A Monetary Cliff or a Fiscal Cliff: these are the two poisons that Barton Biggs sees rushing straight toward America, with little hope of an uneventful collision. While we have not been shy of our opinions on Barton Biggs' flip-flopping positions , his note on the US "as a nation of totally self-centered special interest groups that terrorize our politicians" struck a chord and deserves praise in its clarity. Noting that Europe seems stuck again, he points to the US market being data and Europe-dependent for the next month and believes the correction is little less than half way over (in terms of size not time). In Biggs opinion "although the Monetary Cliff is more long-term dangerous, the proximity of the Fiscal Cliff, if not dealt with, will trigger the dreaded double-dip recession we are all terrified of and bring on another financial crisis."
SIMPSON BOWLES FOREVER
A lethal, poisonous uncertainty hanging over U.S. markets (and world markets for that matter) is the so-called Fiscal Cliff. As of January 1, 2013, the Bush tax cuts, the temporary payroll tax cut, and long-term unemployment benefits will all expire. To make matters worse, on January 15th, because of the failure of the Joint Select Committee on Deficit Reduction, other formulaic draconian cuts will go into effect, which in total will abruptly subtract about 350 basis points of real GDP from what will still be a fragile economy expanding at perhaps two percent. This is the Fiscal Cliff the economy faces.
Unfortunately, there’s another precipice looming – a Monetary Cliff that is even steeper and more hazardous. By the fall of this year, it will become very evident that the U.S. is living beyond its means and that there is an entitlements deficit of truly mountainous proportions. By December of this year, we will be bumping up against the national debt ceiling and a possible downgrade of our sovereign debt. The budget and the deficit are out of control. Just as serious is the enormous liability America has created in the last ten years of unfunded promises to pay to our people when they retire and for their medical expenses. Investors, businessmen, and the people themselves sense these lethal imbalances, and if they are not addressed, they eventually will erode confidence, consumer and capital spending, and will drastically affect valuations. This is the Entitlements Cancer.
In my opinion, although the Monetary Cliff is more long-term dangerous, the proximity of the Fiscal Cliff, if not dealt with, will trigger the dreaded double-dip recession we are all terrified of and bring on another financial crisis. Congress could deal with this issue over the course of this year, but is that a realistic hope with a cantankerous, highly partisan Congress while an election is going on? Is a Lame Duck Congress likely to get anything done (supposing Obama is re-elected and the House and Senate are Republican)? Of course, the other alternative is that Congress defers the issue, in effect kicking the can down the road again, but the tolerance of the equity and fixed income vigilantes has been stretched thin. And make no mistake; the vigilantes are international, cold-blooded and very powerful, and they are like wolves attacking a weak and wounded buffalo.
The debt extension is no minor event. Here are some nasty facts. The average maturity of the U.S. Treasury debt is five years, and the average interest rate is 2.2%, so the interest expense last year was about $450 billion. Since inflation is running close to three percent, in total, the owners of Treasuries have a negative real return. $5.9 trillion or about 70% of the total is the amount of debt coming due in the next five years. Unless an economic miracle occurs, additional Treasuries will have to be sold in the years to come to fund the budget deficit. This year, according to Caroline Baum, a 100 basis point increase in the average interest rate will add $88 billion of interest expense. Last year, the Federal Reserve bought 61% of the new debt issuance and foreigners (probably most of the central banks, particularly of China) purchased about 20%.
Thus, we are very dependent on the Fed and the kindness of strangers for the rollover of our national debt. One of those strangers, China, is already choking on T-bonds and has expressed its reluctance to increase its holdings. Japan is transitioning to its own quantitative easing. Suppose China and Japan not only stopped buying but actually tried to sell. Baum puts it succinctly: “The U.S. is more dependent on short-term funding than many of Europe’s most indebted countries, including Greece and Spain.”
