Seeking Alpha
Registered investment advisor, CFA, portfolio strategy, macro
Profile| Send Message| ()  

The recent economic news out of Washington D.C. has been most distressing. Not distressing in terms of the negative impact that the looming budget sequestration might have on our economy. To the contrary, those desperate claims are not only ridiculous when put into a broader context, but also downright irresponsible in the fact that policy makers are unnecessarily trying to alarm the American public for political gain. No, the part that is far more troubling about the rhetoric from policy makers is the fact that we currently lack the bold leadership necessary on both sides of the aisle to have any real chance of fixing the fiscal and economic problems we face today.

How Bad Is The Problem Anyway?

The fiscal problems in Washington are unprecedented in many respects. While this can be illustrated using a variety of different data and perspectives, for the purposes of this discussion we will get right to the heart of the matter by focusing on the budget deficit. As the chart below illustrates, it has exploded to unprecedented proportions since the outbreak of the financial crisis several years ago.

(click to enlarge)

To put this chart into context, the previously largest budget deficit prior to the new millennium occurred in 1992 when it reached $290 billion. And the previous all time high prior to the financial crisis came in 2004 when the budget deficit reached a then unheard of $413 billion. But over the last four calendar years, we have had readings in excess of $1 trillion including $1.4 trillion in 2009, $1.3 trillion each in 2010 and 2011 and $1.1 trillion in 2012. Although the estimated number for 2013 at roughly $845 billion is somewhat better, this is still a preliminary estimate and is still more than double the previous pre crisis high in its own right. These are staggering readings to be certain, which have served to send the U.S. federal debt from $9 trillion before the crisis to $16 trillion and counting today. If the federal debt were a stock price chart, people would be referring to it as a bubble.

(click to enlarge)

But here's an important point. The above two readings are measured in nominal dollars and do not account for the impact of inflation on diminishing the purchasing power of the dollar over time. With this in mind, perhaps the magnitude of the problem is not as dire as it seems at first glance. In order to put the recent budget deficits into perspective, it is worthwhile to measure these readings in the context of the broader economy. And one very reasonable way to make this assessment is by measuring it relative to U.S. gross domestic product (GDP). After all, if the U.S. economy has expanded sufficiently to adequately support these larger numbers, then the size of the deficit may not actually be a problem today.

(click to enlarge)

But when viewing the federal deficit as a percentage of GDP, it only confirms that we are in uncharted territory with our economy. During the budgetary explosion in Washington over the last several years, the deficit as a percentage of GDP reached just over -10%. Putting this into context, our recent deficit as a percentage of our overall economy was effectively double the previous record peacetime high in U.S. history. And while it has since improved somewhat over the last few years to -7% in 2012, this is still well above the previous all-time highs.

In short, we have a fiscal problem in the United States, and it is a serious one at that.

Do We Have A Spending Problem Or A "Revenue" Problem?

Before going any further, I don't know when we started regularly referring to raising taxes as "increasing revenues," but I'm not a buyer of this change in wording simply because it sounds better. I'm sticking with raising taxes. And the debate surrounding how to try and fix the fiscal mess boils down to two primary choices: raise taxes or cut government spending. The lines are clearly drawn in Washington today.

"We don't have a spending problem"

-President Obama according to Republican House Speaker John Boehner

"So it is almost a false argument to say we have a spending problem, we have a budget deficit problem"

-Democratic House Minority Leader Nancy Pelosi

On one side of the argument are the Democrats. While they give lip service to the idea that we need to cut spending, their primary emphasis remains on increasing taxes. This fact was clearly demonstrated in the final deal from the Fiscal Cliff negotiations at the end of last year. With the Democrats clearly in the driver seat following the November elections, the American Taxpayer Relief Act of 2012 included $600 billion in tax increases against $15 billion in spending cuts. And in the current squabbles over the looming budget sequestration set to take effect on March 1, a key sticking point on negotiating a better deal has been the fact that Democrats want additional "revenues" to go along with the already agreed upon spending cuts. So make no mistake, Democrats want higher taxes far more than any meaningful spending cuts.

"We can't be raising taxes every three months in this town"

-Republican House Majority Leader Eric Cantor

On the other side of the argument are the Republicans. And they have been far less equivocal on their stance by focusing exclusively on spending cuts while flatly refusing to even consider any further tax increases. The GOP is so hungry for spending cuts that they are now gladly willing to take what was once considered the unthinkable budget sequestration and its $1.2 trillion in automatic across the board spending reductions that are set to take place between now and 2021.

Thus, the battle lines are clearly drawn. But unfortunately, the underlying problems that have been created for the U.S. economy are now far more nuanced. And instead of it being simply a "spending" problem or a "tax receipts" problem, the problem has become far more than that now. And the way out of this current mess involves far more variables including time. As a consequence, it may turn out that neither side is right in the end.

