Fwd: Restoring Fiscal Sanity in the United States: A Way Forward - John Mauldin's Outside the Box E-Letter

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From: John Mauldin and InvestorsInsight <wave@frontlinethoughts.com>
Date: Mon, May 2, 2011 at 10:53 PM
Subject: Restoring Fiscal Sanity in the United States: A Way Forward - John Mauldin's Outside the Box E-Letter
To: jmiller2000@gmail.com

	Contact John Mauldin Print Version Download PDF Volume 7 - Issue 18 May 2, 2011 Restoring Fiscal Sanity in the United States: A Way Forward One of the great privileges of traveling and speaking as I do is getting to meet a wide variety of very interesting people. Of late, I have become friends with David Walker, former Comptroller General of the US, who is now crisscrossing the country warning of the deficit crisis. It is a message that my book Endgame resonates with. If we do not bring the deficit down below the growth rate of nominal GDP, we become Greece. We hit an economic wall and everything collapses. It will be a real and true Depression 2.0. Fixing this is the single most important topic and task of our generation. If we do not, worrying about P/E ratios, moving averages, long-term investments – anything else, in fact – is secondary. Solve this and we can go back to the usual issues. This week's Outside the Box is a presentation that David made recently. Powerful stuff. I urge you to forward this on. The message must be heard so that we can as a nation get this right. The world does not need a crippled USA. David released a short statement about the Navy Seals getting Osama (finally!). It echoes my own thoughts. "All Americans should come together in appreciation for the work of America's intelligence agencies and special forces who planned and executed yesterday's Osama Bin Laden operation. While his death is a key milestone in the fight against terrorism, the battle is far from over. More importantly, as I said in a CBS 60 Minutes segment in 2007, 'The greatest threat to America is not a person hiding in a cave in Afghanistan or Pakistan, it is our own fiscal irresponsibility.' That statement was true then and it is even more true now. It's now time for the President and the Congress to work together and address the fiscal debt bomb that represents a much greater threat to our country's and families futures." My flight was cancelled, so I am in Toronto for one more night. The folks at Horizon Funds have graciously offered to take me to an early dinner and a private wine cellar, as I have a 4:30 AM (ugh) wake-up call and will turn in early. I hate 4:30 AM. That is not a civilized time of day. If I wanted to live like Dennis Gartman I could learn to deal with it, but I guess occasionally one does what one must. One final thought. While getting OBL is a wonderful thing, it does little to change the reality of the Middle East, and may even finally create a true martyr (albeit one who was living well, and not in a cave). The world remains unsettled. Every speaker at my recent conference was asked what keeps them up at night. Every speaker mentioned the Middle East, some rather pointedly. It is a true wild card. But let us enjoy for the moment some token of pleasure for the just end of the planner of the 9/11 tragedy. I will report more about the conference in future letters. Your having a lot to think about analyst, John Mauldin, Editor Outside the Box Restoring Fiscal Sanity in the United States: A Way Forward By: Hon. David M. Walker, Founder and CEO of the Comeback America Initiative and Former Comptroller General of the United States (1998-2008) Two hundred and twenty two years ago, the American Republic was founded. The United States had defeated the world's most powerful military force to win independence, and over a several year period, went about creating a federal government based on certain key principles, including limited government, individual liberty, and fiscal responsibility. That government was established by what is arguably the world's greatest political document - the United States Constitution. Our nation's founders understood the difference between opportunity and entitlement. They believed in certain key values including the prudence of thrift, savings and limited debt. They took seriously their stewardship obligation to the country and future generations of Americans. The truth is, we have strayed from these key, time-tested principles and values in recent decades. We must return to them if we want to keep America great and help to ensure that our future is better than our past. Believe it or not, to win our independence and achieve ratification of the U.S. Constitution, the U.S. only had to go into total federal and state debt equal to 40 percent of the size of its then fledgling economy. Fast forward to today, when the U.S. is the largest economy on earth and a global superpower – but total federal debt alone is almost 100 percent of the economy and growing rapidly. Add in state and local debt, and the total number is about three times as much as the total debt we held at the beginning of our Republic – and it is headed up rapidly. As the below graphic shows, our total federal debt has more than doubled in just the past ten and a half years. America has gone from the world's leading creditor nation to the world's largest debtor nation. We have also become unduly dependent on foreign nations to finance our excess consumption. Many of these foreign investors have shunned our long-term debt due to concerns over future interest rates and the longer-term value of the dollar. And PIMCO, the largest Treasury bond manager in the U.S., also recently sold their Treasury security holdings due to a lack of adequate return for the related interest rate risk. And who is now the largest holder of Treasury securities? It's the Federal Reserve. I call that self-dealing. The Fed may be able to hold down interest rates for a period of time; however, they cannot hold them down forever. The Fed's debt purchase actions are just another example of how Washington policymakers take steps to provide short-term gain