Sometimes terminology confuses an issue.
We are currently engaged in a great national debate over fiscal and monetary policy, based in great part upon the rapid growth of the "national debt." What if it's not debt at all? In finance, debt is generally defined as a monetary obligation that a debtor is obligated repay, plus a return to the lender for the use of his money.
With one glaring exception (Andrew Jackson's repayment of the national debt in 1835), as a nation we have never repaid the national debt, and there is no indication that either the administration or Congress has any intention of doing so in the foreseeable future. In the modern era. the U.S. has rarely even paid down the debt (the heady days at the end of the Internet Boom being a much noted exception). Moreover, Mr. Bernanke has announced that, for the foreseeable future, there will be no meaningful yield on the national debt. In fact on a real dollar basis, short- and intermediate- term Treasury yields are actually negative. Thus, Treasury bonds do not pass the second test of the definition of debt: they do not provide the holder with a return for use of its money.
So what if this stuff that we call the national debt is not debt? Investment in a Treasury bill or bond is actually an intermediate- or long-term investment in U.S. dollars. In some ways, it's more akin to a derivative security than a creditor's claim. Treasury's only obligation at the end of the term is to hand the bond holder another form of obligation in exchange for his bond, a dollar bill, which Treasury can manufacture out of thin air. Perhaps purchase of a Treasury security should be thought of as an equity investment in the concept of America.
How we think of the national debt and the deficits that are currently driving its growth has profound implications for such issues as the Fiscal Cliff. How Congress addresses that issue will dominate the equity markets from now to the end of 2012, and possibly well beyond.
We have struggled for some time with the question of how the United States has been able to run budget deficits in the range of 10% of GDP without creating far more inflation than has been apparent to date. One answer is that the U.S. may be experiencing more inflation than the data implies. Shadow Government Statistics has published data indicating that, were the BLS to use the methodology today that it used in 1980, inflation would be six or seven percent higher than the 1.7% annual rate recently reported by Bureau of Labor Statistics.
While we believe that this overstates the case, a good argument has been made by many observers that current BLS statistics are understating the effective rate of inflation for real American consumers. For example, the Guild Basic Needs Index indicates a level of inflation in the purchases important to ordinary consumers since January 1, 2000 of 85%, vs. a cumulative 36.9% reported by the BLS over the period.
We've previously noted our belief that the U.S. has entered into a decade similar to the 1970s, during which the nation will see increased inflation and stagnant economic growth. One major difference between the current period and the 1970s is the amount of excess human capital that appears to be present in the economy today vs. the earlier period. After a severe recession early in the decade, unemployment peaked at 9% in 1975 and dropped rapidly to under 6% four years later.
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As a result, as inflation began to really take off in the latter half of the 1970s, real per capita income grew steadily.
That's not the case today.
In the current period, we are likely witnessing more rapid price inflation than wage growth to compensate for the extent to which American consumers overindulged during the boom years. Peak year balance of payment deficits of approximately 7% of GDP serve as a possible measure of the extent of the living standard adjustment needed to bring consumption back into balance with the economy's productive capacity. This implies that several years of real wage declines will be needed in the U. S. to adjust for the imbalance. In other words, the pain is not yet over.
From this background, what do the Federal deficits and the resulting national debt actually reflect, and what are the implications of various approaches to their treatment for considerations of the Fiscal Cliff?
- A large portion of the Federal Deficit coming out of the financial crisis related to a transfer of private obligations to the federal government, which took responsibility for trillions of dollars of mortgage debt as a result of nationalization of Fannie Mae and Freddie Mac, as well as the acceleration of FHA housing refinance programs. This played a major role in the bailout of the financial industry by limiting the extent of the defaults actually incurred by the banks. These actions prevented a far more serious crash and recession than would have otherwise been the case, but have changed the role of the Federal Reserve in fundamental ways through the explosion of its balance sheet from $800 billion to a current $2.8 trillion -- the ultimate consequences of which are still unclear.
- Another very large portion of the Federal Deficit may, in fact, represent something akin to free money. Through the automatic stabilizers (unemployment insurance, food stamps, etc.), the deficits have created artificial demand in the economy. So long as there is slack in productive resources (labor and capital), these expenditures can, in a sense, be looked upon as having created a form of an economic free lunch. Resources and people were put to work, and economic output was generated that would have otherwise been lost. In a closed system, this could work for long time. However, we don't operate in a closed system. A portion of the created demand bled into imports, which has negative implications for the long-run value of the dollar.
- Some of the deficits went to fund investments in future productivity through education, research and development, infrastructure development, etc.
- An argument can be made that each of the first three were either necessary and temporary, or had a relatively low cost to the society due to future benefits to be derived as a result of the expenditures. Today, however, a large and likely growing portion of the deficits has gone to cover the shortfall created by the nation's unwillingness to fund the ordinary and necessary functions of government through taxation. Over the long haul, this portion of the deficits and the debt reflect nothing more than an alternative form of taxation, through future inflation or alternatively, a transfer of U.S. wealth to other nations. This portion of the deficit and the debt is most worrisome, as it is structural rather than cyclical.
By focusing on the national debt as if it were comparable to private debt, the parties have skewed the debate in ways that have the potential for tremendous economic harm. As outlined above, there are situations where deficits and debt are necessary, have a low cost in terms of real output, or may even have beneficial impacts. Alternatively, ongoing deficits may be quite pernicious if they result in political inaction and lack of a clear national will to make necessary and rational adjustments to budgetary and taxing policies.
Focusing on a balance sheet number that we call the national debt clouds the real issues and creates a strong likelihood that the nation will head down some very dangerous trails. In the short term, a focus on the debt rather than the real issues at hand could easily lead to a mishandling of the Fiscal Cliff impasse, precipitating a serious recession that ultimately results in more deficits and debt, not less.
In the longer term, a focus on the giant phantom of the "national debt" provides political cover for the national leaders to ignore the real decisions that must be made about the appropriate and affordable role of government, and the most effective mechanisms to fund it. Continuation of this "kick the can down the road" approach almost certainly assures continuation of high deficit levels that will ultimately spark inflationary forces that take us back to the worst days of the '70s -- or something even worse.
From an investment perspective, the political focus on the national debt in the abstract rather than on the real budgetary choices increases the risk that a short-term action to address the long-term problems will unnecessarily precipitate a recession. The exact mechanism -- tax cut expiration, budget sequestration or something else -- really doesn't matter; the global economy is fragile and it won't take much to push it over the edge. Continued focus on the wrong variables indicates that there may be higher risks in equities than the market is reflecting. Longer term, there is a risk/likelihood that the budget debates will play out in a way that leads to a period of much higher inflation and further adjustment to real consumer buying power. As we noted in August, that would be very bad for bonds, perhaps even leading to another cyclical bear market in fixed incomes.