We all know that high debt is a growth killer. In fact, there are more economic papers showing how high debt kills growth than there are how to make pancakes.
At the moment, the US has a budget deficit of about $1 trillion. That's a very big number. I done know how many times you can wrap the glob in dollars, but I am sure someone has made the calculation.
The question is, at what point do countries have to deal with high debt levels? How high do debt levels have to be before one has to deal with the problem by lowering budget deficits? Also, what are the consequences of such debt and budget reductions?
If the US government tries to lower spending in order to close the budget deficit gap, then chances are the US economy will contract as much as Greece has contracted recently. Yes, you heard correctly. When Greece decided to lower spending in order to reduce its budget deficit, it had a gap of about 30 billion euros. The US is about 33 times the population of Greece and therefore 30 billion euros more or less is analogous to the current US budget deficit.
Well after about 28 billion in spending cuts Greece has about 2-3 billion euros more to go to actually producer a primary surplus. I don't think it will ever get there, but even assuming that it does, that comes at a great cost to the economy, which so far has contracted about 25%.
Can you imagine what would happen if the US economy contracted by 25%? Well it happened once in the 1930's and the picture wasn't pretty. They didn't call it the Great Depression for nothing. And if you didn't know, the Dow Jones Industrial Average fell by about 90% from its high point during that period.
Now take a look at the chart below. From about September 20, 1999 to May 21, 2012, the Athens General Index has sunk to the tune of 90%.
The common element between the US and Greece is that the 90% contraction of both Indexes was the result of a 25% contraction in the economy.
Believe it or not, that's what happens when you crash the economy with fiscal constrain and budget cuts that lower pensions, government employee payrolls, defense spending, public works spending and special social programs.
And if the US (or any country for that matter) cuts spending the way Greece has, its economy would contract as much as Greece's did and its major stock market index would go down as much.
My question is, how is the US going to close its budget gap? Answer: Unknown.
How long can the US continue to have a $1 trillion deficit? Answer: Unknown.
Will the US ever need (or be forced) to close its budget gap? Logic dictates yes, but try telling that to Japan.
The only thing I know is that the US and every other western country will have to deal with their budget deficits sooner or later. If they follow the road Greece took, the shock of economic contraction will have a huge impact on equity prices, as in the case of Greece.
I am not sure how the debt problem in the western world will end. Monetary inflation is easier said than done and central bank money printing, so far, has failed to make people feel they are richer than they really are. Also, population demographics are such that hoping for economic growth as a way to solve this problem is slim (my opinion).
In any case, however governments decide to reduce debts and deficits, one thing is for sure: The impact on the real economy will not be a pretty picture. As for the impact on equities, the carnage will be even grater.