Friday, April 15, 2011

Looking over the Horizon - US Economic Challenges beyond the Near Term

As our political leaders gather to raise the debt ceiling and debate yet another profligate budget, many now increasingly ask “Where does this lead?”; How will this all end?” It is a worrisome consideration for all of us.

America’s Financial Situation

The national debt (Federal only) now exceeds $14 trillion (putting that painful number on paper, it is $14,000,000,000,000). Over the last decade that number has been soaring. Historically, the US debt load has been about 35% of GDP where it was just 12 years ago. The IMF projects that by 2015 it will reach 100% of the GDP (about the level of Greece today). America has an addiction to debt. It will come to an end. If we do not deal with it through our own (painful) public policy initiatives, it will be imposed upon us by the global capital markets.

Federal spending now exceeds tax revenues by 42% and was 12% of GDP in 2009 and 10%+ in 2010. There is no end in sight for the spending binge by our political leaders. If one thinks about this in the context of a business, it would be like a company that was losing 42% on revenues every year. It would be like a family that spends 42% more each year than they earn. For any such company or family, it could only be accomplished by borrowing from the future to have a better life today. But some day the future comes around…and it is approaching us today.

Another troubling way to look at our financial plight is to examine the growth of government as a fraction of the US economy. Government spending (federal, state & local), as a fraction of the economy, stood at about 12% a century ago. By the 1930s it had grown to 22%; by 1960 it grew to 28%. Then it began to accelerate especially in the last decade, reaching the 47% level currently. Think about that. Government spending is now almost the same size as the private economy. This is scary, since the government produces nothing, uses the nation’s wealth rather than creating it and is not the source of tax revenues. The burden of carrying the economy falls exclusively on the private sector.

When we think about a nation’s currency, it is useful to think about it like the stock of a company. Would you want to own the shares of a company that was running such big losses, experiencing very little growth and deep in debt? Furthermore, printing money is like issuing a lot more stock. It dilutes the value of the currency…in the same way that issuing more shares in a company dilutes the ownership of shareholders.

Next 2-3 Years

We are currently in a relative period of calm. The US economy is showing signs of improvement, albeit tepid. Inflation and interest rates are low in America. The US Dollar is gradually weakening, but trading calmly, helped by its reserve currency status. As the world’s reserve currency, US dollars are used to trade oil and other commodities. Therefore, foreign governments and companies must buy our currency to affect their transactions. According to the Bank for International Settlements, the US dollar was used in nearly 87 percent of all international currency transactions during 2010. Central banks around the world, especially in emerging nations, continue to purchase large amounts of US Treasuries (keeping interest rates low).

But increasingly our nation’s creditworthiness is coming into question. By the beginning of this year, many other nations had credit ratings better than the US (among them Finland, Sweden, Singapore and Norway). In coming years our nation’s creditworthiness is certain to slide further, increasing our borrowing costs. It is noteworthy that PIMCO, the world’s largest bond investor, sold all of its US Treasuries in April this year. The global financial markets are already sorting out the differences between those nations that have low debt burdens and low government deficits and those that do not. In addition to being reflected in the credit rating of nations, it also shows up in the value of their currencies. One can see the effect of this in the chart showing the two-year appreciation of currencies of a sample of nations that exhibit solid growth but are comparatively unlevered with debt and operate with low government deficits.

This is a serious problem and our nation’s political leaders must find the courage to deal with it. The political debate has heated up, talking about the nation’s debt and deficits…but it is doubtful that anything meaningful will be done. In their Panglossian way they will ultimately push the problem down the road into the future.

Also, propping up our economy these days is an unprecedented accommodative monetary policy. With the Fed at a near zero interest rate policy level and printing money like it is “going out of style” (as it may), it is no wonder that things have (superficially) improved a little.. But this cannot go on forever and what happens when the stimulus is withdrawn? The headlines say that the US GDP is growing in the 3 ½ percent range. But if one were to subtract out the 10 percent of GDP that the government is spending in excess of its revenues (the deficit), the nation’s growth would be negative. Can the private sector, that has been “jump started on hormones”, keep growing and begin carrying the nation forward?

Where does this lead us?

This leads us to the question “What happens over the horizon, beyond the next 3-5 years?” To assess this, we must ask some tough “What if?” questions. What if foreign buyers of our national debt (mostly emerging market central banks) lose faith in our government’s creditworthiness; our political will to manage our country’s financial affairs in a conservative, responsible way? Or what if they simply want to repatriate those funds for their own domestic purposes…or they decide to diversify away from holding almost exclusively US dollars as foreign currency reserves? Under any of these scenarios, the US dollar drops sharply, interest rates move up and inflation accelerates as the cost of imports rise sharply. This is not a pretty picture.

As we look out beyond 2020, the costs of embedded entitlements, defense spending and debt service become untenable, consuming most of our national resources. It is often said that the national debt is a burden that we place “on the next generation”. It now appears that the storm is approaching faster and will probable set in in sooner, rather than later.

What it means is that America must live within its means and begin doing so soon. Austerity is tough medicine as the people of Greece and Ireland are learning. This will come at a price. It will lower the standard of living in this country and slow the progress in developing nations around the world, since we are their biggest customer. But it must be done to avoid catastrophe. However, many nations have gone through the process moving from socialistic excess to responsible fiscal management, and have gone on to more prosperous times. Think about the turnaround that Margret Thatcher engineered in the UK during the early 1980s.

An American transition to “living within its means” also has significant foreign policy implications as our nation pulls back from being the world’s policeman and providing many nations with economic aid.

America remains the greatest nation on the planet earth, but has lost its way. It can regain its strength and prosperity only by returning to the principles that made it great in the first place (individual freedom, rewarding hard work, risk taking and investment, promoting/nurturing private sector enterprise, shrinking the size & spending of government). Those principles created our national wealth. No country can be generous that does not first achieve and sustain its national wealth.

The growth of government and tax policy began to change that, decades ago. The nation’s tax system was created to cover the cost & investment in those things that were in the common good (infrastructure, education, defense, law enforcement and public safety). At some point it became a system for the redistribution of wealth, to take from the producers and to give to the users in our society. This has been accelerating as politicians see their opportunity to give away benefits to a larger cohort of voters, instead of advancing public policies that make our economy more efficient, innovative, and enterprising on the world’s competitive stage. In the end, we live in a competitive world, where labor, capital, and prosperity migrate to the strongest player.

Post note: This essay was written originally on April 15, 2011. On the following Monday, Standard & Poor’s downgraded the US credit outlook to “negative” the lowest level since the Pearl Harbor invasion in 1941.

1 comment:

  1. Chuck,
    We are of the same understanding of the critical nature of the problems. The Rebellious Truths movement can help significantly move our nation to the solutions. The primary season and general election are approaching rapidly. With your help we can influence the voters to come together to make this happen.