U.S. Fiscal Train Wreck Underway

I think a technical recovery will happen in the Q4 to Q1 timeframe. But this recovery is likely to be weak, if it happens at all. Downside risk remains. Unfortunately, the Obama administration has fired all its bullets, spending huge political capital bailing out the big banks and putting together a weak stimulus package we all knew was going to fail.

Now Joe Biden is trying to save face, talking as if recovery is guaranteed and no further stimulus is necessary. Yet, on the eve of the G-8 summit, it takes Gordon Brown to remind us that the Great Depression II meme is still at play. If the United States wants to keep deflationary forces at bay, it will need to support the economy with fiscal stimulus.

The problem is the U.S. government budget deficit. In April, in a post called “The Cult of Zero Imbalances,” Marshall Auerback made the case for stimulus, aware of the downside risks for the dollar and bond prices because of that deficit. Yes, there are risks for America associated with deficit-inducing stimulus in the short-term, but they can be mitigated if the Obama Administration actually showed a plan to reduce the longer-term deficit. But, as David Leonhardt has argued, Obama’s team has no deficit reduction plan whatsoever.

So now we must contemplate America’s fiscal train wreck; and that is exactly what Richard Berner at Morgan Stanley is doing. Here is an excerpt of his research note published today.

America’s long-awaited fiscal train wreck is now underway. Depending on policy actions taken now and over the next few years, federal deficits will likely average as much as 6% of GDP through 2019, contributing to a jump in debt held by the public to as high as 82% of GDP by then – a doubling over the next decade. Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP. Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth. And soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service. Not only will those factors steadily lower our standard of living, but they will imperil economic and financial stability.

Later in his missive Berner rightly admits that economists warning about deficit spending in America have been singing this tune for quite some time. And, as with the boy who cried wolf, no one believes them any longer. No less than former U.S. Vice President Dick Cheney said “deficits don’t matter.”

Well, they do matter. Eventually, the day of reckoning will come. Berner puts it this way.

Some are concerned that our reckless fiscal policy will trigger a downgrade of the US sovereign debt rating, making the financing of our burgeoning deficits more difficult. While worries that the US will default on its debt are illogical, global investors and officials are concerned about the credibility and the sustainability of our fiscal policies. So am I. They fear that we will adopt policies that will undermine the dollar and the domestic value of dollar-denominated assets through a combination of risk premiums and inflation. I worry about that too, although such policies probably would be accidental rather than deliberate. As a result, interest rates may have to rise significantly to compensate investors, including reserve portfolio managers and sovereign wealth funds, for such dangers. While the dollar will for now retain its reserve-currency status, such concerns put it at risk.

Definitely read his piece which is linked below. He does an excellent job of demonstrating that healthcare is a large part of the problem and sounding the alarm for fixing it once and for all.

Source

America’s Fiscal Train Wreck – Dick Berner, Morgan Stanley

Comments

[Mad Hedge F...:]

Let’s say we spend our $2 trillion and get a couple of quarters of weak 2% type growth. Then once the effects of the stimulus wear off, we slip back into recession, setting up a classic “W” type recession. Unemployment never does stop climbing. This happened to Roosevelt in the thirties. So congress passes another $2 trillion reflationary budget. Everybody get’s wonderful new mass transit and alternative energy infrastructure. But with $4 trillion in spending packed into two years inflation really takes off. The bond market collapses, the dollar tanks big time, gold goes ballistic to $3,000, and silver to $50. Ben Bernanke’s replacement has no choice but to engineer an interest rate spike, taking the Fed funds rate up to a Volkeresque 20%. Housing, having never recovered, drops by half again. This all happens in the 2012 election year. Obama is burned in effigy, a Mormon is elected president, and the Republicans, reinvigorated by new leadership, retake both houses of congress. We invade Iran. Crude hits $200. This is not exactly a low probability scenario. Remember Jimmy Carter? This is why junk bond yields are still stubbornly high at 14.5%, and credit default swaps are at lofty levels. The risk of Armageddon is still out there. Just thought you’d like to know. Pass the Ambien.

Jul 06 11:18 AM

[Edward Harr...:]

That's good! Give me some Ambien too, we all are going to be needing some. The scenario you lay out is not too far fetched, especially the double-dip aspect of what you're saying. This is similar to one of two scenarios I laid out in a recent post.

The problem here is that this inflationary scenario leads straight back to the deflationary one because the aggressive monetary response it will engender will kill any recovery dead.

Until the private sector has worked off its huge debt burden, deleveraging and the attendant deflationary are always going to be lurking underneath.


On Jul 06 11:18 AM Mad Hedge Fund Trader wrote:

This is not exactly a low probability scenario. Remember Jimmy Carter? This is why junk bond yields are still stubbornly high at 14.5%, and credit default swaps are at lofty levels. The risk of Armageddon is still out there. Just thought you’d like to know. Pass the Ambien.