while failing to take steps to avoid the longer-term pain that will surely come if we fail to put our nation's fiscal and monetary policies in order. The Fiscal Fitness Index In March 2011 the Comeback America Initiative (CAI) and Stanford University released a new Sovereign Fiscal Responsibility Index (SFRI) - or as my wife Mary refers to it, a Fiscal Fitness Index. We calculated each country's SFRI based on three factors – fiscal space, fiscal path, and fiscal governance. Fiscal space represents the amount of additional debt a country could theoretically issue before a fiscal crisis is imminent. Fiscal path is an estimate of the number of years before a country will hit its theoretical maximum debt capacity. (The U.S. will hit its maximum within16 years, but will enter a "fiscal danger zone" within 2-3 years). Fiscal governance is a value based on the strength of a government's institutions, as well as its transparency and accountability to its citizens. Unfortunately, the U.S. ranks far below the average in all three of these categories – in particular, the fiscal governance category. The overall SFRI index showed that the U.S. ranked 28 out of 34 nations in the area of fiscal responsibility and sustainability. And when you see which countries rank around us, it's clear that we're in a bad neighborhood. We're only a few notches above countries like Greece, Ireland, and Portugal, all of which have recently suffered severe debt crises. That report also showed that the U.S. could face a debt crisis as soon as two to three years from now, given our present path and interest rate risk. Below is the full list of rankings. On the positive side, the CAI and Stanford report showed that if Congress and the President were able to work together to pass fiscal reforms that were the "bottom line" fiscal equivalent of those recommended by the National Fiscal Responsibility and Reform Commission last year, our nation's ranking would improve dramatically, to number 8 out of 34 nations. In addition, we would achieve fiscal sustainability for over 40 years! So what are our elected officials waiting for? Do they want a debt crisis to force them to make very sudden and possibly draconian changes? If not, they need to wake up and work together to make tough choices. That's what New Zealand did in the early 1990s, when that country faced a currency crisis. Due to tough choices then and persistence over time, New Zealand now ranks number 2 in the SFRI - second only to Australia, which the Kiwis are not happy about! If New Zealand can do it, America can too! The Recent Budget Policy Proposals In order for us to begin to restore fiscal sanity to this country, President Obama has to discharge his leadership responsibilities as CEO of the United States Government. He got into the game with his fiscal speech on April 13, in which he largely embraced the work of his National Fiscal Responsibility and Reform Commission, although with a longer timeframe for implementation and less specifics on entitlement reforms. The President also endorsed the debt/GDP trigger and automatic enforcement concept that CAI had been advocating. Under this concept, Congress could agree on a set of statutory budget controls that would come into effect in fiscal 2013. Such controls should include specific annual debt/GDP targets with automatic spending cuts and temporary revenue increases in the event the annual target is not met. In my view, a ratio of three parts spending cuts, excluding interest savings, to one part revenue would make sense. House Budget Committee Chairman Paul Ryan recently demonstrated the political courage to lead in connection with our nation's huge deficit and debt challenges. His budget proposal recognizes that restoring fiscal sustainability will require tough transformational changes in many areas, including spending programs and tax policies. Chairman Ryan's proposal includes several major reform proposals, especially in the area of health care. For example, he proposes to convert Medicare to a premium support model that will provide more individual choice, limit the government's long-term financial commitment and focus government support more on those who truly need it. He also proposed to employ a block grant approach to Medicaid in order to provide more flexibility to the states and limit the governments' financial exposure. These concepts have varying degrees of merit; however, how they are designed and implemented involve key questions of social equity that need to be carefully explored. And contrary to Chairman Ryan's proposal, additional defense and other security cuts that do not compromise national security and comprehensive tax reform that raises more revenue as compared to historical levels of GDP also need to be on the table in order to help ensure bipartisan support for any comprehensive fiscal reform proposal. The President and Congressional leaders should be commended for reaching an agreement that averted a partial shutdown of the federal government and resolved funding levels for fiscal 2011. While it took way too much time and effort, this compromise involved real concessions from both sides and represents a small yet positive step towards restoring fiscal responsibility. But this action is far from the most important fiscal challenge facing both the Congress and the President. After all, Washington policymakers took about 88 percent of federal spending, along with much-needed federal tax reforms, "off the table" during the recent debate over the 2011 budget. In essence, they have been arguing over the bar tab on the Titanic when we can see the huge iceberg that lies ahead. The ice that is below the surface is comprised of tens of trillions of dollars in unfunded Medicare, Social Security and other off-balance sheet obligations along with other commitments and contingencies that could sink our "Ship of State". It is, therefore, critically important that we change course before we experience a collision that could have catastrophic consequences. As you can see in the series of pie charts below, mandatory programs like Social