Debt Ceiling Debate Only Kicks the Can Down the Road

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Includes: DIA, IEF, QQQ, SPY, TBT, UDN, UUP
by: Steven Hansen

The markets were in turmoil this week, reacting to news conferences with claims / counterclaims and general disagreements over legislation to increase the debt ceiling. Eventually, a compromise will be reached and the debt ceiling raised – and sometime in the future we’ll face this debt ceiling again.

No matter what budget cutting occurs, the Federal Budget will grow faster than the economy – solely due to entitlements and the baby boomers. Between now and 2019 entitlement (health care) spending will grow even if all costs remain the unchanged because the number covered will grow by 38%.

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With no inflation, the growth of the population covered under government sponsored health care programs will add $3.2 trillion to the deficit. The Obamacare glitch is reflected in the government’s forecast, and its background in a Forbes article. Between 2020 and 2030 – the number of people covered on the entitlements program will grow another 28%. So between 2010 and 2030 the growth of participants is expected to be more than 75%.

As entitlements currently consume 100% of all government tax income, if discretionary spending was frozen the USA would have a budget deficit of $1.0 trillion each year. This leaves the total growth of the deficit at least $12.2 trillion ($1 trillion x 9 years plus entitlement 0% inflation shortfall of $3.2 trillion).

Through cutting, some of the $1 trillion per year could be saved, but the $3.2 trillion forecast for entitlement growth is low. Likely, the USA debt will almost double by 2019 without major spending surgery (which is not being discussed) or taxes.

If the plan was to cover this growth by taxing, there is some bad news here too. Many think taxing more will balance the budget – whether it be increasing the rates for the rich, corporations or everybody. What are they missing? They do not account for the shrinking tax base population ratios.

The baby boomers will move from paying into the government to receiving benefits from the government. The boomers are the wealthiest segment of society, and their lower incomes will reduce income tax revenues.

In 2010, there were 3.7 workers per entitlement beneficiary. In 2020, there will be 2.9, and in 2030 only 2.4. Just to keep the personal income tax revenue equal, the average taxes citizens pay must rise by 35% to cover just the shortfall caused by the shrinking ratio of working taxpayers. To cover the added costs of health care by 2019 – the overall tax rate must rise by a minimum of an additional 20%. Put this on top of the taxes needed to balance the budget – and the average overall personal tax rate schedule would need to increase 104% by 2019.

All other government taxes (corporate, fuels, excise, etc) would need to rise 51% by 2019 to cover their portion of the growing budget if we wanted to keep the current ratios. There is options for changing the tax ratios, new taxes (like VAT) – or doing a lot of budget cutting and adding a lot of taxes.

Both taxing and budget cutting remove money flows from an economy. The less money flowing removes taxes (government income) too. Higher corporate income taxes move jobs overseas to countries with lower tax rates thanks to free trade. Some hard and terrible choices need to be made – and likely will be made over time as the USA population begins to understand the inevitable.

Investors are in for death by a thousand cuts. The can will continue to be kicked down the road only to have the debt continue to grow much faster than GDP. It does not appear likely that the government can tax its way out of debt, nor will it be possible to cut its way out of debt.

Investors will likely celebrate when a budget compromise is reached. But beware, the USA budget crisis is far from over.

Economic News This Week:

The Econintersect economic forecast for July 2011 indicated the soft patch will continue. This is based on “less good” data, not data suggesting the economy is falling off a cliff.

This week the Weekly Leading Index (WLI) from ECRI rose from a downwardly revised 1.6% to 2.0%. This level implies the business conditions six months from now will be approximately the same compared to today. This index has eroding and in a three month overall downtrend. However, this index was been holding for the previous three weeks, and now in the fourth week has move upward.

Initial unemployment claims fell 24,000 to 398,000 – the first time in 15 weeks the initial claims have come in under 400,000. The real gauge – the 4 week moving average – fell only 8,500 to 413,750 due to backward revisions. If the recent pattern holds, this 398,000 will be revised up over 400,000 next week.

Because of the noise (week-to-week movements), the 4 week average remains the reliable gauge. Historically, claims exceeding 400,000 per week usually occurs when employment gains less than the workforce growth, resulting in an increasing unemployment rate.

The data released this week confirms the economic soft spot is continuing. The decline in rail traffic is troubling and is covered by Econintersect News (news here).

Weekly Economic Release Scorecard:

Item Headline Analysis
University Of Michigan Sentiment Down Now at the lowest level since March 2009
2Q2011 GDP Up 1.3% The story is the downward revision of 1Q GDP to 0.4%. A lot of negative trends in this number
Auto Sales Rick Davis shows how car buying patterns respond to economic events
June Durable Goods Down Durable Goods may be down 4% MoM – and almost flat YoY, inflation adjusted
Unemployment Rate John Mauldin shows the employment growth necessary to bring down the unemployment rate
Another Recession? Caroline Corbett and Lance Roberts ponder whether we are entering another recession
May Case-Shiller Home Price Index Up Home prices are increasing in the normal seasonal surge but are 4.5% below a year ago
June New Home Sales Up Home sales may be up, but it is only 1,000 houses. New home sales remain depressed
Europe Bailout Dirk Ehnts says the current agreements ignore the disease
Medicare John Lounsbury & Steven Hansen: Medicare and private health care delivery costs are similar
June Chicago Fed National Activity Index Down This super coincident index is showing the economy is deeply in a soft spot
Economic Theory Van Hoisington & Lacy Hunt argue that government fiscal and monetary policy do not aid the well being of the economy
Consumer Metrics Improving Rick Davis: There is a disconnect between what consumers are saying and what they are doing
Real Estate Bubble William Black: Bush Council of Economic Advisors’ reports said no real estate bubble was underway
China Frank Li looks at the Chinese system looking for lessons that should be learned
Greece & the EU John Mauldin: Eurozone solutions ensure a recession
Hoover & Obama Marshall Auerbach compares the “accomplishments” of both Presidents
Obstacles to Economic Growth Rick Davis questions whether entrenched Keynesian theory is the biggest obstacle
Eurozone Dirk Ehnts points out unemployment is a growing problem
Debt Ceiling Joseph Firestone suggests a debt ceiling workaround – coin seigniorage
Euro Crisis Dirk Ehnts points out much Eurozone debate misses the point
Gold & Miners Why gold miner stocks are not seeing the historic leverage against gold
Debt Ceiling Jeff Miller runs through the debt ceiling crisis likely outcome
China & Silver Keith Fitz-Gerald analyzes the effects of silver trading starting on the Hong Kong exchange
Earnings Season David Grandey looks at several stock plays for earning season
Investing Bubbles Doug Short looks at several past bubbles and answers the question whether gold is in a bubble
Economic and Monetary Imbalances Derryl Hermanutz’s brilliant head piece attacks our concepts of “balance”
Secular Market Cycles Ed Easterling predicts bad investing years are coming
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Bankruptcies This Week: Corus Bankshares (OTC:CORSQ).

Failed Banks This Week:

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