- Mark Twain
"Liberty has never come from the government. Liberty has always come from the subjects of government. The history of liberty is the history of resistance. The history of liberty is a history of the limitation of government power, not the increase of it."
- Woodrow Wilson
"How did you go bankrupt?" Bill asked.
"Two ways," Mike said.
"Gradually and then suddenly."
- Ernest Hemingway, "The Sun Also Rises"
As a professional worrier I've been asked, "what is your biggest worry?"
My answer is easy, the potential bankruptcy of the U.S. Government. If progress is not made to significantly narrow the budget deficit, than the credibility of the U.S. dollar could be called into question, which would usher in an era of hyper-inflation and declining living standards. In a recent analysis, Alan Auerbach and William Gale did an excellent job laying out the facts. In 2009, tax revenues came to about 15.5% of GDP, the lowest level since 1950, while expenditures were 27.5% of GDP, the highest level since WWII. Our country ran a deficit of around $1.7 trillion or 12% of GDP, of which the structural component (the part that is fairly entrenched, interest payments, entitlement programs, etc) was $800 billion or almost 6% of GDP. To put those numbers in context, in 2008 personal income tax receipts were just about $1.2 trillion. To eliminate the structural deficit in one fell swoop, they'd have to go up by 66%!
Another study done by professors Carmen Reinhart and Kenneth Rogoff, has found that a 90% ratio of government-debt-to-GDP is a tipping point to economic growth. Beyond that point developed countries have growth rates two percentage points below their normal levels. The U.S. government-debt-to-GDP ratio is currently 84%. (See Forbes February 8, 2010 "The Global Debt Bomb". http://www.forbes.com/forbes/2010/0208/debt-recession-worldwide-finances-global-debt-bomb.html )
There really are only two ways to make significant cuts in the deficit, 1) massive reductions in entitlement programs, and 2) very large increases in taxes. Unfortunately it is highly unlikely that we will see anything that even resembles a cut in entitlements come out of Washington, so that leaves higher taxes. The question pertaining to higher taxes is not if but when? Taxes were boosted after the Great Depression in 1937 and again in Japan in 1997, both with disastrous consequences. Washington is populated with depression experts (led by Ben Bernanke), and they are in no hurry to kill a barely recovering economy with new taxes. But new taxes are coming, probably a national sales tax or Value-added-tax (VAT). This is a very tricky problem and both the timing and political will to act have to be nearly perfect.
Fortunately by having the dollar as the worlds reserve currency and having China, our largest creditor, engaged in its own program of buying their way out of poverty, we have some time. But make no mistake, U.S. fiscal policy is hurtling toward a currency crisis, and at some point in the next few years the brakes must be applied. Somewhere in the near future we will have to start showing the world that we are reversing the upward trajectory in our deficits, gradually but persistently. We've been going bankrupt gradually, hopefully we can avoid the final sudden drop...This is my biggest worry.
Investment Considerations
All things considered, the immediate risks of an inflationary spiral aren't high enough yet to make dramatic changes to our portfolios. Inflation expectations will probably continue to creep up, and we will need to be very diligent with our fixed income holdings. Fortunately, corporate America has very strong balance sheets, cash flows, and earnings, so equities may continue to do well. But a currency devaluation would destroy profit margins. Obviously international exposure will continue to be a core element of our portfolios. The following graph shows that Developed Country Debt is a much higher percentage of GDP than Emerging Market Debt. In our Global Tactical Asset Allocation portfolios we have equal target weights in both international developed market debt and emerging market debt. While the developed countries have riskier balance sheets, the emerging market countries have riskier political environments, therefore we believe that equal target weights are warranted at present.
Be careful out there,
Chris Wiles
This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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