Security and Medicare already take up the largest share of the federal budget and, absent a change in course, will continue to do so in increasing amounts in the next several decades. The Federal Debt Ceiling Limit Now that the level of federal funding for the 2011 fiscal year has been resolved, there has been an increasing amount of attention on Congress' upcoming vote to increase the federal debt ceiling limit. As is evident by the chart below detailing the debt ceiling limit per capita adjusted for inflation since 1940, the U.S. started losing its way in the early 1980s. Fiscal responsibility was temporarily restored during the 1990s, when statutory budget controls were in place, but things went out of control again in 2003, the year after those budget controls expired. In essence, raising the debt ceiling is simply recognizing the federal government's past fiscally irresponsible practices. But while federal law provides for the continuation of essential government operations even if the government has not decided on a budget or funding levels for a fiscal year, such a provision does not exist in connection with the debt ceiling. Therefore, if the federal government hits the debt ceiling during a time of large deficits, which is the case today, dramatic and draconian actions will have to be taken to ensure that additional debt is not incurred. This would likely include a suspension of payments to government contractors, delays in tax refunds, and massive furloughs of government employees. In addition, since Social Security is now paying out more in benefits than it receives in taxes, the monthly payments may not go out on time if we hit the debt ceiling limit. That would clearly get the attention of tens of millions of Americans, including elected officials. However, although failure to raise the debt ceiling is not a viable option given our current fiscal state, we must take concrete steps to address the government's lack of fiscal responsibility. We must also do so in a manner that avoids triggering a massive disruption and a possible loss of confidence by investors in the ability of the federal government to manage its own finances. Such a loss of confidence could spur a dramatic rise in interest rates that would further increase our nation's fiscal, economic, unemployment and other challenges. In order to begin to restore fiscal sanity, Congress could increase the debt ceiling limit in exchange for one or more specific steps designed to send a signal to the markets, and the American people, that a new day in federal finance is dawning. To be credible, any such action must go beyond short-term spending cuts for the 2012 fiscal year. The debt/GDP trigger and automatic enforcement concepts I advocate above are one specific step Congress could take. The S&P's revised outlook on the long-term rating for U.S. sovereign debt should be yet another wake-up call for elected officials and other policymakers in Washington. S&P's action serves as a market-based signal that independent ratings agencies believe the U.S. is on an imprudent and unsustainable fiscal path and that action is needed in order to maintain investor confidence. In my view, this action should have been taken place some time ago; however, it is now likely that other rating agencies will reconsider their ratings positions on U.S. Sovereign debt. Moving Past Partisan Politics The American people need to understand that doing nothing to address our deteriorating financial condition and huge structural deficits is simply not an option. Failure to act will serve to threaten America's future position in the world and our standard of living at home. Therefore, both major political parties must come to the table and put aside their sacred cows and unrealistic expectations. As John F. Kennedy said, "The great enemy of the truth is very often not the lie — deliberate, contrived and dishonest — but the myth — persistent, persuasive, and unrealistic." Given President Kennedy's admonition, liberals need to acknowledge that we need to renegotiate the current social insurance contract. For example, contrary to assertions by some, Social Security is now adding to the federal deficit and is underfunded by about $8 trillion. As you can see below, it will face escalating annual deficits beginning in 2015. There is no debate that last year's health care reform legislation will result in higher federal health care costs as a percentage of the economy. (See the chart below). In addition, according to Medicare's independent Chief Actuary, based on reasonable and sustainable assumptions, last year's health care reform legislation will end up exacerbating our deficit and debt challenges rather than helping to lessen them. He estimated that the cost of the health care law to the Medicare program could be over $12 trillion in current dollars more than advertised. Conservatives need to acknowledge that we can't just grow our way out of our fiscal hole. They need to admit that all tax cuts are not equal and there is plenty of room to cut defense and other security spending without compromising our national security. And while conservatives are correct to say that our nation's fiscal challenge is primarily a spending problem, they must recognize that some additional revenues will be needed to restore fiscal sanity. The math just doesn't work otherwise. All parties must acknowledge that we can't inflate our way out of our problem and that we must take steps to improve our nation's competitive posture. This means that some properly targeted and effectively implemented critical infrastructure and other investments may be both needed and appropriate even if they exacerbate our short-term fiscal challenge. Washington policymakers need to understand that the same four factors that caused the recent financial crisis exist for the federal government's own finances. And what are those factors? First, a disconnect between those who benefit from prevailing policies and practices and those who will pay the price and bear the burden if and when the bubble bursts. Second, a lack of adequate