Or as John Mauldin would say … can we just “Muddle-through?”
America was founded as a democratic republic. The founders would hardly recognize the nation as it now exists. The founders envisioned a limited government and elected officials that were part-time.
The country exploited its vast resources and grew. But the America the founders envisioned is not the country that now exists. The changes of the last century have been driven largely by technological advances and a changing political and social climate.
Today, we live in a country vastly different than the country our founders envisioned. The current financial crisis and the solutions to solve it will determine how drastic those changes will be.
To understand the forces affecting our economy, we need to look at the big picture. The world economy for the last two years are shown in the following table.
In 2008, the U.S. required about 70% of world savings to finance its increase in stated cash debt and the trade deficit. In 2009, the increase in the deficit raised that to about twice world savings as the recession continued.
According to the IMF, world GDP & savings in 2010 should increase. However, the U.S. deficits will not decrease and the U.S. Treasury will have to raise the largest amount of money in its history due to the shortness of its outstanding maturity schedule. The following table shows the problem.
At the moment, the U.S. and the world is unwilling to accept that the country is basically bankrupt as that would also mean that all the rest of the world is facing the same problem. Competitive devaluation of a fiat currency is deemed to be a better matrix than facing bankruptcy.
However, the U.S. still faces the need to solve its financial problem. GDP in 2010 will be $14.3 trillion. The U.S. stated cash debt will grow to over $14 trillion. U.S. total liabilities are probably in excess of $112 trillion.
U.S. Household wealth is only about $55 trillion. If the government seizes all the household wealth and all the income through taxation for the next 50 years, it is doubtful that the current debt and unfunded liabilities of programs passed by its federal government can be funded.
The consumer used to represent about 70% of total GDP. As the credit crisis erupted, the consumer found the house ATM closing, credit card limits decreased and credit requirements raised. Faced with a new reality, the consumer began to deleverage and until jobs return that will continue. As a result, the outlook for a fast recovery is slim.
Hence, the U.S. is facing some hard choices going forward.
The current crisis was primarily the result of politicians changing laws regarding housing finance and repealing the Glass-Steagall Act. These changes allowed new types of financial instruments to be created known as securitizations and credit default swaps. The lure of huge fees in the financial sector in mortgage financing and various debt instruments caused many to forget prudent investment theory and concentrate on greed.
The rising complexity of the alphabet instruments, e.g., ABX, CDS, CDO, CMO, CMBS, ALDO, LCDO, ECO, MDS, SIV, etc., showed that many investors of all skill levels had very little concept of “counter-party risk” and the risks associated with “mark-to-make believe” accounting rules. An elementary rule of accounting is that both sides of a balance sheet should be equal. In many of the securitization transactions, both parties used different assumptions for evaluating the transaction and hence, both could report a profit which even first graders know to be untrue.
Many investors took comfort in the fact that many investments were rated “AAA” but failed to perform the necessary due diligence on the securities to determine if the ratings were justified.
Significant inter-locking relationships exist between the shareholders of the financial institutions, the Federal Reserve System, and the rating agencies which create many conflicts of interests. Politicians are heavily financed by lobbyists. As a result, an ineffective regulatory oversight infrastructure was put in place which rarely looks at the major players but concentrates on the small fish. Did the SEC uncover the Madoff scandal even after they were tipped off by Harry Markopolos?
With a $14T economy trying to service $110 T of debt and unfunded liabilities, it is simply impossible to continue indefinitely the current government policies of trying to solve problems by spending more money.
In the past 30 years, the U.S. has gone from the world’s largest creditor nation to the world’s largest debtor nation. Unfortunately, we no longer can continue on the current path either politically, militarily or economically without self-destructing … it is simply unsustainable.
Politicians have basically only one solution to a problem … throw money at it. But spending is not the answer to many problems and over the years, government spending has outpaced the growth of GDP and household income as shown in the following chart. The real question is if the taxpayers are receiving value for the money confiscated from the public sector by the politicians.
Make no mistake …. Increased taxes reduces the amount available to invest. Government spending in most cases is simply consumption and not investment. During the past 60 years, the growth of government spending as opposed to median household income has been simply astounding as shown in the following chart. The massive spending by the U.S. Treasury and the Federal Reserve during this financial melt-down has only served to prove that our politicians are afraid to let the capitalistic system work to cleanse the system.