Jul 06 11:40 AM

[Roger Knights:]

"the Great Depression II"

In time I suspect this term will mostly evolve into the snappier "GD2," just as "World War 2" evolved into "WW2."

Jul 06 11:50 AM

[Jason Rines...:]

Great article Mr. Harrison. I always enjoyed reading your work over the last couple of years.


On Jul 06 11:40 AM Edward Harrison wrote:

> That's good! Give me some Ambien too, we all are going to be needing
> some. The scenario you lay out is not too far fetched, especially
> the double-dip aspect of what you're saying. This is similar to one
> of two scenarios I laid out in a recent post.
>
> The problem here is that this inflationary scenario leads straight
> back to the deflationary one because the aggressive monetary response
> it will engender will kill any recovery dead.
>
> Until the private sector has worked off its huge debt burden, deleveraging
> and the attendant deflationary are always going to be lurking underneath.
>
>
> This is not exactly a low probability scenario. Remember Jimmy Carter?
> This is why junk bond yields are still stubbornly high at 14.5%,
> and credit default swaps are at lofty levels. The risk of Armageddon
> is still out there. Just thought you’d like to know. Pass the Ambien.

Jul 06 11:50 AM

[mplaut:]

These are just scenarios and have no probability attached to them. They are possible but so are thousands of similar and not-so-similar scenarios possible. If that is the best that you (or someone) can do, the only thing is to invest for the short term and keep an eye on everything.

In "normal" times there should be some visibility a year to two years ahead. Now, since what happens depends so much on policy choices and not on impersonal market forces, there is no way to know what will happen. Plan accordingly, and not based on a scenario that is possible, but nothing more than that.

Jul 06 12:10 PM

[John Lounsbury:]

Edward - - -

mplaut is correct. However, I do appreciate your discussion of scenarios without waiting for you to consider probabilities. Even if you waited to consider probablilities, they might not be the best information to be putting out. After all, as mplaut said: "In "normal" times there should be some visibility a year to two years ahead. Now, since what happens depends so much on policy choices and not on impersonal market forces, there is no way to know what will happen."

I appreciate your very logical arguments, but do, privately most of the time, consider the probabilities. After all, I am mostly guessing in that regard (probabilities), too.

Jul 07 11:43 AM

[TradingHelp...:]

MHFT, you have a gift. Is your comment an economic prediction or a movie idea? Either way you are onto a winner.


On Jul 06 11:18 AM Mad Hedge Fund Trader wrote:

> Let’s say we spend our $2 trillion and get a couple of quarters of
> weak 2% type growth. Then once the effects of the stimulus wear off,
> we slip back into recession, setting up a classic “W” type recession.
> Unemployment never does stop climbing. This happened to Roosevelt
> in the thirties. So congress passes another $2 trillion reflationary
> budget. Everybody get’s wonderful new mass transit and alternative
> energy infrastructure. But with $4 trillion in spending packed into
> two years inflation really takes off. The bond market collapses,
> the dollar tanks big time, gold goes ballistic to $3,000, and silver
> to $50. Ben Bernanke’s replacement has no choice but to engineer
> an interest rate spike, taking the Fed funds rate up to a Volkeresque
> 20%. Housing, having never recovered, drops by half again. This all
> happens in the 2012 election year. Obama is burned in effigy, a Mormon
> is elected president, and the Republicans, reinvigorated by new leadership,
> retake both houses of congress. We invade Iran. Crude hits $200.
> This is not exactly a low probability scenario. Remember Jimmy Carter?
> This is why junk bond yields are still stubbornly high at 14.5%,
> and credit default swaps are at lofty levels. The risk of Armageddon
> is still out there. Just thought you’d like to know. Pass the Ambien.

Jul 07 12:05 PM

[pete123:]

The added danger is that if MHFT's scenario comes to pass, and the US markets turn into a wild emerging-market-like roller-coaster ride, our creditors will have reason to cut their losses on dollar holdings and seek stability elsewhere. The natural American response to this, of course, is to destabilize that elsewhere. We still know how to do that :-/ .


On Jul 06 11:40 AM Edward Harrison wrote:

> That's good! Give me some Ambien too, we all are going to be needing some.
...
> The problem here is that this inflationary scenario leads straight
> back to the deflationary one

Jul 07 01:34 PM

[Steven Hansen:]

i seem to be the puppy getting the hind tit arriving late for feeding.

Edward, i enjoy reading your material. i know things will not turn out well without a forward looking plan to keep deficits under control. political leadership cannot do this as it requires hard choices.

whether the recession ends in an L or W, a 2% gdp growth is not growth. most people do not grasp this concept. having an infrastructure so vast as ours, a certain amount of money must be spent to maintain it or replace it as it deteriorates. and we have a population growth rate now of over 1% - which leaves real growth negative.

maybe the budget can be prepared by the cbo based on priorities dictated to them by congress. this way somebody with fiscal control concepts can lead us though the maze.

Jul 07 09:32 PM