The Debt Ceiling Deal, A Drop in the Bucket at Best

Last night our government reached an early agreement on spending cuts in order to raise the debt ceiling.  I assume most people, even non-financial industry types, have been keenly aware of the debate going on between Republicans (via John Boehner) and Obama.  I am not terribly surprised that a deal was reached.  We have raised the debt ceiling 70 times in 50 years.  It's hardly a ceiling. 

But net net, pressure was as high as its ever been on Washington to stop dickering around.  Threats by the ratings agencies to downgrade Treasuries was also a big factor.  So, last night Obama and the Republicans agreed on a $2.5 Trillion dollar deficit reduction bill over the next ten years.  The problem is, this is akin to resolving who will pay the bar tab on the Titanic.  This fiscal ship that is our US government is still sinking.

Not Enough
Understand that with $1.4 Trillion dollar annual deficits, our 10 year total deficit forecast is forecast to be $13 Trillion.  These aren't my numbers by the way, they are government numbers, and way understated.  They always are.  $13 Trillion will likely end up being 25% higher, figure $15-$17TT as a realistic deficit number.  We have millions of baby boomers retiring starting in 2015, and their increased need for Social Security and Medicare will be tremendous.  Even at a low $13 Trillion deficit over the next decade, it doesn't take a genius to realize that $2.5 Trillion in cuts is still far from what we need to balance our budgets and get us back toward fiscal soundness.  $10TT of cuts anyone???  Don't sell your gold yet.

The question is, how will our government finance these deficits?  That is $11+ Trillion in additional bonds our country has to sell, in addition to our current maturities that will roll off.  While China gave up on large UST purchases back in 2009, now the Russians are looking to diversify into other currencies and securities as well.  The reality is that our US Treasury and Government will be forced to continue to print money to fund deficits for as far as the eye can see.  I am not sure that there really is another $10 Trillion of capital in the world willing to add to our existing $14.3 TT of debt.  I mean, the entire world's economy is only $60 TT, and we expect them to lend our government $23TT by 2021?  That's a lot for an economy that is now under 25% of world's GDP.

Some Perspective on the Size of Our National Obligations
So, if we have $11 TT in deficits over the next decade, where will we end up in terms of Debt-to-GDP?  Well, assuming a 2% economic growth rate, we'll get pretty close to 140% Debt-to-GDP by 2021.  That is pretty close to Greece today, and about guarantees our future insolvency.  But if you actually include the present value of our entitlement programs too, we are well beyond insolvent today.  I have seen total government liability estimates ranging from $50 Trillion, to $200 Trillion dollars.  These are inconceivable numbers.  To fund $200 TT of obligations with a $15 Trillion economy is impossible unless you taxed 100% of people's income for 18 years!  (in case you're wondering, you cannot tax government receipts, so its $200 TT divided by the sum of corporate income plus personal income which is closer to $11 TT).  Or put differently, if we raised tax rates to an astonishing 50% of income on everyone, it would take us almost 40 years just to fund what we owe today!  Consider too that today around half of our citizens pay no income taxes at all.

I think this first "scare" is a canary in the coal mine.  We will have many more similar debates in Washington over the next decade, and it's going to be far uglier.  Eventually the debate has to extend to Medicare, Medicaid and Social Security.  If nothing is done, then in 20 years, 100% of our tax receipts will be needed just to cover these 3 programs.  That would leave zero dollars for education, defense, infrastructure, or anything else.  This isn't our kids problem anymore, it's ours.

And how do you reduce healthcare benefits and Social Security from elderly and indigent people?  I don't know.  But at some point, you either cut entitlements, or risk default and dollar devaluation.   Debt monetization inevitably leads to hyperinflation, an economic depression, and mass unemployment.  The savings of our population would be decimated.  Imagine 20-25% unemployment and the stock market down 60% and you start to see that perhaps cutting entitlements is the lesser of 2 terrible evils. 

Economic Numbers Last Week
Amidst the "good" news of a debt ceiling agreement, last Friday we got a glimpse of what GDP looked like in Q1 and Q2.  It was ugly.  Q1 GDP growth was a dismal 0.36%, and Q2 GDP growth was a meager 1.3%. Both were far below economists' expectations.  No surprise that the US market fell 4.2% last week.  This chart below shows that in almost every instance when GDP fell below 2.0% since 1945, it signaled a recession. 

The horizontal line above is at the 2% level and the shaded areas are recessions.  I think what raises the recession probability for me is the fact that a big component of GDP, government spending, is now poised to fall.  While the details on our debt ceiling agreement haven't really been worked out, I can only assume that we'll see around $250BB in cuts to government spending over the next 12 months.  That is a 1.5% drag on GDP.  In Q2, when GDP was up 1.3%, government spending actually increased 2.2%, around $325BB annualized.  If government spending had been down $250BB, then GDP would have been in negative territory. 

The really bad news?  The stock market has fallen on average 26% during the last 11 recessions.  Today we will likely get a relief rally, but I am cautious and would lighten any risky stocks you hold.  I am hiding in cash, gold, international big caps, IG corporate bonds and dividend yielding stocks.  Good luck.