrees of differences in how much they buy of our debt, I think, can make a big difference in interest rates that we have to pay people to buy our debt.”
With the federal government having piled up $14.2 trillion in debt, budget experts are warning that the country is on an unsustainable fiscal path. Congress, they say, must find cuts in all areas of the budget, while reforming the entitlement programs — Social Security, Medicare and Medicaid — that are the biggest drivers of national spending.
Congress has passed short-term spending bills this year that nibble on the edges of government spending, and President Obama has offered a 2012 spending plan that also saw spending rise.
Concerns about the financial plight facing Japan, which trails only China among foreign holders of U.S. Treasury debt, aren’t helping the picture.
“They have a lot of bonds,” former Sen. Pete V. Domenici told The Times this month after testifying before Congress about the country’s mounting debt woes. “Are they in such bad trouble that they are not going to buy anymore? If they don’t, who do we look to?”
Asked point-blank last week if he thought Japan’s troubles could affect the U.S. borrowing costs and interest rates, Treasury Secretary Timothy F. Geithner told a congressional hearing, “I do not.”
Japan, which held some $886 billion in U.S. debt in January, is “a very rich country, with a very high savings rate,” Mr. Geithner said.
But some two weeks after the earthquake, uncertainty still reigns over whether Japan will reduce its purchases of Treasury debt and other foreign assets — a decision that could force the U.S. to pay higher rates on its securities to attract buyers and possibly drive up U.S. interest rates.

America's Finances Rank Among World's Worst

The US ranks near the bottom of developed global economies in terms of financial stability and will stay there unless it addresses its burgeoning debt problems, a new study has found.

In the Sovereign Fiscal Responsibility Index, the Comeback America Initiative ranked 34 countries according to their ability to meet their financial challenges, and the US finished 28th, said David Walker, head of the organization and former US comptroller general.

"We think it is important for the American people to understand where the United States is as compared to other countries with regard to fiscal responsibility and sustainability," Walker said in a CNBC interview. "Americans are used to rankings and they're used to ranking very high, but frankly in this area we rank very low."

While the news is bad, there is a bright side.

"Here's the good news: Some of the top countries had their own fiscal challenges, made reforms and now rank highly," Walker said. "If we adopt the recommendations of the National Fiscal Responsibility and Reform Commission or ones that have similar bottom-line impact, we move from 28 to 8."

As the US languishes near the bottom, these countries make up the top five: Australia, New Zealand, Estonia, Sweden, China and Luxembourg.

1/3 of Wages Are From Government

from CNBC:

Government payouts—including Social Security, Medicare and unemployment insurance—make up more than a third of total wages and salaries of the U.S. population, a record figure that will only increase if action isn’t taken before the majority of Baby Boomers enter retirement.

Even as the economy has recovered, social welfare benefits make up 35 percent of wages and salaries this year, up from 21 percent in 2000 and 10 percent in 1960, according to TrimTabs Investment Research using Bureau of Economic Analysis data.

“The U.S. economy has become alarmingly dependent on government stimulus,” said Madeline Schnapp, director of Macroeconomic Research at TrimTabs, in a note to clients. “Consumption supported by wages and salaries is a much stronger foundation for economic growth than consumption based on social welfare benefits.”

The economist gives the country two stark choices. In order to get welfare back to its pre-recession ratio of 26 percent of pay, “either wages and salaries would have to increase $2.3 trillion, or 35 percent, to $8.8 trillion, or social welfare benefits would have to decline $500 billion, or 23 percent, to $1.7 trillion,” she said.

Last month, the Republican-led House of Representatives passed a $61 billion federal spending cut, but Senate Democratic leaders and the White House made it clear that had no chance of becoming law. Short-term resolutions passed have averted a government shutdown that could have occurred this month, as Vice President Biden leads negotiations with Republican leaders on some sort of long-term compromise.

“You’ve got to cut back government spending and the Republicans will run on this platform leading up to next year’s election,” said Joe Terranova, Chief Market Strategist for Virtus Investment Partners and a “Fast Money” trader.

Terranova noted some sort of opt out for social security or even raising the retirement age.

But the country may not be ready for these tough choices, even though economists like Schnapp say something will have to be done to avoid a significant economic crisis.

A Wall Street Journal/NBC News poll released last week showed that  less than a quarter of Americans supported making cuts to Social Security or Medicare in order to reign in the mounting budget deficit.

Those poll numbers may be skewed by a demographic shift the likes of which the nation has never seen. Only this year has the first round of baby boomers begun collecting Medicare benefits—and here comes 78 million more.

Social welfare benefits have increased by $514 billion over the last two years, according to TrimTabs figures, in part because of measures implemented to fight the financial crisis. Government spending normally takes on a larger part of the spending pie during economic calamities but how can the country change this make-up with the root of the crisis (housing) still on shaky ground, benchmark interest rates already cut to zero, and a demographic shift that calls for an increase in subsidies?

$223 Billion -- Largest Monthly Deficit in History

A new record high deficit! Well, fancy that! Meanwhile, the 10-year is higher. Makes perfect (tongue-in-cheek) sense!

from Washington Times:

The federal government posted its largest monthly deficit in history in February at $223 billion, according to preliminary numbers the Congressional Budget Office released Monday morning.
That figure tops last February’s record of $220.9 billion, and marks the 29th straight month the government has run in the red — a modern record. The last time the federal government posted even a monthly surplus was September 2008, just before the financial collapse.
Last month’s federal deficit is nearly four times as large as the spending cuts House Republicans have passed in their spending bill, and is more than 30 times the size of Senate Democrats’ opening bid of $6 billion.
Senators are slated to vote this week on those two proposals — both of which are expected to fail — and then all sides will go back to the negotiating table to try to work out a final deal.