Massive deficits are not the solution to the financial crisis. It just postpones the day of reckoning.
The increase in government spending during the financial meltdown has been dramatic and has caused the percentage of government spending as a percent of GDP to rise to almost 44% as seen in the following chart.
The response of Congress to the recession has been to increase spending. The decrease in tax revenues has created the largest gap in history with spending as shown in the following chart. It should not take a genius to understand that the current situation is unsustainable. Either taxes must go up which will defeat the ability of the economy to produce jobs or spending must go down.
During the recession sparked by the financial meltdown, the U.S. economy has lost over 10 million jobs. The following chart shows the decline in total employment and the rise in unemployed since the beginning of 2005.
The current number of employed is at the same level as 1999 but the U.S. has 30 million more people. To absorb those now unemployed will require an improving economy as well as the normal increase in the work force of 150,000 people/month.
Politicians along with their proxies (the US Treasury and the Federal Reserve System) have only proposed solutions that increase spending and increase taxes along with more regulatory oversight. The infusion of billions of aid has done little to solve the insolvency of the financial system. The Federal Reserve’s low interest rates policies benefits people and institutions that are in debt and penalizes those who save and provide the capital for businesses.
The proposed solutions have little real and permanent incentives for businesses and/small entrepreneurs who create most of the jobs to increase employment. The uncertainty of future costs from health care reform, tax rate changes and interpretations of existing regulations and environmental regulations further cloud the decision making process of investors.
Increased credit requirements and a lack of certainty about the prospects for making a profit in future years have created a situation where despite substantial liquidity in the financial system, bank lending has dropped sharply. Sinking loan demand is a function of both credit requirements plus the lack of a need to increase capacity or risk investment capital in new projects.
The number of US venture capital deals have dropped significantly as well as the number of new business startups during the last 24 months. The following chart shows the level of venture capital deals in the Bay Area since 2003 of which an increasing percentage was allocated to companies located off-shore.
The economy will only recover when entrepreneurs and investors are willing to take risks and receive what they perceive to be adequate returns for their capital. Higher taxes and costs make those decisions to invest more difficult.
Almost since its founding, one of the major strengths of the U.S. has been its being a leader in technological innovation. Unfortunately, following WWII, changes were made in education that have seen the country’s superiority decline.
In 1980, the US Department of Education was formed to increase the subject proficiency of US students. It was an outgrowth of the teacher certification movement pushed by the teacher unions and social and political changes aimed at helping racial minorities, individuals with disabilities, women, and people of non-English background. Rather than focusing upon improving subject proficiency, the result has been a major deterioration in the placement of the US against other nations.
In 1950, the majority of engineering, technical and medical college applicants were US citizens. The subject proficiency of those graduates placed the US in the top 10% overall. The vast majority of teachers in American colleges were native-speaking US citizens.
The teacher certification movement for primary and secondary schools began to gain steam in the 1950’s. The result is that today we are now in the third generation of teachers who have been certified by a state agency as qualified. Unfortunately, the qualification is for lesson plans rather than subject knowledge. Moreover, the majority of students seeking to become teachers are now from the bottom third of the high school graduating classes.
It should not surprise anyone therefore that our subject proficiency has been reduced. In the latest evaluations from the Program for International Student Assessment, subject proficiency of secondary school students placed the US in the bottom 50%. In 2006, on the science portion, U.S. students, most of them 10th-graders, received an average score of 489 on a 1,000-point scale, 11 points below the average of the 30 countries. In math, only four countries had average scores lower than the United States.
In 2010, most graduate school applicants for Master’s or doctorate degrees were foreign citizens. Moreover, many of the professors at engineering and technical colleges were not native-born US citizens.
Prior to 1988, about 80% of the foreign-born graduates stayed in the US and became citizens. Many successful companies in technology were started by those students. However, in 1988, the US State Department revised the rules to obtaining a green card. Since then, the percentage of foreign-born students has fallen dramatically to where today less than half remain after graduation.
