The US Budget Deficit and the Golden Goal Posts

Every day there is a barrage of information -- news stories, blog posts, print ads, and television ads -- with two different (but equally bearish) themes:

1. The central banks of the world are running the printing presses and debasing their respective currencies.  The result is incipient and inevitable inflation.  Gold is the best refuge.
2. The world economic leaders have no plan nor ability to avoid a global economic collapse.  In the deflationary environment, gold will be the best choice.

Let us call these the "golden goal posts."  Thanks to The Reformed Broker for posing this "riddle."

The two arguments, inconsistent at the base, are argued in the alternative and even simultaneously.  There are many people making money from selling fear and selling gold.  (Full Disclosure -- I frequently hold GDX in client accounts for one or more of our four different strategies.  We are long GDX right now).  While there is nothing wrong with investing in gold, the most radical proponents create an excessive emphasis on extreme economic scenarios.

Let us take a deeper look.

The Best Analytic Framework

I take an approach that involves four steps:

1. Analyzing the problem
2. Identifying an acceptable goal
3. Considering paths to the goal
4. Evaluating probabilities

Can this approach shed any light?  Let me consider each step in turn.

Analyzing the Problem

The overall debt level is large and growing.  For a great presentation of the problem, take a few minutes to watch this video from the Kauffman Foundation's Economic Bloggers Conference.  World-class economist Robert Litan chairs the panel and sets the stage.  There are strong presentations from the intellectual and objective Donald Marron, the highly-regarded Angry Bear, Ken Houghton, and economic journalist Ryan Avent.  We were all pretty depressed about the prospects, and that was even before we heard from Mish!

If you can take a few minutes -- and you should -- watch the entire panel for some great background on this issue.  I thought that they needed a public policy guy to suggest a possible path out of the woods.

An Acceptable Goal

To establish a reasonable hypothesis, I am going to suggest that a surplus in the federal budget is an acceptable goal.  I realize that there is increased globalization and the we have state and local governments to consider, but we must start somewhere.

Wouldn't we all be delighted to see headlines that showed a federal budget surplus?

Is There a Path to This Goal?

If you want to understand how governments  (or large private organizations) deal with problems, you need to quit thinking in terms of your family, your small business, or a chess game.  This is not a situation where you see a problem, analyze alternative, identify a solution, and make a choice.  It is decision making under extreme uncertainty.  Most observers get this wrong.

Here are the paths that I see as plausible, and even likely:

1. The economic rebound will increase tax revenues, reducing the non-structural part of the budget deficit.  (The structural deficit (simplified) is what we would still face if we were operating at full employment).
2. The consideration of the Bush tax cuts will lead to a number of compromises.  Taxes will be increased, but some of the cuts will be preserved -- at least in part.  Like all compromises, everyone will hate the result.  The final tax rates will be lower than we had in the Clinton era.
3. Entitlement benefits will be cut.  This will require success from the Deficit Commission.  Once again, most will hate the result, but these commissions are the only way to achieve change.

Probabilities

At the outset, I want to make something very clear.

The chance of success is vastly under-estimated by the media, by bloggers, and by the financial markets.

The basic reason is that the problems are easy to see and the solutions are not.  People are not used to thinking in terms of government policy.  The governments involved may make some mistakes, but they will keep trying.

From Doug Short (see the full article for alternative views) we can see the dimensions of the problem.

It is obviously a tall order.  This is information that everyone sees: The problem.

The Probabilities

To evaluate the probability of improvement, we need to keep the mainstream projections in mind.

The OECD sees 3.2% growth for the US in the next two years.

The Wall Street Journal Panel sees 3%.

There are many pundits, mostly non-economists writing about economics, who have more pessimistic forecasts.  They often cite a "laundry list" of problems.  None of them provides any long-term forecasting records of their own.  Mostly they just criticize professional economists.  Meanwhile, you should keep in mind the following:

The OECD economists, and the 53 pros in the WSJ survey are constantly following the markets.  They know about and have considered every "headwind" identified by your favorite bearish pundit.

So what is the chance of a result that is neither wild inflation or deflation?

My own estimate is in the 90-95% range.  The extreme outcomes might occur, but are very unlikely.  The bonds and TIPS don't show it.  Meanwhile, the attentive investing public places far too much weight on these alternatives.  CNBC recently ran one of their silly polls asking whether gold or the S&P 500 would do better in the next three months.  The majority of respondents voted for gold.  No doubt the rationale was split between those voting for each upright.

I see gold prices as an excellent reflection of market fear, skepticism, and doubt about future earnings.

Monitoring Progress

The key to following progress is understanding that economic improvement is not a "light switch."  At the time you see a headline that all is well, it will be too late to invest.  I follow many economic indicators and challenge each results.  You should, too.

Separate the Structural Deficit

Here is a nice discussion of the Bernanke concern via Colin Barr.