transparency and accountability in connection with the true financial risks that we face. Third, too much debt, not enough focus on cash flow, and an over-reliance on narrow and myopic credit ratings. Finally, a failure of responsible parties to act until a crisis was at the doorstep. There is growing agreement that the greatest threat to our nation's future is our own fiscal irresponsibility. In fact, as I noted in 2007 and Joint Chiefs Chairman Admiral Mullin stated last year, our fiscal irresponsibility and resulting debt is a national security issue. After all, if you don't keep your economy strong for both today and tomorrow, America's standing in the world and standard of living at home will both suffer over time – and waiting for a crisis before we act could also undermine our domestic tranquility. So where should Washington go from here? First, Congress and the President should reach a compromise agreement on an appropriate level of spending cuts in 2012 while also providing for some additional properly designed and effectively implemented critical infrastructure investments. Second, they should agree to re-impose tough statutory budget controls that will force much tougher choices on both the spending and tax side of the ledger beginning no later than 2013. Third, they should authorize and fund a national citizen education and engagement effort to help prepare the American people for the needed actions and to facilitate elected officials taking them without losing their jobs. Fourth, they should create a credible and independent process that will provide for a baseline review of major federal organizational structures, operational practices, policies and programs in order to make a range a transformational recommendations that will make the federal government more future focused, results oriented, successful and sustainable. Spending levels certainly need to be cut. After all, the base levels of federal discretionary spending increased by over 30 percent between 2007 and 2010 during a time of low inflation. At the same time, all parties must be realistic regarding how much should be cut and how quickly it can be achieved. In my view, we should be targeting greater cuts than have been recently considered, but over a longer period of time: for example, real spending cuts of $125-$150 billion over several years. If we did so, the related savings would be significant and would compound over time. As the National Fiscal Responsibility and Reform Commission, CAI, The No Labels political movement (of which I am a co-founder), and others have noted, everything must be on the table – and all political leaders need to be at the table – in order to put our nation on a more prudent and sustainable fiscal path. This includes a range of social insurance program reforms, defense and other spending cuts, and comprehensive tax reform that generates additional revenues, including both individual and corporate tax reform. We must keep in mind that the private sector is the engine of innovation, growth, and jobs. In addition, many businesses are taxed at the individual, rather than the corporate, level. Realistically, it will take us a number of years to get back into fiscal shape. And while it would be great if we could do a "grand bargain" and enact a broad range of transformational reforms in one step, that just isn't realistic in today's world. Therefore, what is a reasonable order of battle to win the war for our fiscal future? First and foremost we need to enact budget process reforms, re-impose the type of budget controls and engage in the fact-based citizen education and engagement effort referred to previously. The next order of battle items should be corporate tax reform and Social Security reform. Why corporate tax reform? Because it can help to improve our competitiveness, enhance economic growth and generate jobs. And why Social Security reform? Because we have a chance to make this important social insurance program solvent, sustainable and secure for both current and future generations. We can also exceed the expectations of all generations and demonstrate to both the markets and the American people that Washington can act before a crisis forces it too. The above efforts should be followed by broader tax reform and Medicare/Medicaid reforms. We will then need to rationalize our health care promises and focus more on reducing health care costs in another round of health care legislation. We must also begin a multi-year effort to re-baseline the federal government's organizations, operations, programs and policies to make them more future focused, results oriented, affordable and sustainable. In summary, the truth is that the government has grown too big, promised too much and waited too long to restructure. Our fiscal clock is ticking and time is not working in our favor. The Moment of Truth is rapidly approaching. As it does, let us hope that our elected officials must keep the words of Theodore Roosevelt in mind: "In any moment of decision the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing." And "We the People" must do our part by insisting on action and by making the price of doing nothing greater than the price of doing something We must insist that our legislators offer specific solutions to defuse our ticking debt bomb in a manner that is economically sensible, socially equitable, culturally acceptable, and politically feasible We need to recognize that improving our fiscal health, just like our physical health, will require some short-term pain for greater long-term gain. The same is true for state and local governments. We'll soon know whether Washington policymakers are up to the challenge and whether they will start focusing more of doing their job than keeping their job. They need to focus first on their country rather than their party. And yes, the President and Congressional leaders from both political parties need to be at the table and everything must be on the table in order to achieve sustainable success. Let's hope they make the right choice this time! All of us who are involved with the Comeback America Initiative (CAI) will do our part. All that we ask is that you do yours. The future of our country, communities and families depends on it. For more information about the Comeback America Initiative and No Labels, check out www.tcaii.org and www.nolabels.org. John F. Mauldin johnmauldin@investorsinsight.com You are currently subscribed as jmiller2000@gmail.com. To unsubscribe, go here. Reproductions. If you would like to reproduce any of John Mauldin's E-Letters or commentary, you must include the source of your quote and the following email address: JohnMauldin@InvestorsInsight.com. Please write to Reproductions@InvestorsInsight.com and inform us of any reproductions including where and when the copy will be reproduced. Note: John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. 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Fwd: The Endgame Headwinds - John Mauldin's Weekly E-Letter

