Cliffs, Bubbles, Toils, and Troubles

By September 21, 2012The Friday Brief

“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
– Ernest Hemingway, The Sun Also Rises

The economy is weak and probably getting worse. Europe remains shaky and China is slowing. Gasoline and food prices are high and going up, yet stocks are up 4.2% in September. How is that? A big factor is that last week the Federal Reserve renewed the lease for the money printers with its QE3. As the sole actor in Washington moving to stimulate jobs, the Fed took further bold steps.

One of Wall Street’s most honored maxims is ‘don’t fight the Fed.’ In this case, the Federal Reserve is doing all it can do to drive investors into riskier assets and endeavors; translated stocks, lending, and job creation. Among those investors the Fed is most interested in are banks and businesses. They want banks to lend money. By driving down the returns they currently derive buying risk-free US Treasuries yielding 2% with funds they borrow from the Fed at near zero, they hope to force them to lend to corporations and individuals at higher returns.

In like fashion, non-financial businesses now sit on huge stockpiles of cash totaling well over a trillion dollars. By reducing returns on this cash, the Fed wants to motivate managers and owners to invest in the more productive capabilities of their businesses by hiring and investing in plants and equipment.

But, as we mentioned last week, the main problem is uncertainty. Before businesses decide to invest capital beyond their immediate requirements, they will require greater certainty than currently exists in vital areas such as demand for their products and services from consumers as well as costs of production which are driven by government reach and inflation.

But uncertainty has been part of every recovery in the past, why is this time so different? Why are we setting new records in cash on the sidelines, unemployment, years of no budgets from the White House, and Congressional stalemate in the face of obvious economic disaster, to name just a few?

The answer is not all that complicated. In effect, too many bubbles have burst already, driving many investors away from risk. The continuing threat of new bubbles such as price bubbles (inflation) keeps some out of the risk markets while others are convinced Treasurys remain the next bubble. The looming fiscal cliff generates terrific near-term uncertainty for businesses as they wonder how policymakers will address it, or if they will address it.

And long term there looms a much more menacing mega-cliff that will dwarf the fiscal cliff in its destructive ability. This cliff represents the eventual inability of the US government to pay its ‘mandatory programs’ (Social Security, Medicare, and Medicaid) and interest due on its debt. This cliff is probably not a country-killer, because we have seen other countries in Latin and South America survive government collapses in the 80’s and 90’s. Some even managed to avoid iron-fisted dictatorships. But, what a cost they extracted in human and economic potential.

The White House and the Congress have been ineffective in dealing with our problems largely because we are no longer a republic as we once were. In effect, they lead by real-time polls, rather than in the best long-term interest of our country. The passage of the 17th Amendment in 1912 provided that Senators would be directly elected by the voters, rather than by state legislators. We began our march toward a more democratic government focused ever more closely on the matters at hand and less on the long-term costs of the remedies hastily (within their election cycle) applied.

The Great Depression opened the door for the government to take a significantly larger role in the welfare of its citizens, well beyond what the Founding Fathers’ had envisioned, of securing the borders and ensuring domestic tranquility. And with the last 60 years of politics we’ve seen battle lines clearly form between capitalism and socialism with politicians attaining office and remaining there by pandering to one ideology or the other. The result is this; we find ourselves in an unprecedented fiscal mess, with a democratic system largely incapable of fixing it. Half of the country is focused on remedying the ever-present pain, while the other half believes those remedies risk killing the patient in the not-so-distant future.

The US government now spends $3.8 trillion, but it collects only $2.5 trillion in taxes, which leaves a deficit of $1.3 trillion. When politicians talk about cutting government spending, they are talking about cutting ‘discretionary’ government programs such as defense or education, or the EPA. Defense and Social government programs total $1.3 trillion, the same as the current deficit. So the only way to balance the budget on discretionary cuts alone would be to eliminate the US government.

Here’s the rub. The rest of the government budget is non-discretionary. The Congress must pay the interest which totals $225 billion annually as well as the more significant “mandatory” programs which include Social Security, Medicare and Medicaid – $2.3 trillion. US debt now totals $16.4 trillion and is racing toward a projected $25.6 trillion in the next ten years.

Consider the significant concern that Greece has generated over its potential default these past several months. Yet Greek debt is only 1/32nd the size of US debt. While Greece’s debt represents only 1% of global debt, US debt represents a full third and 45% of the world’s economic output. Left alone, our debt problem poses problems of epic global proportions.

So far this election seems to be over whether we want a bigger or a smaller government. But in reality, it should be whether our country will survive the next generation without Greek-like tragedy.  A speaker on CNBC recently posited that “these guys (politicians) know how to fix the problem, they just don’t know how to fix it and get re-elected.” The problem is therefore not so much with our politicians, but with us, the US electorate. We are not educated as to the true long-term consequences of our increasing dependence on our government. The Simpson-Bowles plan and the Ryan plan, and others represent excellent starts and at least some in Congress are talking seriously about them.

Only by right-sizing our entitlement programs (based on the realities of our economy and demographics), simplifying our tax code through the elimination of virtually all tax loopholes (created by decades of political favors), incenting businesses big and small to hire, innovate, and invest will we get this economy back to full health allowing it to reach the potential we, and especially our children, deserve.

Author Sam Bass Jr.

Sam founded Beacon Wealthcare in 1998. He has thirty five years' experience investing money for his clients. In 2006 he changed the focus of his firm from asset/return to a client/goal-centered and adopted state-of-the-art planning and management systems to deliver the best fully integrated planning service available. Sam holds a BA in English Literature from Hampden-Sydney College, 1975 and an MBA from Wake Forest University, 1981. He concentrated in International Finance, and did research for an International Finance textbook which included a summer at the London School of Economics. He is married to Sharon, a talented pleinAir oil painter, They enjoy being with their three children, their spouses, and five beautiful grandchildren as often as they can. Sam loves Jesus, sailing, cycling, and writing.

More posts by Sam Bass Jr.

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