Congress has two objectives at this critical moment: balance the budget and manage the debt ceiling.
Congressmen have two objectives at this critical moment: don’t do anything that imperils reelection and, according to Congressman Ron Paul, come to a resolution before vacation plans run awry.
The 2010 budget was $3.456 trillion. The 2011 budget is $3.819 trillion. Congress is discussing cutting expenses from a range of $1 trillion over ten years which averages $100 billion (2 1/2% of budget) a year to a range of $3 trillion over ten years which averages to $300 billion a year (8% of budget). Cutting back 2 1/2% to 8% doesn’t even eliminate last year’s budget increase of $363 billion and has virtually no impact on solving the problem.
In 2010 revenues were $2.163 trillion. In 2011 they are projected to be the same. Thus, the spending deficit in 2010 of $1.293 trillion has increased to a spending deficit of $1.645 trillion in 2011. The current proposals for expense management are virtually meaningless given the imbalance between revenues and expenses. The debate is less about fixing the problem than it is about coming up with a political compromise.
The solution to the overspending is obvious. In addition to across-the-board cost management, there needs to be radical reduction to military expenses (20% of budget) and radical reduction of clearly excessive healthcare expenses (another 20% of budget). Social Security (yet another 20% of the budget) is a matter of matching the payments to the expenses, just as the system was appropriately designed, so it is a self-contained issue. Unless Congress is willing to discuss openly the obvious need for cuts in the military and healthcare budgets, no progress will ever occur.
The underlying problem is that almost everyone who is associated with the military or who is Medicare eligible is a voter. Accordingly, the conservatives are attacking laws or programs that look too liberal and liberals are doing what they can to preserve those laws and programs, none of which have anything to do with the military or healthcare. Politicians are playing to their base while avoiding disenfranchising their electorate who are looking to receive Medicare or who support the military.
Net interest payments on government debt are only 6.3% of the budget, due to low interest rates, so there is more than enough revenue under any scenario to service debt. As long as debt is serviced, default is averted. The default scare tactics, which are extremely effective not only in the United States but around the world, are designed to foster public support of deferring the need to solve the spending imbalance.
Impact on Markets
Markets hate uncertainty so anything that removes the uncertainty is a near-term positive. Thus, a resolution to the debt crisis is going to stabilize the markets after a relief rally occurs, whereas continued uncertainty will destabilize the markets. However, markets are also smart. There is no default looming. If the government runs out of money, and it is not generated from replacing maturing debt, issuing new debt, “printing” money, or from reaching a political solution, then necessary cuts will have to occur in order to service expenses, which ultimately will not only remove the uncertainty but solve the problem. So in either case, the outcome for the markets should be positive, eventually.
The greater question has to do with why the debt limit discussion is even before us. In the past, growth cured all ills. Now that growth in developed countries has either stalled or, more likely, ended, the spending habits of governments have been laid bare. Employment growth is at risk. Real estate gains that fueled consumers have turned into real estate losses. Perceptions of wealth have turned into perceptions of the need to save. The problem has less to do with government spending than it has to do with our economic prospects. Is this the “new normal”? Is there now a need to have businesses, governments and lifestyles become sustainable and if so, how does that paradigm shift impact the markets?
Fortunately for equities in the developed markets, companies can do business in the developing markets where growth appears to be intact. At the same time, U.S. companies enjoy low cost of capital, low cost employees and low employee turnover. Lack of growth and competitive forces have driven higher efficiency, improving sustainable profits. Ultimately, as companies go out of business or merge, the competition will be reduced. The growth of earnings in companies and the low amount of debt most companies carry has resulted in a relatively good investment opportunity for equity buyers. Another benefit of investing in equities is that they represent real value, so any loss in value if currencies depreciate will not necessarily be reflected in equity valuations.
Perversely the U.S. Treasury debt is rallying, despite the alleged default risk. There is nowhere else to go. There is so much capital available that U.S. debt continues to be the main place to make a debt investment, despite the currency and default risks. At the same time, most country reserves and virtually all international trade is in U.S. dollars. There are limited options for a back-up currency. Thus, under any scenario, there does not seem to be the possibility in the near term of a major debt or credit crisis in either dollars or Treasury debt. However, the dependency of the entire world’s economies and commerce on the stability of the U.S. Treasury and of the U.S. dollar should be a catalyst for Congress to be good stewards and get the U.S. budget balanced.
Ultimately, the advice for investors is always discipline and diversity. Stay the course, but be invested appropriately and be diversified in different assets.
The Proposal at this Moment
According to a J.P. Morgan report, at this writing:
The new deal would hike the ceiling in two parts: the first would raise it by ~$900B, getting Washington through approximately the end of 11, while reducing spending by about an equal amount. The second part of the joint Reid/Boehner plan would create a special committee (made up in equal parts of Republicans and Democrats) to decide on further spending cuts amounting to $1.5T (so $2.4T in total). The committee is expected to deliver its report before Thanksgiving. In the event this committee fails to reach a consensus, deficit-cutting mechanisms would kick-in automatically and impose predetermined spending cuts worth $1.2T. This second batch of deficit cuts would accompany another debt ceiling hike to last Washington into early ’13 (in the original Boehner plan, there were no automatic deficit cutting mechanisms meaning that if the committee wound up deadlocked, it would have been impossible for the debt ceiling to rise a second time).
Figures for this analysis are from http://www.whitehouse.gov/omb/