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Date: Fri, Apr 29, 2011 at 6:14 PM
Subject: The Endgame Headwinds - John Mauldin's Weekly E-Letter
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The Endgame Headwinds By John Mauldin | April 29, 2011
In this issue: The Endgame Headwinds If Something Can't Happen… GDP = C + I + G + Net Exports Increasing Productivity Toronto, Cleveland, LA, Philadelphia, Boston, and Italy
I have written repeatedly about the Endgame in the weekly letter, as well as in a New York Times best-seller on the same topic. By Endgame I mean the period of time in which many of the developed economies of the world will either willingly deleverage or be forced to do so. This age of deleveraging will produce a fundamentally different economic environment, which the McKinsey study referenced below suggests will last anywhere from 4-6 years. Now, whether this deleveraging is orderly, as now appears to be the case in Britain, or more resembles what I have long predicted will be a violent default in Greece, it will create a profoundly different economic world from the one we have lived in for 60 years. This makes sense, in that the prior world was defined by ever-increasing amounts of leverage. Outright reductions in leverage or even a significant slowing of the rate of growth is a whole new ballgame, economically speaking. In all this I have explained the various options facing the developed world, but I have refrained from putting forth my own estimates as to what will actually happen and what the environment surrounding that outcome will be. That is about to change. I have been giving this a great deal of thought and research. While my conclusions will be somewhat controversial (I know, surprise, surprise), with enough to offend almost everyone on some point, I hope that I can muster enough clarity to help you think through your own personal views and how you will respond to what I think will be yet another crisis on the not-too-distant horizon. Whether that is Crisis Lite or Crisis Depression is up to us and the politicians we elect. I argue that we need to choose most wisely, because we are at a crossroads that is as critical as any since 1940. As I start this letter, I am on a flight to San Diego, where I will co-host my 8th annual Strategic Investment Conference. As usual, I will be the last speaker on Saturday. This letter will be the beginning of that speech, and we will conclude (hopefully) next week. What I hope to do here is summarize the main points, add some new ones, and then move on to how I think the Endgame will play out. These next two e-letters will be among the more critical ones of the last few years. Feel free to forward, and if you are reading this letter you can join my one million closest friends and sign up for my free weekly letter at www.johnmauldin.com. (This letter may print longer than usual, as it will have a significant number of graphs.) But before we jump in, many of you know that I am a serial entrepreneur. I look for business opportunities for inclusion in "the Mauldin companies." My "hobby," if you will, is looking at cutting-edge biotechnology. You have been asking for details and an update on one I mentioned last year. We partnered with a very serious biotech research firm, International Stem Cell Corporation, whose scientists discovered a patent-pending formula that rejuvenates skin. We continue to partner with them to help augment this breakthrough and, most importantly, to help fund their therapeutic research to find cures for very serious diseases. You can learn more at www.lifelineskincare.com/antiagingbreakthrough. Now, let's get into the letter. The Endgame Headwinds Before we can get to how I think the Endgame of the debt supercycle plays out in the US, we need to quickly survey the current environment, and revisit (at least for long-time readers) a few basic economic themes that I will call the "headwinds" of economic growth. So many leaders in so many countries think that with the right policies they can grow (export) their way out of the problem. As I have written, not everyone can grow their way out of a crisis at the same time. Someone has to buy. And while the right policies will in fact help, growth is, in my opinion, going to be severely constrained in the multi-year period of the Endgame. But, jumping right to the bottom line here, one way or another we will get through this very difficult period. Really. And my personal view is that in the period following the Endgame cycle we're going to see a very real economic boom, for reasons we will visit briefly in this series and at length over the coming year. I am quite optimistic longer-term, but the flight to get there may be very bumpy if you are not prepared for it. I will try to do my part to help you. Briefly, for new readers, let me define what I mean by the Endgame, as dealt with at length in Endgame: The End of the Debt Supercycle and How It Changes Everything ( www.amazon.com). The US in particular and much of the developed world in general began a cycle of ever-increasing debt in the late '40s, after World War II, both in the private and public sectors. Government began to grow