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We have been more frustrated than most by the lack of political cooperation in the US. While we could go on a rant about the ineffectiveness of the US political system, it would serve readers much better for us to follow our usual “read and react” posture. In short, when we read today’s political outlook, the US looks almost certainly headed for another recession. The current political direction in this country is alarming. The Democrats want to raise taxes to cut deficits, whereas the Republicans want to cut spending. Either of these (or both of them in a compromise) would have the purpose of reducing the US budget deficit, and, hopefully, restoring confidence in federal government finances. Sound like a great idea, right? Wrong.

The reason why we are so alarmed is that while neither party agrees how to do it, they both agree that the deficit must be reduced. This is incredibly bearish for the US economy. If you raise taxes, you kill consumption by reducing disposable income. If you reduce government spending, you take dollars directly out of people’s pockets.

Between federal, state, and local governments, there are 22 million Americans working directly for the government, and any spending cuts will include them. This doesn’t even include the amount of money that could be taken out of the general population’s wallets through reduction of entitlement programs. This is called fiscal tightening, and it has the obvious and direct effect of reducing GDP. At a time when US GDP growth is tenuous at best (and still negative when factoring inflation), the government is taking tightening steps, not the loosening steps it should be taking. This will almost surely force the US economy back into a protracted recession.

The absolute best outcome at this point for markets would be a temporary extension of the debt ceiling with no real progress on deficit reduction. If we sound hopeless, we apologize for our extreme negativity. However, we must stress that the situation is dire. While the rest of the world waits for a “grand compromise,” we are here to tell you that the more the US budget deficit is decreased, the greater the likelihood, quicker the beginning, and deeper the severity of the next US recession.

While this sounds like an irresponsible view, the simple truth is that the economy is based on debt and deficit spending, and if we try to cut that, especially if we do it quickly, the economy will suffer drastically. The following chart shows US federal debt in green and the Consumer Price Index in white, and the chart has been normalized for percentage.

[Click all to enlarge]

From RealFinance Commodity Analyst Newsletter

The federal debt rose roughly in tandem with inflation until the ‘80s, when government debt started to absolutely explode. From this perspective, Republicans’ claim that the deficit is all Democrats' and President Obama’s fault is laughable. The real debt problem started during Ronald Reagan's presidency in the ‘80s, and was continued indefinitely by short-term minded politicians and their need to please constituents with a perpetually-vibrant economy.

The real truth is that the economy is mature and cumbersome, and has no engine of organic growth. Even the tech boom of the ‘90s was fairly short-lived when considering how the national debt has just absolutely skyrocketed from the year 2000 on (not coincidentally when Bush took office). At this point, the only way the economy can grow is to saddle us with more debt. However, this is not the worst thing in the world; it is actually a desirable outcome compared to fiscal tightening.

To illustrate the point, the following chart shows the same federal debt outstanding and CPI index as above, but also included now are the S&P 500 index and the price of gold.

The chart is from 1980 to present day and is also normalized for percentage.

From RealFinance Commodity Analyst Newsletter

The S&P 500 has actually underperformed when considering how much new debt the government has taken on. In response to the last two stock market routs in 2000 and 2008, the government can clearly be seen adding more and more debt, and what is even more alarming is that the pace at which government debt is accelerating is starting to go parabolic, yet the effects on the stock market appear to be more and more muted over time. This does not bode well for us long term, yet our borrowing costs are at all-time lows.

In a normally-functioning, ceteris paribus global economy, the US and its consumers would not have unlimited borrowing power, meaning as we borrowed more and more, our ability to pay back debts would be in question and interest rates on our debt would rise. However, with interest rates at all-time lows, the exact opposite has now become the case. The following chart shows the yield on the 10-year US treasury note since 1962.

From RealFinance Commodity Analyst Newsletter

Interest rates have gone nowhere but down since 1980. If you were my lender and I told you I was going to increase my debt by 100% in the next five years (the same amount the US debt has increased since 2006), would you give me a lower or higher interest rate? The answer is higher, yet the yield on the 10-year has actually decreased from slightly under 5% in 2006 to now 3%, a 40% reduction.

China, Japan, and other large buyers of US debt are not buying our debt because they think it’s a good deal. They are buying our debt because they have no other choice. The US is the world’s #1 consumer by far; our thirst for consumer goods, oil and other expensive products is insatiable. Because the US is not producing any new money organically (we produce very little of value that other countries actually need), we need to finance our continued appetite for consumer expenditure by increasing our debt.

Since China and other emerging economies are selling a huge portion of their goods to us, it is in their best interest to artificially support our borrowing. By being the largest buyer of our debt, they ensure that our interest rates remain low so that we can keep borrowing in order to buy their goods. While this may be viewed as unsustainable in the long run, this has been the de facto state of the US economy for the past 30 years; first it was Japan, now it is China.

While pundits will point to Europe and say that we need to cut debt so we don’t end up like Greece, that scenario is not really possible. Greece’s real problem is not that it can’t pay back its debt (although that is a problem as well); it is that it doesn’t control its own currency. The US has the ability to simply print dollars to pay back debt, unlike Greece. Although this is not necessarily a good thing because it causes inflation, it removes the element of credit risk in our government bonds that European bonds are rife with.

If we decide to get our fiscal house in order, while that sounds like a good idea, it will cause a huge amount of pain for the US economy. By removing any portion of the ability of the largest borrower in the world, the US government, to borrow, consumption across the entire world will fall. Risk assets such as stocks and high-yield bonds will experience huge selling pressure as it becomes apparent that the economy is both not growing and is shunning debt for the first time in 30 years. While government economists would point to the ability of the corporate and consumer sectors to increase borrowing (and indeed consumer and small business debt remains at depressed levels), why on earth would consumers and responsible small businesses do this if aggregate demand is falling? Periods of fiscal tightening are no time to start building new factories and buying more iPads.

While the debt situation is unsustainable in the long run, it is imperative that the fiscal tightening be put off indefinitely if the US wants any chance of avoiding another recession so quickly after the financial crisis. The simple truth is that the US dug its own grave many years ago, and there is nothing to be done to stop the chain reaction. The only question at this point is whether we would rather have a recession sooner or later due to government deleveraging. My preference would be later.

Source: U.S. Austerity Package Could Usher in Global Recession