In the last 60 years, we have trained many of the faculty of universities throughout the world and today they are no longer sending their top students to the US. Rather we have now trained our competition and many foreign universities in Japan, Taiwan, China and Eastern Europe are now educating their first tier of students. The US is now getting foreign students who do not qualify for the top-rated universities in those countries.
The loss of these highly-trained professional students is helping to diminish the U.S. position as the innovative technological leader of the world.
Globalization and the failure of the U.S. education system has reduced US technical superiority. Out-sourcing has helped nations develop not only the manufacturing but also the technical skills to compete with the US on just about any level. Many politicians and academics that pushed globalization forgot that product improvements often are achieved by a close interaction between design, engineering, quality control and field service.
We are beginning to see the impact of a brain and capital drain to countries that prior to the 21st century were sending their best and brightest students to the US for their education.
Loss of manufacturing capacity thanks to out-sourcing, a declining literacy level, government taking an increasing percentage of GDP, and soaring debt and unfunded liabilities have caused the US to go from the largest creditor nation in the world in 1980 to the largest debtor nation in 2010.
Could bankruptcy arrive suddenly if the pump-priming fails?
GAAP accounting presents a totally different picture of the US than does the data bandied about by Congress and the administration irrespective of party affiliation. How close is the tipping point as the federal government must refinance about $4 trillion in debt during FY 2010?
If the PIIGS are a concern about sovereign debt ratios and the ability to refund debt, what does Jason Saving’s predictions and research suggest about the US? After all, the U.S. is the biggest elephant in the room!
The following chart shows the ratio of sovereign debt to GDP for selected countries.
At the moment, the U.S.’s sovereign debt is viewed differently from many countries because of a perception of military superiority and the dollar’s role as a reserve currency. The current rate of increased spending and increasing debt loads will continue to accelerate the erosion of the reserve currency role. In fact, U.S. debt is in danger of being downgraded from AAA status and is now priced higher than the AAA debt of some public companies for the first time in history.
Unless major changes are initiated in the very near future, the road to bankruptcy is assured.
The US is now facing major policy decisions. The passage of health care reform has only added to the costs of the government. Cap & Trade legislation, if enacted, will also increase regulations and costs to the economy. It is highly doubtful if the benefits will out-weigh the costs and will only reduce our ability to compete globally. Granting amnesty to illegal aliens will only create more problems and increase welfare costs.
Social Security was sold in 1935 to Congress as revenue neutral. Today, the program has missed the target by some $60 Trillion. Both Medicare and Medicaid have exceeded their initial CBO cost estimates by many magnitudes. Almost every government program in history has exceeded its initial cost estimates.
Congress can reduce spending, increase taxes or a combination of the two alternatives while trying to keep currency depreciation within some sort of control. However, politicians will only increase taxes while reducing services with the result being nothing constructive for the economy.
The eventual outcome will be the reduction of the U.S. political power and our standard of living. Sweeping problems under the rug and the refusal to accept the consequences of a capitalistic system along with the unconcern for the results of moral hazards will effectively doom the U.S. the founders envisioned.
The only alternative is an uprising, hopefully, of a non-violent nature. The major impediment to success is the current electoral process without any restrictions on term limits. As a result, most incumbents are re-elected. However, there is hope.
The current ground-swell of opinion represented by the Tea-Party movement has lowered the incumbents possibility of re-election somewhat. In addition, a larger number of sitting Representatives and Senators are taking retirement this year than in most previous elections.
The only opportunity for a long-term boom in the U.S. is to reduce spending in the public sector, cut taxes on businesses, reduce regulation and sunset most government programs along with a proposal to bring public/private pay scales including all benefits and pensions into parity.
Of course, this course of action implies short-term pain which is unlikely to be adopted by the majority of our current politicians.
There are certain steps which might reverse our head-long slide away from the Constitution and Bill of Rights set forth by the founders of our democratic republic many years ago.
Step 1 should be the development of a national energy policy that puts development of nuclear energy power plants as the number 1 priority. Also, we should develop our domestic oil and gas reserves both on-shore and off-shore and everywhere. The money spent on alternate energy sources will only provide a small amount of our energy requirements in the future under the best scenario. The green scenarios and climate change have skewed heavily the cost/benefit equation for energy.
