"There is not a menace in the world today like that of growing public indebtedness and mounting public expenditures." - President Warren G. Harding, 1921
From the spring of 1920 through the summer of 1921, U.S. nominal GDP dropped by nearly 25%. The consumer price index fell over 8%, and the unemployment rate skyrocketed into the mid-teens. Strangely, the government was nowhere to be found. President Warren Harding had promised "not heroics, but healing" and "not revolution, but restoration" throughout his campaign, and he was intent on balancing the budget and maintaining a hands-off approach towards the economy (he accomplished both). The turmoil that resulted was intense but brief, and once structural imbalances in the market had cleared, the "Roaring '20s" were set to begin. Industrial production grew 27% in 1922, and by 1923, the unemployment rate had shrunk to a mere 3%.
Bring On The Heroics
Today's America seems a bit more interested in "heroics" than "healing." Harding's laissez faire campaign strategy probably wouldn't get him through the primaries, let alone into the White House. Somewhere along the line, a perpetual flow of steadily increasing economic output became an American entitlement. Politicians, therefore, are under immense pressure to campaign on elaborate promises of reform and prosperity only to discover that, once elected, the expectation of producing immediately-felt economic results often flies in the face of doing the right thing for the long-term health of the country. This, according to Frederic Bastiat, is the very definition of a bad economist.
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen. Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Hence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.
Unfortunately, we are seeing a pattern amongst fiscal policy makers of pursuing "small present goods" at the expense of "great future evils." One such example of this is the systematic increases in the U.S. debt limit to accommodate the expansion in borrowing by the U.S. Congress. The chart below seems to speak for itself, but to be fair, we've also included a description of the chaos that would ensue should the legal debt limit be taken seriously (from the U.S. Treasury's website):
Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations -- an unprecedented event in American history. That would precipitate another financial crisis and threaten the jobs and savings of everyday Americans - putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession. Congress has always acted when called upon to raise the debt limit.
(click image to enlarge)
Crisis Before Change
The end of this year marks another monumental decision point for Congress. Known as the "fiscal cliff," a conglomeration of spending cuts and tax increases are currently slated to become effective as of January 1, 2013. At roughly half a trillion dollars, the net effect of these changes represents over 3% of our nation's economic output. They also represent a significant portion of the projected budget deficit (and borrowing requirement) for the next fiscal year.
Using the "expenditure approach" to break down U.S. GDP into its major components highlights how important the fiscal cliff issue is to the short-term outlook for our economy.
GDP = Consumer Spending + Business Investment + Government Spending + Net Exports
Government spending has been a net positive for GDP growth over the past five years, as it has counterbalanced volatile swings in both the consumer and business segments. Since the pre-crisis peak in GDP (2Q 2008), government spending has increased by over $150B, thus cutting this component by $500B would obviously have dire short-term implications for economic growth.
The laundry list of items that comprise the fiscal cliff is quite lengthy, but some of the highlights are as follows:
- Roughly $110B of automatic spending cuts required per the Budget Control Act
- Income tax rates rise to a range of 15-39.6% from 10-35%
- Capital gains tax rates rise from 15 to 20%
- Dividend tax rates rise to personal income tax rate from a flat 15%
- Child tax credit falls from $1,000 to $500
- Estate tax exemption falls to $1M from $5M, top rate rises to 55% from 35%
- AMT taxes will apply to roughly 30 million tax payers, up from 4 million
- Payroll tax holiday expires (2% rise in payroll tax on first $110K)
- Extended unemployment benefits expire
It is widely anticipated that Congress will "do something" to dampen the near-term impact of the fiscal cliff on the U.S. economy. The question seems to be not if, but when and how much? There is sure to be heated partisan debate over which items deserve the most attention as well. For instance, the arguments for extending unemployment benefits again will look significantly different than the arguments in favor of capping tax rates on dividends, etc.
Despite all these nuances, however, one thing is virtually guaranteed. Our elected officials in Washington will not consider recession an option, and will do anything and everything to keep quarterly GDP numbers positive. In the meantime, financial media will continue to hype the uncertainty and economic risk posed by the fiscal cliff. We think this will create risks as well as opportunities for investors in risk assets such as the SPDR S&P 500 ETF (SPY) and iShares MSCI Emerging Markets Index ETF (EEM) over the next six months.
Jean Monnet once said, "People only accept change in necessity and see necessity only in crisis." Europe is the poster child for this sentiment right now, and we can only hope U.S. policy makers will begin to properly recognize necessity before reaching the same point of crisis.
Additional disclosure: Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.