Very quietly yesterday the amount of total public debt currently outstanding exceeded $15 Trillion Dollars. While that may or may not surprise some of you; it is an issue that we have been watching sneak up on us. As the “Super Committee” approaches their deadline for finding $1.2 Trillion in spending cuts over the next 10 years, or just $120 Billion in cuts annually, this becomes an even more pressing and important issue for the economy and the markets. Don’t forget that the 20% sell off this past summer was sparked by the political warfare of raising the debt ceiling. That war could be set to rise again.
We have discussed this issue in the past but did some deeper work on the issue to create projections based on the current rate of debt growth as well as comparing it to the Congressional Budget Office estimates. In the first chart we have take the amount of total public debt outstanding, which is debt held by the public plus intragovernmental holdings, from when President Bush’s fical budget year started on October 1st of 2001 until November 15th, 2011. We have then extrapolated the increase in debt based on the average rate of increase of the debt under the current administration to the end of President Obama’s potential second fiscal year term ending September 30th, 2011. This estimation is shown by the dotted red line. The blue line is the current level of debt with the Congressional Budget Office estimates for the same time period. Gross Domestic Product has been plotted as well and assumes a 2.5% annual growth rate for the years 2012-2017.
There are three things of importance to take away from this chart. First, the rate of growth in debt has ramped up, not surprisingly, due to the onset of the second recession and financial crisis beginning under the Bush administration. Poor policy choices to solve the financial crisis from bailouts to backstops to direct financial support has caused total public debt outstanding to mushroom. Secondly, while the CBO estimates a leveling off of debt growth beginning roughly today; the current run rate of debt growth will begin to accelerate if some measure of fiscal stabilization is not enacted. (Side Note: The CBO projections since 2000 have been woefully short of reality) Lastly, this analysis assumes that there will not be another recession or economic slowdown in the next four years which is hardly realistic. IF a recession or economic slowdown occurs these estimations rise sharply.
Which brings us to the main point. When the debt to GDP ratio of a country exceeds 90%, much less broaching 100% by year end, the drag on economic growth begins to rise sharply. This is one of the main problems facing many of the smaller Euro-zone countries today which is that they are carrying so much debt that they do not have the ability to “grow” their way out of their debt problems. The U.S. has now also reached that level to where the total indebtedness is robbing future economic growth.
However, the situation is must worse than even these charts show as we are only discussing the total public debt outstanding which is most commonly focused on by the government, media and mainstream analysts. The government has much more indebtedness that is considered “off balance sheet” such as Social Security, Medicaid, Medicare, Fannie Mae, Freddie Mac and Student Loans which we only hope won’t be a constituent to the next financial crisis lurking in the shadows.
As you can see the current run rate of debt growth the US will be running in excess of $19 Trillion in debt by the time President Obama ends his first term and will be pushing $30 Trillion in debt by the end of his second term should he be re-elected.
Here is the good news. This absolutely WILL NOT happen.
Here is the bad news: This won’t happen because either the powers that be will begin to make the massive cuts necessary to reduce the debt growth or the bond market calls “the bluff”.
In either event there WILL be another very nasty recession in our not so distant future. We can spend our time blaming Bush for poor policy choices or pointing fingers at Obama for his mistakes. In reality, it just doesn’t matter who is to blame as “we are where we are”. What does matter, and matters greatly, is what we choose to do next.
For policy makers this is a time to set aside differences, stop working for your individual interests, shut out the lobbyists and start coming to the realization that the economy is in a debt deleveraging cycle. The requires an entirely different set of policy prescriptions than what has been relied on in the past. Cutting spending and reducing debt is critical but it must be done carefully. Cuts and reductions must be done slowly while creating an environment to induce economic growth. Cutting spending arbitrarily will not only plunge the economy into a recession immediately but also exacerbate the situation far more than necessary.
For investors, there is a very dangerous cross-current of events running both above and below the surface. While the Euro crises is dominating the headlines the impact of a failure by the “super-committee” and the impact of the automatic spending cuts will impact not only the economy but also the financial markets. The Euro-zone economy is already running at near recessionary levels and since the Euro-zone makes up 20% of the exports of the U.S. and 20% of the corporate profits; this doesn’t bode well for a the economy or the markets in the coming quarters. Lay on top of this rising oil prices, high unemployment, stagnant wages, a depressed housing market and very depressed consumer sentiment and you have an environment that is frought with economic and market risks.
We have been repeatedly espousing market strategies of hedging investment risk, focusing on income over growth and protection of principal. These mantras have played out well during this past year and we suspect they will be key in 2012 and beyond as well.