The Deficit Reduction Plan Not Likely to Make a Difference

Includes: AGG, DIA, GOLD, QQQ, SPY
by: Disruptive Investor

As the debate rages on the issue of increasing the debt ceiling before August 2, 2011, few things are most likely to happen –

  1. An increase in the debt ceiling by the proposed USD2.5 trillion.
  2. A plan on deficit reduction over the next decade.

This article focuses on the deficit reduction plan and its workability.

The USD3.7 trillion deficit reduction plans by the “gang of six” might be the lines around which the final settlement is expected to come. According to the plan, 74% of the deficit reduction would come from spending cuts and 26% from new taxes.

Before talking more on the reasons why deficits might just climb up further, I would like to point out the stance of S&P on U.S. ratings related to the current crisis –

“Standard & Poor’s warned there is a 50% chance that it will lower the U.S. government’s AAA credit rating by one or more levels within three months. S&P said yesterday that, even if Congress raises the debt limit in time to avert a default, it might lower the U.S. sovereign rating to AA+ with a negative outlook if it isn’t accompanied by a “credible solution” on the debt level. “

In my opinion, the final solution on the debt ceiling and deficit reduction program will not be one of the “credible solutions” and U.S. might be faced with a rating downgrade.

The immediate impact is on bond yields and S&P expects short-term interest rates to rise by 50bps, while long-term interest rates are expected to increase by 100bps. This, in itself, has the potential to make a mockery of the entire plan. Increased yields would result in higher debt servicing cost on government bonds and it calls for either further tax increases or higher spending cuts in order to control the deficits (as per the plan).

Even if there is no S&P downgrade, I suspect the level of interest China would still have on U.S. Treasury bonds, which yield 3-4% (with China’s inflation at 6%).

Flight to Safety (Away from U.S. Treasury Bonds)

(Click to enlarge)

The key point I would like to make here is - Just one factor (not in control of the government) can change the budget dynamics. This is a matter of concern going by the fact that even debt monetization did little to keep yields significantly under control.

Moving on, the next crucial factor is economic growth. Budget deficits in 2010 were USD1.3 trillion. Further, as per CBO expectations, budget deficit in 2011 and 2012 is expected to be USD1.5 trillion and USD1.1 trillion respectively. This is mainly on the assumption that the economic growth will be sluggish and government support would be needed to keep economic activity at positive levels (in terms of GDP growth).

The question one needs to ask here is – With plans to increase taxes and with economic activity sustaining due to higher levels of leverage, will U.S. growth be meaningfully robust to allow the government to hold back its spending or receive meaningfully increased individual and corporate taxes?

What big difference would trillion dollar deficits in 2011 and 2012 have on economic growth? Did the big government stimulus programs post 2007 really help in strong economic growth?

The huge amount of money in the system would just be used in speculation across asset classes. In my opinion, with no concentrated effort on increasing manufacturing and production, growth in the U.S. economy (largely driven by consumption), would remain sluggish for years to come. Hence, expecting meaningful increase in tax revenues would be a disappointment.

Therefore, while the deficit reduction might come from spending cuts in social security programs, it might be more than offset by further funds required to prop up economic growth.

In my personal opinion, this might not be a difficult thing to predict or assume. However, the government would ignore this perspective as its immediate focus is to increase the debt ceiling. In the long run, we can expect further increases in debt ceiling and more promises on debt reduction. Finally, we are moving in a path which has only one end – Paper money ending up at its intrinsic value, which is precisely zero.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.