The only thing that looks really “promising” is US debt, as the government budget deficit will stay between 4~6% even after its economy is fully recovered from the Great Recession. It is estimated that the debt will double from 42% of GDP in 2008 to 83% of GDP by 2019. By considering agency debt, the total public debt might be well above 90% of GDP already. Does it mean the end of the game for the US? Definitely not. Here are 6 ways, good or bad, for the US to climb out of the death spiral.
1. Curb government expenditures. This is always easier said than done. The latest example is from Greece as the government is trying to cut spending to reduce the deficit. The result? Strikes. “Greek state power company workers and hospital nurses went on strike Tuesday to protest government austerity measures designed to pull the country out of a major financial crisis.” It seems to be the last resort for politicians to dodge the bullet.
2. Increase tax. It is relatively easier, as the saying goes, taxing that fella behind the tree. Tax rate hikes will be unavoidable in the next decade. The chart (courtesy of Wikipedia.org) below shows that US taxpayers have enjoyed the lowest income rate in the past two decades in the period started from 1940. The payback time will come sometime in the next decade.
3. Inflate out of debt. There are several ways of doing that. Quantitative easing is one talked about lately by the press, thanks to Bernanke’s efforts of stabilizing the economy. Note that the oil price still stays around $80 per barrel while OPEC’s production is 2 million barrels short of its full capacity per day. That’s the power of quantitative easing. Let’s look backward to the Great Depression. In 1931, the US devalued its currency against gold to avoid a direct default on its debt obligation. Fast forward to 1946, the US national debt was 122% of GDP, while most of the world was made defunct by the war. A decade of 4% average inflation followed and the debt was half of that. (See the chart below, courtesy of Wikipedia.org.) That’s why some central bankers are talking about a 4% inflation target rate. The flip side is the increasing cost of financing. Though, it could generate an once-in-a-lifetime opportunity to buy 30-year treasury bonds with a 10% yearly return.
4. Grow the labor force. One of the reasons behind Reagan’s budget deficit was that as boomers went into their golden age, the US tax income would increase decently. Thus, a short burst of a budget deficit wouldn’t damage the long-term future of the States. It has been proven in history. From that perspective, the future of the US is much brighter than its major competitors. The following chart (courtesy of Mark Schill) is based on data from the US. Census Bureau, International Database, clearly showing the strong growth of the US labor force, compared to Europe, Japan, China and Korea. China’s recent rapid economic growth matches its faster growth of a labor force until 2017, when the US will lead the growth rate again.
5. Cut the current account deficit. Lately, there are two hot topics circling around the financial world. One is China’s currency manipulation, as its RMB yuan has been pegged with the dollar for the past 18 months. Another is the push for consumption increase in Germany and China. Both might be related to the fact that China and Germany should produce less and buy more, particularly for China. There are two issues. First, China labor cost is about 1/7th of the cost in the US at the minimum wage level, and people there are paid at the minimum wage level. A 25% currency appreciation won’t change the equation. Second, compared to the US, China's economy is still too small.
Last year, China’s consumer market totaled $890 billion, the 5th largest market in the world. It is expected to grow to $2.5 trillion in 2015, roughly 25% of the size of the US consumer market in 2009. To a certain extent, it is reasonable to ask countries with current account surplus to share more responsibilities of the world economic recovery. Beyond that, the US is simply destroying their economies politically, which would negatively affect the US economy in the long run. Current account deficits have been there for decades, if not centuries. The US needs to export more high tech products as it is the only country capable of producing them.
6. Wage trading wars. Paul Krugman, a Nobel Prize-winning economist, has taken to advocating a 25% import tariff on Chinese goods until China's government caves in to appreciate its currency by 25%. Instantly, it reminds people of the Smoot–Hawley Tariff Act that caused the Great Depression. Actually, Paul has a valid point. If China were to sell all of its US. investments, it would help the economy by acting as a form of quantitative easing and fighting a “liquidity trap” that has recently been affecting the US. economy. Why is that? Well, assume that the US sold its debt a dollar on the dollar plus coupon. When China dumped its US debt in a short period, the US could buy the debt back a penny on the dollar. A $1 trillion debt became $10 billion dollars. It would be very painful for the moment, but create a bright future for the US. Historically, similar things happened in the summer of 1914 as major European countries dumped their US debt to raise money for World War I, transferring the wealth from Europe to the US.
All in all, choices 3 and 4 might be major forces shifting the paradigm in the next decade. Inflation is on the way. India has raised its interest rate while facing 9.89% inflation. Guangdong Province, China’s largest export center, will increase minimum wage by more than 20%. It is just a matter of time for inflation to hit the US hard again.
Disclosure: Short S&P500, short finance