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“Signs, Signs, Everywhere Signs”…The Five Man Electrical Band

September 8, 2012

For this week’s post, I had promised one of my friends to be the band leader on the Titanic rather than one of the panicked passengers. Regretfully, I have seen the icebergs and they are sobering (though I am tempted to become one of the inebriated passengers). Meanwhile, the amazing Teflon stock market continues to ignore the long-term fundamentals and hit a 5 year high on Thursday. This market reaction has put me into full Cassandra mode. To those who think the economy will eventually grow robustly again and that the bond, stock and real estate markets will continue their recent gains in the longer run, I offer them the following inconvenient truths:

(1) US Federal Government Debt is at a record $16 Trillion and still growing rapidly. We should easily hit $20 trillion in the next 3-4 years. We were ONLY $9 trillion as recently as 2007 and less than $1 trillion in 1980. Our total debt stands at about 100 percent of US GDP which is almost as bad as several European Countries such as Italy and Spain which even the EU recognizes as being in horrible financial shape. But even the percent of GDP doesn’t put the magnitude of the problem in the right perspective.

Tax revenues and expenditures as a percent of GDP gives us a better indication of our ability to eventually pay down the debt by running future budgetary surpluses:

  • Our tax revenues are currently stuck at only 15 percent of GDP (for the past 3 years) though at the end of the Bush years in 2007 we hit 18.5 percent of GDP. Optimistically, with broad tax reform (see my previous post on this and the Fair Tax) we might be able to get back to 20 percent of  GDP BUT this will require a complete jettison of the current code and deductions which will be politically very difficult. (We have only hit 20 percent once in the last 60 years –in 2000). Notably, we have averaged 18 percent of GDP since WWII and assuming anything higher without MAJOR tax reform, as the White House and CBO have done, is just sheer fantasy.
     
  • We hit all-time expenditure records during the past 3 years (between $3.5 – 3.6 trillion). Also, as a % of GDP, we spent between 24-25 percent of GDP– a post WWII record.  Unfortunately, even with the  “aggressive” budget cuts proposed by the Republicans, we might get this number down below 20 percent in the next 5-10 years. But this will have to occur at the same time expenditures for Social Security and Medicaid and inevitably interest on the debt are increasing substantially. In other words, though essential to do, it will be very difficult and painful.

Thus, we “might” be able to get revenues up to about 20 percent of GDP and expenditures down to about 20 percent of GDP and run a balanced budget but this will take MANY years to do. For years and probably decades into the future , it is hard to see that the debt will ever be paid down, let alone stabilized. As this likely scenario plays out in the next few years, the realization will dawn on the markets that the US is completely BROKE.  At that point, few will lend the US money absent a very high interest rate. This has begun to happen over the past few years as the Fed itself has become the biggest lender  to the US government ( Yes, we are lending money to ourselves by printing money !) having tripled its holdings of treasuries and other government debt in the past 4 years. Meanwhile the Chinese who were the largest buyers of US treasuries have shifted away from that strategy the past few years– another ominous sign.

(2) The Fed has engaged in the most reckless increase in US money supply in modern  history,  increasing our monetary base by a factor of 3 times in only 4 years! This occurred after a century of increases in the 2-7 percent per year range with only a few years in the 8-11 percent range (e.g.  in the late 70s we fueled stagflation by increasing money supply by 10 percent+ per year) . We are likely to do even more money printing with the widely anticipated QE-3 probably beginning later this month. For centuries, when countries printed large amounts of money, there has only been one long-term result, very high inflation (double-digit or more) and a falling currency value. (See “This Time is Different: Eight Centuries of Financial Folly” by Reinhart and Rogoff).  This is ultimately terrible news for retirees on fixed incomes or pensions, stocks, bonds and the economy in general.

(3) The US Consumer is Still Drowning in Debt– Despite the supposed deleveraging of consumer debt obligations, US consumer debt of $2.6 trillion is still at very high levels. In fact, it is now higher than previous peak levels of $2.5 trillion reached during 2008 just prior to the recession.   And it is still more than three times higher than in 1990, ($0.8 Trillion) and 7 times higher than in 1980 ($0.36 Trillion). With stagnant income and job growth and the strong likelihood of much higher interest rates in the not too distant future, the reality is that it will take many years if not decades before consumers are completely deleveraged. And this is all in the face of lower real wages, social security benefit cuts and likely higher taxes in the future. Given that retail spending accounts for almost 3/4 of the economy, this does not bode well for GDP growth and job growth.

(4)  The Baby-Boomer Negative Demographics– The baby boomers are beginning to reach retirement age and with it comes another economic nightmare for the US.  First, as is widely known, as the number of retirees increase relative to the number of workers, there is a growing future liability in Social Security and Medicare which cannot be funded under the current payroll taxes. In fact, current estimates indicate that the system faces HUGE unfunded liabilities–$125 TRILLION (yes with a T) per most estimates. This suggests a virtual certainty that these benefits will have to be cut, probably very significantly.

In addition, overall retail spending amounts to an inflated 74 percent of GDP today, but is very likely to decline to a more normal 60-65 percent of GDP for the US  ( and “normal” is even a lower percentage in most other developed countries). This will occur because while boomers accumulated durable goods, autos and homes during their high earning years (i.e. 35-55) and borrowed lots of money to do so, they will no longer demand a lot of these goods during their near-retirement years and post-retirement years. Further, for reasons outlined above, they will no longer by able to afford to buy as much as they did earlier, because their benefits will likely be cut for Social Security and Medicare and they will still be paying off debts. Meanwhile, the working population will be paying higher taxes and so won’t be able to afford to buy as much.

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I could go on (e.g. interest rates are going to increase substantially eventually and with other very negative effects for US and consumer debt, stocks and bonds and the economy as a whole, states also have huge unfunded pension liabilities etc.). But that is enough for now. I am getting too depressed to write any more.

As I have noted in past blogs, we can make our future US growth picture brighter (albeit it will be a much slower growth economy than we are used to). This would involve (1) True Tax Reform such as the Fair Tax so we could again raise 20 percent of GDP in taxes (2) Major cuts in all domestic discretionary programs including Defense (3) Substantial Changes and Cuts in all Entitlement Programs. But we are not even CLOSE to these changes in the current political dialogue from our clueless folks in Washington DC. And these changes MUST be started NOW!!!

So the next time you hear Wall Street analysts talk about how we can ultimately stimulate our economy and get back to strong economic growth and that we are still on an up-cycle of the economy, consider the self-interested nature of the comments. They are just bandleaders on the Titanic striking up a lively tune and trying to keep the passengers happy. Please remember for many years people have been saying that “We are borrowing from our future” when talking about US government debt or the overextended consumer, our low savings rate or massive money printing.  And unfortunately, the future is NOW.

 

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