As with past periods of economic stress, current budget deficits are typical. They are also unsustainable. The deficits we are experiencing are similar to those during the Civil War and two world wars. The past decade has seen a tremendous increase in deficits due to many factors. The wars in Iraq and Afghanistan, along with the domestic wars on poverty and lenders, coupled with low tax rates and low tax participation, have brought us to the brink once again.
The Office of Management and Budget (OMB) reports that the primary deficit (net interest payments minus revenue) has averaged -8.6% for the years 2009-2011. This compares to essentially zero for the period of 1955-2008. The current -8.6% of GDP is roughly identical to the Civil War period and both World Wars. Surprisingly, the New Deal period following the
Great Depression only saw primary deficits of -3.7% of GDP. Our overall deficit is approximately 100% of GDP; roughly equivalent to Greece. While we have more choices than Greece, our choices are still limited.
It would be great to simply go to the rich uncle and have him pick up the tab. The lopsided nature of our tax code means that the few rich uncles we have would be broke in minutes. The truth is we have become accustomed to a lifestyle that is unsustainable. I don’t believe that abrupt changes are necessary or desirable. But we tend to respond better to acute needs, since we put off dealing with pain and can’t seem to make a cerebral argument without a scary motivator. So as long as all seems well, I don’t think we can expect much change. Eventually, the problem will grow and then get truly scary when our interest payments skyrocket. It’s surprisingly fortunate that the rest of the world looks scary too, or our interest rates would have jumped already. Think about the compounding difficulty of paying down debt at the same time your borrowing costs are escalating. Because the US seems to be the least scary place on the planet, our borrowing costs have actually dropped dramatically since our debt was downgraded. This will eventually reverse, and then it will get ugly.
We can talk all day long about how the rich supposedly don’t do their fair share, or how 51% of America receives benefits without paying any income tax. Several scenarios are likely to emerge; the rich will pay more, the poor will pay more, and everybody gets fewer benefits.
In tackling the deficits, we really have just four possible outcomes: (1) We can grow the economy and vanquish the debt from new tax receipts. Considering the recent large growth spurt we experienced due to the technology revolution, a second wind seems unlikely (I give that a 5% chance); (2) We can default on our debt and tell all of our creditors to take a hike. That is not likely, even though roughly 55% of our debt is held by foreigners (I give that a 2% chance); (3) We can devalue the dollar like third world countries do to their currencies (I give that a 3% chance); (4) We can create inflation and slowly erode purchasing power with our dollars (I give that a 90% chance). Yet, we have attempted that already and it’s not working. This is because the economy is in such a state of contraction, even QE1, QE2, and Operation Twist all had little positive inflation outcome. This means we are having a hard time even fabricating inflation intentionally. Due to mounting political pressure, and surprising young voter support for Ron Paul, the tide is seemingly turning as people see the long term implications of mounting debt. This means that any new rounds of inflation creating policy should find soft support and a lack of will. Accordingly, I’m predicting a second recession as worldwide trade becomes suppressed under uncertainty about the Euro and continued contraction in the US.
Implications for Investment Strategy:
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