It's the Roads, Stupid - Part 2

Includes: DTUS, DTYS, TBF
by: Chip Krakoff

Nearly two years ago, I wrote a blog post in which I argued that Africa’s enduring poverty is attributable in large part to its awful roads, which make it cost roughly three times more to move a shipping container by truck the 750 miles from Kampala, Uganda to Mombasa, Kenya, than the equivalent distance from Portland, Maine to Cleveland, Ohio. It turns out, though, that the quality of American and African roads is converging faster than I knew, and not because Africa’s have become so much better.

Last weekend I drove from Boston to Utica, New York, to pick up my daughter who goes to college nearby. Much of Interstate 90 in New York State runs parallel to the Erie Canal, arguably the first major public infrastructure project in the United States, begun in 1817 and opened in 1825, which connected the Great Lakes to the Hudson River, and from there the Atlantic Ocean. The canal today carries mostly recreational traffic, though there has been a recent uptick in commercial use. The bridges that cross the canal, and the locks and the tidy white lockkeepers’ cottages spaced at intervals along its length, create a pleasing impression of efficiency, order, and purpose.

It took the canal’s backers 10 years to assemble the financing. The U.S. Congress refused, questioning the constitutionality of using federal funds, and Presidents Thomas Jefferson and James Madison both considered it a lunatic scheme. New York State, under Governor Dewitt Clinton, stepped into the breach and issued $7 million in bonds – around $130 million in today’s money – representing about one percent of U.S. gross domestic product of $700 million. The equivalent expenditure today would be $150 billion out of a GDP of around $15 trillion. But the tolls levied on canal users repaid the initial investment in less than 30 years, and generated a surplus that funded much of the state budget until 1882, when the tolls were abolished.

The canal transformed New York City into the premier port and the economic and business capital of the United States, and helped make the United States a world industrial, commercial, and political power.

We don’t do those kinds of grand projects anymore. Not only that, we don’t even maintain the infrastructure we have. According to the American Society of Civil Engineers (ASCE), which periodically puts out a report card on America’s infrastructure, we are flunking, with grades ranging from C+ (solid waste management) to D- (roads, wastewater, drinking water, levees, and inland waterways). The ASCE estimates the U.S. would need to spend $2.2 trillion over five years just to bring its transport and water infrastructure back up to a passing grade after years of under-spending. That’s about $440 billion, or 3% of GDP, annually.

Right now, total U.S. public spending on infrastructure is about 2.4% of GDP, or $360 billion. In contrast to Europe, which spends much more on maintenance and repair, nearly half that amount goes to new construction. There is more political mileage to be gained from building a new bridge than from filling 10,000 potholes. Also in contrast to Europe and much of the developing world, where private capital has filled a big part of the funding gap, Americans on both left and right oppose public-private partnerships with equal fervor.

To climb substantially above our current 23rd place in the World Economic Forum international ranking of infrastructure quality and to accommodate the expected 40% rise in the U.S. population over the next 40 years, we would probably need to spend at least four, if not five, percent of GDP each year, or between $240 and $390 billion more than we do now. The European Union countries already spend about five percent, and China nine percent of GDP, on infrastructure.

What does this mean in concrete terms? According to the ASCE, one in four of the nation’s bridges are either structurally deficient or functionally obsolete. One-third of America’s major roads are “in poor or mediocre condition,” and highway congestion is a growing problem. In the ASCE’s words, “The current spending level of $70.3 billion per year for highway capital improvements is well below the estimated $186 billion needed annually to substantially improve the nation’s highways.”

President Obama was wrong when he said recently, that the U.S. needs to “out-invest China.” China and India, rapidly developing countries with awful infrastructure, ought to spend far more, proportionally, than the U.S. We already have interstate highways and sewage systems, and they don’t. But how far are we willing to let our existing assets crumble? Shouldn’t we spend at least enough to prevent our roads from turning into the potholed nightmares of Tajikistan or Haiti?

In today’s political climate, the question can’t even be asked.

Paul Krugman, on his blog and in his New York Times op-ed column, has referred to the federal government as “an insurance company with an army.” It’s a picturesque image and true, though awfully sad. Our country’s founders surely had loftier ambitions when they cast off British rule to usher in a “Novus Ordo Seclorum,” a new order for the ages.

Sadder still is that so few mainstream politicians have questioned this state of affairs. Instead, they argue about cutting $8 billion out of foreign aid and State Department budgets – a whopping 0.3% of the $3.7 trillion budget – while ignoring the entitlement programs and invasions of other countries that are bankrupting us.

Fuel taxes support the Federal Highway Trust Fund, but the fund will become insolvent in 2012, largely because the tax of 18.4 cents on gasoline and 24.4 cents on diesel hasn’t gone up since 1993. Congressional transfers have kept the fund afloat for the past several years, but with a $1.5 trillion budget deficit those transfers will end next year, and with gas at $4 a gallon it would be political suicide to suggest raising the tax.

I would like to think that sense will prevail and that we will emerge from the current impasse with a sustainable budget that substantially reduces the deficit and reverses the decline in infrastructure spending. We are, alas, in an election season, and no one on either side of the aisle is willing to suggest raising taxes or spending. The state governments, which fund about three fourths of total highway construction and maintenance, are in even worse shape, struggling to meet or wriggle out of unfunded public pension liabilities. New Jersey Governor Chris Christie last year cancelled his state's commitment to a commuter rail project to link northern New Jersey and New York City, even at the cost of having to repay $300 million in federal funds already spent. It's not because Christie thinks it's a bad project, but he was concerned New Jersey would be on the hook for a big portion of the $2.5 billion in expected cost overruns. And, as he constantly says, "We don't have the money."

What does this mean for investors? When I was a child, I participated in my school's savings bond program, pasting a 25-cent stamp each week into a special book until I had a bond. It gave me a certain pride to think my quarters were helping to put a man on the moon. I hate to short my own country, but no less an investor than Bill Gross of PIMCO, the world's largest bond fund manager, has done the same, reportedly dumping all his holdings of U.S. Treasury bonds, going short U.S. debt, and switching a big chunk of his holdings into cash.

You could always buying into a number of ETFs that are short U.S. Treasuries: ProShares Short 20+ Year Treasury (NYSEARCA:TBF), iPath US Treasury 10-year Bear Fund (NASDAQ:DTYS), and iPath US Treasury 2-year bear Fund (NASDAQ:DTUS) are among the available options. With the deadline for raising the federal debt ceiling having come and gone (the "real" deadline has been extended to August, which is when we would actually have to start defaulting on payments instead of shifting money around, as we are now doing), this might not be a bad bet.

You could short the U.S. dollar too, since one way out of the crushing debt burden we face would be to inflate. Lots of countries have done it, and though it would hurt savers and benefit borrowers, there are a lot more borrowers than savers, and those who splashed out on a 42-inch plasma TV instead of contributing to their 401(k) would stand vindicated. You can do this by buying foreign currencies or funds that invest in stocks or bonds denominated in foreign currencies. I'd steer clear of any currency pegged to the dollar, of course, and the euro looks shaky, but Swiss francs, Australian and Canadian dollars, and Danish and Swedish kronor look pretty solid.

None of which will prevent our roads and bridges from falling apart. In spite of rising gas prices, maybe a big SUV is what you will increasingly need to navigate our country's highways. If American carmakers can ramp up production of SUVs and pickup trucks and steer away from hybrid econoboxes, they could be attractive investments too.

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