I recently attended a breakfast with former Senator Alan Simpson, Erskine Bowles, and Mayor Bloomberg. I think the Simpson Bowles Committee (SBC), appointed by the President (which incidentally was truly bi-partisan), came up with reasonable, compromise solutions to these big issues, but which do require a pound of flesh from everyone. Subsequently, the President and the Majority Leader dropped it like a hot potato. Everyone got fat in the last ten to fifteen years and now Mr. Everyone is going to have to lose some weight. Since we are an equal society, the top echelons are going to have to give up the most. A few weeks ago, the SBC was summarily dismissed by the House. We are a nation of totally self-centered special interest groups that terrorize our politicians. Our politicians are scared to death of them. As Senator Simpson, a life-long Republican and one-time Minority Leader of the Senate, put it, “if President Obama had endorsed our proposals they would have torn him limb from limb”.
The “they” whom he was talking about principally is the American Association of Retired People (AARP) which has 45 million members and is growing by 10,000 new members a day. The AARP is a single issue voting bloc, and on Election Day it can turn out its members, most of whom have not much else to do. Social Security is their beta noire. In the late 1930s, when FDR created Social Security, the average life expectancy of Americans was around 60 and there were 33 workers for every beneficiary. The retirement age was set at 65 and benefits were later indexed to inflation. Today, the life expectancy is close to 80 and there are 3 workers on the way to 2 for each beneficiary. The retirement age is still 65. The Social Security System is bankrupt with an unfunded liability in the trillions that is rising every day. The SBC recommended that the retirement age be gradually raised over 20 years to 70, and that the Social Security payroll tax assessment be raised from the first $110,000 to $175,000. Of course, the other AARP (The American Association of Rich People) screamed bloody murder as they do about any tax rate increase on higher income payers.
The same dynamics apply to Medicare, and here the SBC suggested maintaining the Medicare cost controls associated with the recent healthcare reform legislation and increasing the authority of the Independent Payment Advisory Board. Again, the AARP went nuts, screaming about “death panels”. The issue is that at a huge expense, modern medicine can prolong hopelessly dying peoples’ lives until they are virtually vegetables. End of life care is a major reason health insurance is insolvent.
The SBC also proposed a $200 billion reduction in discretionary spending with proposed cuts including reducing defense procurement by 15%, closing one third of overseas bases, eliminating “earmarks”, and cutting the federal work force by 10%. In addition, it suggested $100 billion in increased tax revenues through reforms such as introducing a 15% gasoline tax and eliminating or restricting a number of exemptions, such as the home mortgage interest deduction on expensive homes and the deduction for employer-provided healthcare benefits. Another proposal was a reduction in entitlements including farm subsidies, federal pension service reform, and student loan subsidies. Senator Simpson points out that last year we spent $740 billion on defense; the next 14 biggest spending countries combined spent $560 billion.
The tax reform proposed by the SBC is staggering in its dimensions. Almost all deductions are eliminated, capital gains and dividends are taxed as income, and we go to three brackets (12%, 20%, and 27%). All corporate and individual deductions and exemptions including mortgages, ear marks, and charitable contributions are gone, as is the Alternative Minimum Tax. A federal excise tax on gasoline goes into effect in 2015. However, all this is another, very complex subject. All manner of fiscal experts have objected, showing disastrous consequences. Senator Simpson just smiles: “Torture statistics long enough and they will confess to anything.”
Alan Simpson and Erskine Bowles are great Americans and their program needs serious consideration. At the breakfast, Bowles said he had just spent time with the President and that Obama had told him after the election he thought progress would occur. Someone then asked Simpson, Bowles, and Bloomberg whether they thought these issues could be dealt with without another financial crisis occurring first. All three regretfully said they did NOT think so. Depressing!
As for the markets short-term, my guess is that we are about half way through a correction slash pullback whatever. The U.S. market for the next month will be data and European dependent. The American economy is looking a little soggy here, but I think the 2% momentum is still up. Europe seems stuck again. That the ECB and EFSF are already talking about spending their precious firewall funds that are supposed to last for three years is not cheery. Italy today sold one year paper at 2.84% whereas a month ago it financed at 1.40%. Germany’s financing stumbled too. It’s clear Europe is in a recession that is affecting everyone, including former stalwarts like the Netherlands. I’m out of Italy and have sold short some French and German equities.
Barton M. Biggs