There are currently five workers for every retiree in the country, Bernanke said. That stands to shrink to three workers by 2030 -- at a time when "expenditures on health care for both retirees and non-retirees have continued to rise rapidly as increases in the costs of care have exceeded increases in incomes."

The path of success is a Keynesian one...

The Keynesian Logic

Brad deLong argues that these times call for unusual measures.

It is a time for not normal economics but rather “depression economics.” The terms on which the U.S. government can borrow now are exceptionally advantageous. And because of high unemployment the benefits of boosting government purchases and cutting taxes right now are exceptionally large.

The result is that the costs of borrow-and-spend policies are overturned for the short run—indeed, for as long as the current economic crisis of high unemployment lasts, which may well mean that the short run is not very short.

Think of it as a kick between the uprights.  There is enough economic growth to avoid deflation, a relatively timely reduction in the Fed balance sheet, and a reduction in Federal deficits.  From the daily media barrage and from gold prices one would think that the "between the goal post" result was unlikely.

He explains in more detail, and it is all worth reading.  It is an outline of what to observe.

The Politics

The political dimensions are easy to outline.  The deficit questions will not be resolved before the mid-term elections.  Compromises on taxes and spending will happen in 2011.

Until then we can depend upon the political environment to distract the investor with extreme arguments.

Investment Conclusion

As usual, I recommend political agnosticism.  This is an environment where investors can do very well if we make gradual  progress toward solving problems.  The key word is "gradual."  I predict that the combination of economic improvement and compromise over taxing and spending will move us in the right direction.

With this article I am also introducing a new feature requested by readers -- the Resource Page.  When I do an update on a topic (like today's article) I will also introduce a resource page that shows summaries and links to former articles that provide additional depth.  I invite reader suggestions for any old favorites that we have missed.

Today's Resource Page is Debt Crisis?.  (Thanks to Derek Miller for a nice job of analyzing old articles).

Comments

[oldprof]

Ken -- Thanks for such a thoughtful comment, and I am sorry that my mini-vacation delayed my reply. I hope that readers click through to the video and enjoy your presentation and charts.

I have three general reactions:

1) I do not accept your criticism of forecasters based upon the 2007-09 period. There were specific consequences from the fall of Lehman, starting with a complete cession of lending. I have an earlier article on this topic where I suggest that it is like forecasting an earthquake. You would not use that important but low probability event as part of a model forecasting traffic in San Francisco, for example. Alternatively, do you have your own forecasts? What forecasting method do you prefer?

2) Even if the consensus forecast is a little high, we are still well between the golden goal posts. Meanwhile, you should note that only half of the stimulus money has been spent so far, so it is not over. I did not find Mish to be very persuasive on government.

3) There is a big gap to make up, and your panel did an excellent job of highlighting that point. As a public policy/poli sci specialist, I am making observations about how our political system "works". Mostly it is slow to address problems because it is democratic. You and I cannot just huddle up and agree on solutions. I think that the expiration of the Bush tax cuts will force some horse trading. I also think that social security changes will happen only with an outside commission leading the way. It has worked before.

At some point we'll have a higher retirement age and various adjustments to health care.

Thanks again for your comment, and for your excellent presentation at the conference.

Jeff

[Ken Houghton]

The OECD economists, and the 53 pros in the WSJ survey are constantly following the markets. They know about and have considered every "headwind" identified by your favorite bearish pundit.

Uh huh. That's why those OECD/WSJ predictions were so spot on from late 2007 and up through the third quarter of last year.

Don't get me wrong. I would love to see 3%+ real growth--it's rather essential, and even rather low for a "recovery period." But the algebra doesn't bear it out.

_I_ is muted by cash-hoarding and banks holding mispriced assets not being willing to lend. (they may be mispriced, but the banks don't believe the marks either.) And that's ignoring the lack of demand, which brings us to

_C_ -- Debt ratios are improving, but that appears to be mainly because of forgiveness/writeoffs, not savings. And you can't increase consumption if you can't spend savings.

_G_ - So far, the stimulus has balanced to cuts in state/local governments (ask, for instance, TX, which turned a $9B deficit into a $12B surplus). But there won't be a Federal stimulus this year, and the requirement of a balanced budget remains a requirement in 47 or 48 of the states. Even if there is a recovery, the "hangover effect," plus the lack of remaining "rainy day" funds is going to drag this one. Which leaves

_NX_ - Devalue the dollar? Great idea. Except that (1) others will try to do the same, (2) the "safe haven" argument abides, and (3) the other major areas are either in worse shape near-term (EUR, GBP). (Hans-Werner Sinn, one of the perennial OECD/WSJ economists, told me about a year ago how great the Spanish banking system was doing in the face of their own silly homebuyer lending. Anyone think he still believes that?)