Step 2 should be the immediate reduction of at least 15% in all government programs across the board. However, the military budget should be reduced by 25% and except for token embassy forces, all military forces should be returned to the U.S. This proposal obviously means that the U.S. should withdraw from the Middle East and Afghanistan quickly. Without counting the troops fighting in Iraq and Afghanistan, the US has over 110,000 troops in just four occupied countries, Germany, South Korea, Japan and Italy. Bringing them home and putting them on the US border might reduce significantly the illegal immigration and drug problems.
Step 3 should be the development of a true sunset commission to review the necessity and costs of every governmental agency. It should also have the power to close agencies without further government legislation. We must make a comprehensive review of all programs including social security, Medicare, Medicaid and health insurance programs and eliminate those that the country can simply not afford. Welfare should not be available for extended periods of time. In many cases, people are receiving welfare payments for life.
At the beginning of social security, life expectancy was just three years longer than the retirement age. Today, it is almost 18 years. It should be obvious that the retirement age needs to be adjusted. While the social security system has always been a Ponzi scheme, a few changes in the retirement rules and in the disability determination process could postpone the immediate bankruptcy of the system in the next few years. The ability to double/triple dip the pension systems also has to be brought under control at all levels.
Step 4 is to eliminate all foreign aid. In fiscal 2008, the U.S. provided about $26 billion in foreign aid of which Israel was the largest recipient. It would be cheaper to give a free plane ticket and $250,000 to each Israeli that wanted to immigrate to the US along with US citizenship. After six months, we would stop the program and no further aid would be available to any nation. The US must realize that it is no longer the world’s largest creditor nation but the world’s largest debtor nation. We simply can no longer afford the money.
Step 5 should be a constitutional convention to place term limits on every elected federal, state and local official and to require mandatory retirement. The framers believed in the concept of part-time representatives … not politicians who spend their entire lives on the public dole. Other than those in the military and the post office, individuals can only work for a governmental agency including the public school systems for a total of 20 years at all levels. The balance of their working life must be spent in the private sector.
Step 6 should be a requirement that public servants must abide by the same rules and laws applied to the rest of the citizens. For example, pensions of Senators and Representatives and their health benefits will not be different that those afforded to the general population. Pay scales for government employees including benefits are substantially higher than pay for comparable jobs in the private sector. Further, public employee unions at all levels of government shall be eliminated. Outsourcing of many jobs currently performed by local and state employees would also reduce costs significantly. At the moment, government employees represent 51.4% of all union members in the US. Does that not suggest that something is wrong with the current system?
Yes, I can see a boom ahead … Let us take a look at the S&P 500 since 1980.
The growth of the index during the past 30 years looks reasonably good. However, when you measure the S&P 500 by that old relic, gold, a different picture is seen.
As I have often said, purchasing power is the most important thing to not only long-term investors but should be to everyone.
The boom might be one where purchasing power continues to shrink. Could the Dow Jones Industrial Average rise to 36,000? Certainly, but a cup of coffee might cost $24.
What type of recovery will we have? Probably, a long period of uncertainty and at best, only a double dip recession. Hopefully, we will not see the dreaded ski-jump recovery and a slide into a depression.
To have the republic survive to its 250th birthday, we will need to make major changes. The electorate will have to decide whether we live in a republic to be governed by a constitution and laws or whether we will become a banana republic where the rules are set arbitrarily by those who assume power.
We must reduce taxes and regulations to enable our businesses to compete on a level playing field worldwide. Politicians must understand that entrepreneurs and money, the lifeblood of business, always flows to where it is treated well and that it does not respect borders. The United Kingdom never learned that lesson after WWII with its confiscatory taxation and socialist policies. Today, only an empty shell of its former world empire remains.
Failure to rein in government spending at all levels of government and to bring the public sector pay/benefits back to par with the private sector will surely result in the future bankruptcy and economic destruction of the US capitalistic system.
Unfortunately, I doubt if today’s elected officials have the stomach for the task as they are politicians rather than statesmen.
Fred Richards
March 26, 2010
Corruptisima republica plurimae leges. [The more corrupt a republic, the more laws.] -- Tacitus, Annals III 27
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Last updated - December 20, 2009