So Where Are We Today?

The financial crisis in 2008 spawned a considerable fiscal disconnect. Because of the dramatic shock to the U.S. economy, federal tax receipts declined drastically. As a fiscal response straight out of the Keynesian playbook, the U.S. government dramatically increased spending in an effort to try and offset the hole in output created by the sharp decline in private sector spending by consumers and businesses. At the same time, the government sought to provide an additional boost to the economy by lowering taxes, which served to reduce immediate tax receipts even further. These policy actions created a wide gap between spending and tax receipts and resulted in the record large budget deficits seen over the last few years.

(click to enlarge)

As the thinking goes, the reacceleration of growth as the economy recovers results in the resumption of higher tax receipts. And as the economy fully regains its footing and private sector activity picks up over time, the government can scale back on its additional spending measures and these two lines can converge once again. Unfortunately, this has not happened in any meaningful way over the last five years. While tax receipts have rebounded somewhat, they still remain $119 billion below peak levels from 2007. At the same time, while government spending has leveled off, it is still $809 billion above where it was at the outset of the crisis in 2007.

Fiscal Policy Catch-22

All of this leads to the most vexing of dilemmas. This fiscal budget gap cannot go on indefinitely. We have already been operating over the last four years with a fiscal deficit that is beyond the historical peacetime record as a percentage of GDP, and we have since seen our national credit rating downgraded at a time when our country owes more money to its creditors than ever. Thus, the need to address this budgetary gap becomes increasingly imperative the more time passes. And the primary mechanisms to address this problem is engaging in restrictive fiscal policy that includes raising taxes and/or cutting government spending. Unfortunately, the pace of economic growth emerging from the crisis remains sluggish and fragile. If anything, maintaining output on its current path requires further expansionary fiscal policy including lowering taxes and/or increasing government spending instead of anything restrictive.

Therein lies the rub. Leave the current policy course unchanged, and the fiscal situation threatens to deteriorate further, perhaps in a meaningful way. But take action to correct the fiscal imbalances, and the likely resulting decline in tax receipts from a receding economy more than offsets any progress on the deficit achieved by raising taxes, cutting spending or both. What is a policy maker to do?

Where Have We Seen This Script Before

History provides us with a most relevant guide as to what we might expect to result from the fiscal actions currently under consideration in Washington. Back in 1936, the U.S. economy was trying to work its way out of the Great Depression. Following the severe contraction that occurred from 1930 to 1933, the economy entered into recovery over the period from 1934 to 1936. And by 1936, policy makers in Washington had turned their attention away from the preceding economic weakness and instead were increasingly focusing on the need to close the budget deficit and address the threat of inflation. A variety of restrictive fiscal policy actions were taken including broad government spending cuts and higher taxes that included raising rates on top income earners as well as instituting a 2% payroll tax to help fund Social Security. The result was an economy that quickly plunged back into recession, contracting by over -6% in 1938.

(click to enlarge)

Did the government manage to balance the budget in 1938? Pretty much. But the budget deficit problem quickly returned in 1939 as tax receipts rolled over and government spending resumed its sharp upward climb.

Despite the similarities, a key difference exists between this period in the mid 1930s and today. In the 1930s, as the government was cutting spending and raising taxes, the Federal Reserve was also engaging in restrictive monetary policy by twice raising the reserve ratio for banks. This resulted in a considerable compounding of policy tightening on the U.S. economy. Today, Fed Chairman Bernanke, who is well versed on how events played out during this era, has fully embraced the complete opposite approach by remaining ultra accommodative by flooding the financial system with liquidity. He has also been vocal in his pleas to Congress to wait on taking more restrictive fiscal policy measures until the U.S. economy returns to greater strength.

This raises an important question. Is Bernanke right in suggesting that action should be postponed based on his knowledge of the Great Depression? Unfortunately, we'll never know how the scenario from the 1930s would have finally played itself out, as the onset of World War II not long after completely altered the path of the U.S. economy in a dramatic way. The only thing we do know is that we don't know. Perhaps he is correct. Then again, perhaps the combination of restrictive fiscal policy and expansionary monetary policy may strike an even better mix. Or perhaps the policy solution lies in something else altogether different.

The Answers To Our Problem Lie Within The Sequestration Debate

Some of these politicians in Washington are utterly ridiculous. They talk as though the world is going to end because we are considering making $85 billion in across the board cuts to our fiscal spending budget in 2013. Really? We increased government spending by over $800 billion, or +30%, over the last five years and we cannot honestly find any place where we can make some cuts and increase operational efficiencies. The cuts totaling $85 billion represent a mere 2.4% of total federal net outlays in 2012. But the fact that policy makers are making such a big deal about the sequester not only undermines their credibility but also brings to light an even more critical point.

