“I’ll gladly pay you Tuesday for a hamburger today.” – J. Wellington Wimpy, Popeye character
As we approach the end of 2012, the hills are alive with the sounds of fiscal cliff negotiations. As we pointed out in our Insight back in August entitled The Definition of a Bad Economist, the fact that these negotiations are even happening is a clear indication of the dysfunctional nature of today’s political decision-making process. Politicians like to talk about “making hard choices” and putting America on “the right track,” but when push comes to shove, their actions don’t line up with their words. Consider the following quote from Axel Merk of Merk Investments.
What’s so sad about the discussion about the so-called fiscal cliff is that even the initial Republican proposal results in approximately $800 billion deficits each year. Financed at an average 2%, this would add over $900 billion in interest expenses over ten years; financed at an average 4%, it would add almost $2 trillion in interest expense over ten years… Democrats pretend we don’t even have a long-term sustainability problem, only that the wealthy don’t pay their fair share.
The US is running a current deficit of over one trillion dollars a year. That means that the US government is spending a trillion dollars more than it takes in (e.g. tax revenues) every year. The only way to do this is to finance the gap with new debt, which is why we continue to run up against and raise the debt ceiling. So the deficit is adding a trillion dollars a year to our debt plus the interest we pay to finance the existing debt and deficit. What Axel Merk is simply pointing out is that all the fiscal cliff hand wringing is but a mere drop in the proverbial deficit reduction bucket and accomplishes very little for our long-term financial sustainability. The chart below shows the US deficit as a percentage of GDP over the past 80 years. Today’s regime represents the largest peace-time deficit in our nation’s history.
The next logical question to ask is why isn’t anything being done to address the problem? The root issue is that our society has dismissed the mantra of generations past that emphasized hard work and occasional sacrifice as part of one’s civic duty as Americans. We have abandoned this for a path of least resistance philosophy which believes that pain and sacrifice are unnecessary evils that can be alleviated by borrowing from our future prosperity. After all, what is debt other than a promise to pay back an agreed upon amount of capital in the future in order to have access to said capital today. We can think of this as Wimpy economics since we would “gladly pay you Tuesday” for a hamburger today. For those not familiar with Wimpy from Popeye, Wikipedia describes him as "soft spoken, very intelligent, and well educated, but also cowardly, very lazy, overly parsimonious, and utterly gluttonous." Sounds a bit like our politicians and policy makers today (sans the parsimonious bit).
The problem with always putting off tough decisions and embracing Wimpy economics is that it 1) creates the potential for catastrophic failure as leverage adds risk to any economic or financial system and 2) it creates a moral hazard for those with a short-term focus since it appears that all our problems can be “solved” by simply borrowing from the future. One of the reasons we find ourselves in this current economic mess is that for the past 30 years, banks have been able to capitalize their profits and socialize their losses. This is summarized beautifully in a recent Deutsche Bank research report which stated...
…those who risk and lose, often don’t in fact lose. Loss-makers are compensated by a system that is unable to tolerate the consequences of failure. Moral hazard continues to be encouraged…This makes investment simpler in the sense that one only needs look to what is ‘easiest’ rather than what is ‘right’.
“So what is easiest?” one might be tempted to ask. The US has three paths to bring the debt and deficit back to sustainable levels. It can grow its way out of this mess similar to what happened during the “Golden Age of Capitalism” after World War II, we can embrace fiscal austerity by cutting spending and raising taxes similar to what Europe is doing today, or we can inflate our way out by devaluing our currency. The easiest solution would be the first, to grow our way out of the problem. Unfortunately, policy makers have very little control, contrary to what they would have you believe, over the “invisible hand” that moves the economy. That leaves door number two or three. The second option is wildly unpopular with the masses (see riots in Greece, Spain, Italy, France…) making it extremely difficult to get re-elected. That leaves the third option as the only easy way out.
No policy maker will ever come out and say that they want outright inflation, but as usual, actions speak louder than words. Since the bankruptcy of Lehman Brothers which caused credit markets to freeze, the Fed has almost tripled the monetary base and flooded the market with liquidity. Newly announced QE programs should add around a trillion dollars a year to this number until unemployment falls below 6.5% which the Fed isn’t forecasting until 2015.
So why hasn’t all this new money led to inflation? The answer is twofold. First, inflation is a product of the expansion of money and credit or what is commonly referred to as “too much money chasing too few goods.” Although the monetary base has been expanding, credit in the private market has not as consumers continue to pay down or default on existing debt. The second major factor is that banks have been parking their reserves at the Fed in droves ever since the Fed decided to pay 0.25% on excess reserves during the financial crisis.
In essence, the Fed creates new money and uses it to buy securities from banks that in turn take the money and deposit it back with the Fed. This cycle is not in and of itself inflationary, which is why we haven’t seen the runaway inflation some fear-mongering pundits have been predicting. That being said, one can think of all the excess reserves sitting at the Fed as a pile of gunpowder which is harmless as long as there isn’t a spark that triggers an inflationary explosion.
Again, quoting the Deutsche Bank research report referenced earlier, “The world needs growth and it is willing to go to extraordinary lengths to get it.” It appears as if it is a race against time where policy makers are hoping that they can hold everything in place long enough for real, sustainable growth to pick up (door number one) and bail us out of our current dilemma. If that doesn’t work, then they will be forced to fall back on inflation to devalue the dollars we currently owe to the world. With interest rates already at zero, the Fed continues to flood the system with liquidity to prop up asset prices and create a wealth effect. Whether these “extraordinary lengths” are inflationary or not, or whether they will lead to sustainable growth has yet to be seen. They certainly can’t help to build confidence in the US Dollar, which is why we still favor a meaningful allocation to gold as part of our Diversification 2.0 portfolio construction since it is an anti-currency that can’t be created at the will of Wimpy policy makers.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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