as a percentage of overall GDP in the latter part of this cycle. In addition, politicians created large (well, huge) entitlement programs of pensions and health-care benefits that require significant taxes and, as we shall see, are unsustainable in the our present medium term. There is a limit to how much money an individual or country can borrow. We all intuitively know this. If you grow your debt faster than your income and your ability to service the debt over a long period of time, people will eventually stop loaning you money. This is true for individuals, businesses, and nations. The end result is a restructuring of the debt (default by one of several means, including serious inflation) or a very reduced standard of living (by previous standards) for a period of time in order to service the debt. For individuals, that may mean cutting off the cable, no eating out, no vacations, etc. For countries it means reduced government programs and benefits, and higher taxes. And make no mistake. I believe that the situation in the US is becoming urgent all too quickly. We are risking the health of the economic body of the US. While the republic will survive the crisis, the shocks and burdens it will place on all of us will be very great. For those not prepared it will seem like the end of the world, as jobs and safety nets might evaporate without proper restructuring. As I argue, the goal of fiscal sanity is to get the growth of the debt below that of the growth rate in nominal GDP. Failure to do so will result in the US suffering much as Greece or Ireland are today. Ugly. The 2008 banking crisis showed us the limits of how much individuals can borrow, at least against their home equity. Since then, private debt (except recently for student loans in the US) has begun to shrink. But governments everywhere stepped into the breach by massively borrowing. But even governments, including the US, have a limit. We see that in Greece and Ireland, and are watching the debt crisis unfold in Portugal and Spain as well. It will soon become all too painfully clear in Japan. As I have often noted, Japan is a bug in search of a windshield. Japan is big enough that when it hits its own version of the Endgame, it will shake the world. It will not be pretty. (But there are opportunities for the nimble.) As we will quickly cover here, the economic environment in which individuals and governments either willingly or are forced by the markets to reduce their borrowing and debt is significantly different from the period where they could create ever-increasing amounts of leverage. I call this period the Endgame. What we think of as normal gets turned upside down. Volatility increases, at a minimum. For many people this will qualify as a true crisis. But if you can see it coming and prepare, you can at least insulate yourself (somewhat) from many of the negative aspects of the Endgame. And volatility and crisis also mean that there will be opportunities for those prepared for them. Now, let's look at three graphs. The first is familiar to long-time readers. It shows the rise of debt in the US. And even with the recent pullback in consumer debt, because of the enormous government deficits, the rise is still there if we update this chart to last year. The next two charts come from the Bank of International Settlements. They outline for 12 countries what happens, in terms of the debt-to-GDP ratio, if current spending and tax rates remain unchanged (the top dotted line), what happens if there are efforts to rein in spending with small gradual spending cuts and tax increases (middle line), and what would happen with serious spending cuts and significant tax increases (the lowest line). Some countries, even with measures that could be considered draconian, simply do not recover. While the chart shows what would happen if age-related spending were held constant, most seniors would think that getting ever-smaller pensions and health care would be drastic measures indeed. These countries are in an unsustainable spiral, which means drastic (the word used by the BIS) measures will be needed. Note that there is only one example of a country that ever saw its debt-to-GDP rise over 150% and did not default, and that is Britain at the height of its empire and power, with long-term rates at a very low level and a completely different investment and bond climate. But notice how many of the countries are now on a path to twice that level in the very near future. If Something Can't Happen… There is rule in economics: If something can't happen, it won't happen. That may seem obvious, but so many people think the current linear trend can go on forever. This time is different, we tell ourselves. And I (and some others, like David Walker, Stockman, etc.) are telling you that so many things are on unsustainable paths that changes in present trends, as much as we might not like to think about them, are inevitable. So what we must think about now is what will happen when change is either forced on a country or entered into willingly. Some times you have to think the unthinkable. Look at the projected debt for the US, compiled last year by the Heritage Foundation, based on realistic assumptions, not with rose-colored glasses. This is a chart of something that will not happen. Long before we get ten years of multi-trillion-dollar debt, the bond market will being to require much higher rates than we currently experience, driving up the interest-rate cost as a percentage of tax revenues to very painful levels, forcing cuts in all sorts of things we currently think of as absolutely necessary, like military, education, and Medicare spending. Later on I will put a timeline on this prediction. One way or another, the budget deficits are going to come down. As we will see later, we can choose to proactively deal with the deficit problem or we can wait until there is a crisis and be forced to react. These choices result in entirely different outcomes. In the US, the real question we must ask ourselves as a nation is, "How much health care do we want and how do we want to pay for