Ticking Time Bombs in Budgets Everywhere

by: Cam Hui, CFA

John Maudlin once observed that western governments and societies were behaving like teenagers:

In a way, we were like teenagers. We made the easy choice, not thinking of the consequences. We never absorbed the lessons of the Depression from our grandparents. We quickly forgot the sobering malaise of the '70s as the bull market of the '80s and '90s gave us the illusion of wealth and an easy future. Even the crash of Black Friday seemed a mere bump on the path to success, passing so quickly. And as interest rates came down and money became easier, our propensity to acquire things took over.

And then something really bad happened. Our homes started to rise in value and we learned through new methods of financial engineering that we could borrow against what seemed like their ever-rising value, to finance consumption today.

We became Blimpie from the Popeye cartoons of our youth: "I will gladly repay you Tuesday for a hamburger today."

Today, the bill is coming due. There are now time bombs in budgets everywhere. Reuters has a story out entitled Forget Greece: Italy derivatives also ticking. Local governments in Italy were eager to reduce their financing costs and did so through complex derivatives contracts. When interest rates increase, many cities will face substantial losses.

The cover of Barron's features a story about the $2T public pension hole. David Merkel also has a terrific post about the unfunded obligations of the US and EU governments. Mish has been railing about the ticking time bombs embedded in state and local government obligations, see one of many examples here.

Death by cancer or heart attack?
I go back to my analogy from the Star Trek episode, where Spock’s line was “The guilty party has his choice-- death by electrocution, death by gas, death by phaser, death by hanging...”

Governments have the choice of cancer (inflation) or heart attack (deflation). They can either spend and print money like crazy in order to put off the day of reckoning, or they can bite the bullet now by defaulting on debt, raising taxes or drastically cutting spending. We just don’t know which path they will choose or whether the markets will allow them to choose.

As investors, we need to prepare and watch in order to react accordingly.