On balance, _I_ will go up some; has to. _C_ will probably go up some, just because of how far it dropped. _NX_ has a possibility of coming back some if the rest of world calms down a bit. _G_, as Mish noted, is problematic at best: the places that are in the most trouble are the largest economies (e.g., CA, IL, FL, NY, NJ) with some that were getting support (TX, AZ, OH, MI, GA) likely to suffer more this year. And most of the others (IN, MO, NV, etc.) aren't exactly driving growth.

You can get 3.0-3.2% growth out of that (ballpark 2.5% I, 2.0% C, -0.5% NX, -1.0% G) if a lot of things break right. But it's not the way to bet at even odds, and it's a weak recovery at best.

Can you balance the budget, keeping most of the Bush tax cuts and leaving Medicare Part D intact? Last time I looked that was about a 2.5% of GDP gap. The surpluses run at the end of the Clinton Administration weren't that large, and the 2001 and 2003 tax cuts took GovtRevsas%GDP down around 1.5-2.0% (spending went up even more, to 2006).

That's a big gap to make up, even after you argue that the subsidies from the SocSec and Medicare tax increases are just "part of the Unified Budget" when they are surpluses but "something we have to cut" when there's a good chance they won't be.

[Mike C]

Wanted to add this thought. I've spent countless hours thinking about the inflation/deflation question in the context of the overall debt level. Absent moves by government and central banks, I have zero doubt the natural tendency of the system would be for a massive deflationary drop with massive debt default. That would be the natural equilibrium for a system that piled this much debt the past 20 years which leads me to my next point...

I had asked you the likely policy response in a previous question because I think governments and central banks will face the same dilemma a number of times as fall 2008 so I really am very interested in knowing what they WILL do, not what they SHOULD do. They probably should follow the Carnegie approach of "liquidate it all, purge the rottenness" from the system but from reading you consistently I've come to believe that is 0% probability. Everything possible will be done to reflate the system.

Ultimately, that is very, very bullish for gold long-term. We are in the same geographical region, so I owe you a very high-priced dinner if I make as much money on gold as I think I will because it will be the belief in the policy response that keeps me this bullish.

[Mike C]

Very witty title and excellent note.

As Cam points out the market might swing dramatically between inflationary and deflationary expectations depending on how government fiscal and central bank monetary policy plays out. BTW, in my humble view, you really should consider adding him to your list of recommended blogs. My must read list is pretty short (about 15 names) and includes both him and you.

David Merkel has talked about bicycle versus table stability. I think we are in an era of bicycle stability and politicians and those in authority will do everything possible to keep the wheels turning (as you have pointed out very well). Whether they succeed is another matter entirely. As a single datapoint, it looks like housing is beginning to collapse with the expiring of the tax credit. What is next in the bag of tricks to stimulate housing?

History shows gold does well in both deflationary and inflationary times (30s and 70s). Homestake Mining was one of the best stocks of the Great Depression. Gold does terrible during periods of stability. Gold lost 3/4 of its value during the "Great Moderation" from 1980-2000.

Having a MODERATE allocation to gold in the current environment probably makes sense given the uncertainties on how all this will play out the next 5-10 years, but it would be NUTS to go to 0% in stocks and 100% gold. Personally, I think vice versa is close to as nuts.

Aside comment. Most blogs have an option to check to get e-mails on responses to comments or subscribe to comments. This would be a nice feature if possible so one could see the conversation develop without having to check back at the blog page.

[oldprof]

scm0330 - The story in Illinois is similar. Maybe worse.

But this is not an article of optimism, but one of realism. All I said was that we will probably avoid the worst cases, have modest economic growth, do some compromising on tax increases, and eventually cut entitlements.

The fact that this seems optimistic to you is evidence for my point about the intensity of fear and pessimism.

Just a thought ---

Jeff

[scm0330]

I wish I were so optimistic. Our federal government (and yes, we the people who vote the turkeys in) got us here. What has changed about the political system, its inhabitants, and its processes, to make you think we can reverse course, particularly when the policy model of "buy now/pay later" (health care, SS, Medicare, public pensions) is so rampant. I live in NY, renowned for its statehouse dysfunction, and while the state teeters with a late budget and epic fiscal mismanagement the warring parties still fight for the wheel as the car heads off the cliff. No one can bring themselves to slow the car down, agree on a change of course, etc.

[Humble Student]

I have thought extensively about the inflation/deflation policy dilemma and I agree with the poltical agnosticism stance as it is helpful for understanding policy.

However, as an investor I believe that the markets are fragile and sentiment likely to swing wildly between inflationary and deflationary expectations. Under those circumstances a trend following model can be useful in this kind of environment. See http://www.qwestfunds.com/publications/newsletters_pdf/newsletter_november_2009.pdf

[jdb]

Wow. This is so helpful. I don't have any other place to go where I can get such a balanced approach. One that includes the nature of and effects of public policy.