it?" Everything else can be dealt with if we get that basic question answered. We can radically cut health care along with other discretionary budget items or we can raise taxes, or some combination. Both have consequences. The polls say a large, bipartisan majority of people want to maintain Medicare and other health programs (perhaps reformed, but still existent), and yet a large bipartisan majority does not want a tax increase. We can't have it both ways, which means there is a major job of education to be done. The point of the exercise (reducing the fiscal deficit to sustainable levels) is to reduce the deficit over 5-6 years below the growth rate of nominal GDP (which includes inflation, about which more below). A country can run a deficit below that rate forever, without endangering its economic survival. While it may be wiser to run some surpluses and pay down debt, if you keep your fiscal deficits lower than income growth, over time the debt becomes less of an issue. GDP = C + I + G + Net Exports But either raising taxes or cutting spending has side effects that cannot be ignored. Either one or both will make it more difficult for the economy to grow. Let's quickly look at a few basic economic equations. The first is GDP = C + I + G + net exports, or GDP is equal to Consumption (Consumer and Business) + Investment + Government Spending + Net Exports (Exports – Imports). This is true for all times and countries. Now, what typically happens in a business-cycle recession, as businesses produce too many goods and start to cut back, is that consumption falls; and the Keynesian response is to increase government spending in order to assist the economy to start buying and spending, and the theory is that when the economy recovers you can reduce government spending as a percentage of the economy – except that has not happened for a long time. Government spending just kept going up. In response to the Great Recession, government (both parties) increased spending massively. And it did have an effect. But it wasn't just the stimulus, it was the absolute size of government that increased as well. And now massive deficits are projected for a very long time, unless we make changes. The problem is that taking away that deficit spending is going to be the reverse of the stimulus – a negative stimulus if you will. Why? Because the economy is not growing fast enough to overcome the loss of that stimulus. We will notice it. This is a short-term effect, which most economists agree will last 4-5 quarters, and then the economy may be better, with lower deficits and smaller government. However, in order to get the deficit under control, we are talking on the order of reducing the deficit by 1% of GDP every year for 5-6 years. That is a very large headwind on growth, if you reduce potential nominal GDP by 1% a year in a world of a 2% Muddle Through economy. (And GDP for the US came in at an anemic 1.75% yesterday, with very weak final demand.) Further, tax increases reduce GDP by anywhere from 1 to 3 times the size of the increase, depending on which academic study you choose. Large tax increases will reduce GDP and potential GDP. That may be the price we want to pay as a country, but we need to recognize that there is a cost to growth and employment. Those who argue that taking away the Bush tax cuts will have no effect on the economy are simply not dealing with either the facts or the well-established research. Now, that is different from the argument that says we should allow them to expire anyway Increasing Productivity There are only two ways to grow an economy. Just two. You can increase the working-age population or you can increase productivity. That's it. No secret sauce. The key is for us to figure out how to increase productivity. Let's refer to the last equation. The I in the equation is investments. That is what produces the tools and businesses that make "stuff" and buy and sell services. Increasing the government spending, "G", does not increase productivity. It transfers taxes taken from one sector of the economy and gives them to another, with a cost of transfer, of course. While the people who get the transfer payments and services certainly feel better off, those who pay taxes have less to invest in private businesses that actually increase productivity. As I have shown elsewhere, over the last two decades, net new jobs in the US have come from business start-ups. Not large businesses (they are a net drag) and not even small businesses. Understand, some of those start-ups become Google and Microsoft, etc. But many just become small businesses, hiring 5-10-50-100 people, but the cumulative effect is growth in the economy and productivity. Now, if you mess with our equation, what you find is that Savings = Investments. If the government "dis-saves" or runs deficits, it takes away potential savings from private investments. That money has to come from somewhere. Of late, it has come from QE2, but that is going away soon. And again, let's be very clear. It is private investment that increases productivity, which allows for growth which produces jobs. Yes, if the government takes money from one group and employs another, those are real jobs, but that is money that could have been put to use in private business. It is the government saying we know how to create jobs better than the taxpayers and businesses we take the taxes from. This is not to argue against government and taxes. There are true roles for government. The discussion we must now have is how much government we want, and recognize there are costs to large government involvement in the economy. How large a drag can government be? Let's look at a few charts. The first two are from my friend Louis Gave, who will be speaking at my conference this weekend. This first one is the correlation between the growth of GDP in France and the size of government. This chart shows the rate of growth in GDP and the ratio of the size of the public sector to the private sector. The larger the percentage of government in the ratio, the lower the growth. I know, you think that is just