The problem with the government receiving tax revenues and making spending decisions is that they have no incentive to profit maximize and operate at full productive and allocative efficiency. Instead, their primary incentives are to get reelected and to pursue the interests of their constituents. This is hardly the backdrop where money is spent wisely. And one does not have to search far within any given area of governmental to find countless examples of departmental redundancies and the outright waste of taxpayer dollars.

I remember a presidential candidate back in 2008 that ran on the premise of going through the budget line by line to eliminate government programs we don't need and insisting those we do operate in a sensible cost effective way. It is time to finally get off the campaign trail and make good on this promise for the benefit of the country, for I fully imagine that we could cut ten times as much in government spending and do so in a way that, by utilizing that once promised scalpel, would have little to any negative impact on economic growth. Success in this action alone could probably eliminate the budget deficit altogether. It would take a lot of political courage to get it done, but imagine the legacy if it was achieved. I quite imagine both sides of the political aisle might even celebrate it in the end.

And while I generally believe that capital is better served by remaining in the private sector instead of being sent off to the government in the form of taxes, some honest policy reflection on the part of Republicans in the House of Representatives is also warranted and has the potential to be growth enhancing. Despite the fact that the GOP is getting repeatedly taken behind the woodshed on the policy negotiating front, they did manage to end up with a deal that made more than 98% percent of the Bush era tax cuts permanent. Thus, this is a positive step on the lowering of rates side of their long desired tax reform objective. But the vastly increasing complexity of the tax code over the years has also resulted in countless loopholes and deductions that have been woven into the system. As a result, it is not only highly conceivable but also almost certain that a variety of wasteful tax deductions could be also be eliminated in an effort to increase tax revenues in a way that has a minimal impact on economic output. For if we expect our President to go through the budget with a scalpel to identify spending cuts, we should also expect our Republican controlled House of Representatives to take the lead in going through the tax code with a scalpel in the same manner. Not only would this help narrow the budget deficit and hopefully lead to surplus, but it would also bolster the argument for simplifying the tax code further, eventually lowering rates and broadening the base.

Of course, if the Republicans want to get the public behind them on this or any other policy initiatives, they absolutely must focus on improving their media and public relations strategy. Say what you will about President Obama, he is a master at messaging. And he has a very capable Press Secretary in Jay Carney and allies in Congress that are clearly and effectively disseminating his message to the press and the public every day. At present, the Republicans have neither. Instead, they have a variety of voices that are sometimes disconnected and often have differing views. And it is hard to expect the country to unify behind a particular message if the party itself does not appear unified behind it.

The Bottom Line

The answer to the government's fiscal budget deficit problems resides within the government itself in the end. By working to cleanse government spending of inefficiencies while at the same time revising the tax code to eliminate wasteful loopholes, the opportunity exists to potentially reduce the staggering budget deficit. Perhaps it could even be eliminated again some day the way that President Clinton and House Speaker Gingrich were able to collectively achieve back in the late 1990s. Of course, those were far better economic times, and the appetite today for spending cuts from one side and further tax increases of any kind from the other is seemingly nil at present. Thus, all of this is likely wishful thinking. That is, of course, until the ongoing economic problems we are facing finally erupt into a full blown domestic crisis. Then, and only then, will the attentions of policy makers become truly focused and real solutions to today's problems will be considered. At least we hope. And hopefully it is not too late at that point.

In the meantime, we are left with investment markets that are spellbound in the wake of ongoing government paralysis. This includes a stock market (SPY) that remains highly unstable despite its seemingly endless climb higher thanks to the ongoing generosity of the U.S. Federal Reserve and a bond market (AGG) that remains at artificially low rates at the expense of those living on fixed incomes. While one is well served to own both for diversification and risk control in the current environment, also maintaining an allocation to stores of value such as gold (GLD) and silver (SLV) remain worthwhile despite their recent travails given the persistently heightened uncertainty associated with not only the U.S. government but also the fiscal outlook in many parts of the world. The Central GoldTrust (GTU), Central Fund of Canada (CEF) and the Sprott Physical Silver Trust (PSLV) are all ideal ways to establish these exposures. The fundamentals for both metals remains strong, and as Warren Buffett often says, it is best to be fearful when others are greedy (as they are today in stocks) and greedy when others are fearful (as they are today in gold and silver).

Source: U.S. Fiscal Policy: Highly 'Sequestionable'

Additional disclosure: I am long the stock market via the S&P 400 Mid-Cap (MDY) and the S&P 500 Low Volatility (SPLV) as well as individual stock names.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.