the French. We all know their government is too involved in everything, don't we. But it works in the US as well. The chart below shows the combined federal, state and local expenditures as a percentage of GDP (left-hand scale, which rises as the line falls) versus the 7-year structural growth rate, shown on the right-hand side. And you see a very clear correlation between the size of total government and structural growth. This chart and others like it can be done for countries all over the world. Sidebar: Now, I would not argue, as some libertarians do, that we need almost no government. I do not. But we must recognize the cost-benefit. I think the benefits of police are clear. Schools. A professional military (its use can be up for debate). Financial regulation. Courts. Etc. Certainly, society functions better with these and other services, and in a broad sense you can say that increases productivity. We "buy" services collectively with tax dollars that are seen as essential public goods. Those services could be offered by private companies. But there is a limit in the minds of most people. Do you want your government to own the steel mills and airlines? Energy production? In many countries and at times in history, the answer was yes. But government-run businesses are rarely as efficient as private ones. And that efficiency is a direct component of productivity. Next, (and finally for this week), let's look at a chart from my good friend Rob Arnott. This is part of what will one day be an Outside the Box. (For new readers, this is a publication that goes out Monday night, which features the writing and thinking of someone other than your humble analyst, and which I don't always agree with, but that does make us think. You can get it at www.johnmauldin.com just by putting in your email address and becoming one of my 1 million closest friends.) The chart needs a little set-up. It shows the contribution of the private sector and the public sector to GDP. Remember, the C in the equation was private and business consumption. The G is government. And G makes up a rather large portion of overall GDP. The top line (in dark blue) is real GDP per capita. The next line (yellow) shows what GDP would have been without borrowing. So a very real portion of GDP the last few years has come from government debt. Now, the green line below that is private-sector GDP. This is sad, because it shows that the private sector, per capita, is roughly where it was in 1998. The growth of the "economy" has been government. Is it any wonder that we have no net new jobs over the last decade? I get that there have been two recessions, but in an effort to appear to be "doing something," to "feel your pain," government is slowly sucking the air out of the room. Not all at once. Just a bit at a time. And it shows up in worker pay. The average worker has not seen their pay rise in real terms in almost 15 years. If they have a job. In fact, for the last decade, they LOST 5%. Do you want more tax revenues so we can have more government services like health care? We have to grow the private economy. If we tax the private economy as it is now, that will just reduce the growth in the private economy and slow or reduce the growth of jobs. There is simply no way to get around that fact. I will close here and start with part two next week. But the short take-away? The fiscal deficit and the national debt are a cancer on our economic body. They threaten to destroy the economic body of the republic. As a conservative, simply writing the words "tax" and "increase" in the same sentence makes me nervous. But I am even more afraid of what will happen if we do not get the deficit under control over time (next week we'll explore why we cannot do it all at once). Sometimes, when they have cancer, people take drugs they would not normally want to be in the same zip code with, in order to increase their chances of surviving. But those drugs have side effects, some of them quite severe and long-term. How we solve this crisis will determine the nature of the Endgame. But that is for next week. Toronto, Cleveland, LA, Philadelphia, Boston, and Italy I am in La Jolla with about 450 attendees at my annual Strategic Investment Conference, co-hosted with Altegris Investments. It is a fabulous, sold-out event. It is truly one of the highlights of my year, joining so many old and new friends for a few days. And the intellectual conversation? Wow. We are recording the panels and hope to make them available at some point. I fly to Toronto on Sunday for a quick speech, then back to Dallas, on to Cleveland for a night, then right off to Rob Arnott's annual conference in LA. Another very impressive line-up and one that I am privileged to be allowed to participate in. Then home for a weeks to catch my breath. I will be in Philadelphia Tuesday May 24 to moderate a panel and listen to a serious gathering of speakers at the 29th annual Monetary and Trade Conference, where the topics are "Is Housing Ready for a Rebound?" and "QE2, Housing and Foreclosures: Are they Related?" Philly Fed president Tom Hoenig, Chris Whalen, Michael Lewitt, Paul McCulley, William Poole, and Gretchen Morgensen, among others. To find out more you can go to http://www.interdependence.org/Event-05-24-11.php. Then it's on to Boston with some friends for fun (and a board meeting), then straight to Italy and a train to the little village of Trequanda in Tuscany, where vacation for me is staying in the same place for a few weeks, writing and thinking, and having friends show up. The kids will be there for the beginning, and Tiffani and I will make it a working vacation after that. And then I'm off to Kiev, Geneva, and London with my youngest son in tow; but more on that later. It is time to hit the send button. I have 450 guests wondering where I am, so I bid you adieu for today, and we will finish up next week. Have a great week. Your just a very happy and contented analyst, John Mauldin John@FrontlineThoughts.com Copyright 2011 John Mauldin. All Rights Reserved
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