The Boy That Cried Wolf

Something has been on our minds for a long time, and we have occasionally danced around the issue on these pages, but we always feared being “the boy that cried wolf”. Those fears are unfortunately subsiding.

Why the change? Mostly because financial luminaries are now beginning to make their voices heard on the issue of rising fiscal deficits and Federal debt (see below). For these people to speak out implies that the issue has become urgent. Congressional Budget Office Director, Phillip Swagel, recently testified before the Congressional Budget Committee in a continuing effort to start a Debt Commission to study the debt issue. The problem is that Congress is not ready to toe the line and a Trump or Biden Presidency is no better. Unless that changes, we will continue to head into the abyss until something cracks and politicians are forced to re-discover fiscal religion.

“I do believe we need to reduce deficits and to stay on a fiscally sustainable path” Janet Yellen

Fed Chair Jerome Powell said on 60 Minutes ”In the long run the U.S. is on an unsustainable fiscal path… It’s time for us to get back to putting a priority on fiscal sustainability and sooner is better than later.”

In a recent Bloomberg interview Former Treasury Secretary Robert Rubin said the nation is in a “terrible place” with regard to fiscal deficits.

Citadel founder Ken Griffin told his investors US national debt is a “growing concern that cannot be overlooked.”

Bloomberg quotes Blackrock CEO Larry Fink as saying that the US public debt situation “is more urgent than I can ever remember.”

Bloomberg also quotes former IMF chief economist Kenneth Rogoff as saying that an exact “upper limit” for debt is unknowable and there will be challenges as the level keeps going up.

Current CBO Director Phillip Swagel “I’d like to think there is a broad awareness that we face a serious problem…even with the strong economy you have in mind, we still need to take action to adjust our fiscal trajectory” (We highly recommend that you take 5 minutes to watch a segment of his testimony in What We’re Reading and Watching below.)

Gradually, Then Suddenly

Ignoring the debt problem is a dangerous game because trouble can be perceived to be far in the future when reality suddenly hits. In The Sun Also Rises, Hemingway’s character is asked how he went bankrupt. “Two ways,” he answers. “Gradually, then suddenly.” This describes the debt problem quite well. We can ignore it, we can talk about it, we can expect it to be corrected, but if it is not, eventually a tipping point is reached and that point is typically reached without much warning.

The concerns expressed above are concerns that the tipping point is uncomfortably close. We don’t expect that the U.S. will reach that point, largely because before that happens, we expect markets to push back, meaning that the market will raise rates well beyond where the Fed desires them to be and force the powers that be to address the problem. Just ask Liz Truss.

In 2022, Prime Minister Truss announced deep tax cuts and billions of pounds of fiscal spending (read lots of new debt). The resulting budget gap quickly produced a sudden loss of market confidence in the British Pound, which quickly reached record lows against the U.S. dollar. After only six weeks, the Truss government collapsed, and Truss’s proposals were tabled. If Congress does not get its act together, such a moment can happen here as well.

Fiscal Arrogance

The U.S. dollar is the the most important of the world’s reserve currencies, a title given to the most stable of currency in the world. But the dollar’s position is gradually being eroded as the East attempts to move away from the dollar hegemony. Reserve currency status is not guaranteed, although the U.S. often acts as if it is.

Despite some very reasonable economic growth, the U.S. continues to spend substantially more than it collects in income. As shown below, after five months, the fiscal deficit this year is higher than every year except for the 2021 response to COVID. I can’t recall a period where the U.S. has experienced such a high level of deficit spending in an economy that was growing, except during a war. Economics 101 tells us that deficit spending is a tool the government uses primarily when there is a need to spark an economy out of a recession. The problem today is that the recession is over, if there even was one in the first place. Still, the deficit spending continues to grow. Historically, this is a very odd occurrence. The government has lost its fiscal responsibility and the voters do not seem to be concerned, but they should be.

The federal debt and deficit spending are old problems, in fact, it is another ‘boy cries wolf’ story, at least so far. But this old problem is getting more attention because the debt expanded so dramatically due to the massive COVID response in 2020-21. We returned to more ‘normal’ (we use the term loosely) deficit levels in 2022, but since then deficit spending has ramped up again, despite reasonable economic growth (see chart below – red circle).

The chart below also demonstrates that historically, deficits have grown in response to recessions (depicted by the red bars), and have receded as the economy recovered. All that changed around 2015 when deficit levels began to grow without the trigger of a recession. Post pandemic, the truly massive deficit did decline, but only briefly and it has begun to grow once again, without the trigger of a recession. At some point, we will have another recession, and if we do, the debt could quickly explode even higher.

Historically, entitlement programs (Social Security, Medicare, etc.) get the bulk of the attention in the debt discussion, but recently, interest expense, a function of higher interest rates, has also become a hot button issue. With rates where they are now, U.S. interest expense is annualizing at more than $1 trillion per year. To put that in perspective, it is more than the entire defense budget. If rates stay high and we continue to spend at the current pace, the problem gets very big, very fast.

The Fed would like to lower rates, which would help the situation, but inflation is a bit stickier than hoped and the economy appears stronger than they expected. Rate cuts may not come until after the election. Although it is difficult to see precisely how thin the ice is, it is clearly getting thinner. Deficit spending requires more debt issuance to close the gap and the debt level begins to compound and feed on itself.

The graph below shows how we got to a $1.7 trillion deficit for 2023. Mandatory spending is spending that is already passed by Congress, like Medicare and Social Security. In addition to that, the U.S spent $700 billion on interest expense. When you combine these two items it is roughly equivalent to U.S. revenue (mostly tax receipts). We had to borrow $1.7 trillion to fund all the discretionary items in the budget, defense being the largest portion. And the deficit this year is running ahead of 2023. We have a problem and it is growing fast.

What Can Be Done?

The ideal way to manage the debt problem is to grow the economy faster than the debt, something we have not been doing for quite some time. AI has plenty of promise for productivity gains and more rapid economic growth, but it is not clear how soon that might occur. There are signs that productivity has improved recently, but this by itself is not a solution. If the U.S. is to get started on a path to a sustainable or manageable debt level, it needs to get started soon. There is no quick fix, but we first need to raise public awareness that we have a serious problem. Only then can politicians view a fiscal fix as a winning strategy to get re-elected. Then, and maybe only then, will we stop moving in the wrong direction and start moving in the right direction, but we are a long way from there right now.

Reaching debt sustainability will be highlighted by changes to entitlement programs as well as higher taxes, especially on higher income earners. Social Security is long overdue for revision. Regular Social Security payments began in 1940. If you were 65 years old in 1940, you were born in 1875. The life expectancy of someone born in 1875 was about 40 years. Obviously, if you made it to age 65, you had already surpassed your life expectancy by 25 years! The cost of paying that person was not significant.

Someone born in 2024 has a life expectancy of 83 (men) to 87 (women), yet the age to collect a full Social Security benefit has only risen to 67. Life expectancy generally gets longer and if that trend continues, a ‘retirement age’ of 67 seems increasingly unreasonable. The rules for younger generations to collect Social Security need to change to reflect these realities, yet Congress has consistently declined to take any action. Medicare changes are also going to be required but suffer from similar problems. Reducing entitlements is not a winning political strategy, yet it is one that must occur.

These issues currently appear intractable, and unless we come up with the fortitude to address them in a reasonable way, we may experience our own Truss moment before we finally respond. That will be unpleasant and we can only hope that is as bad as it gets.

Are there hedges for bad outcomes? Absolutely, and gold is at the top of the list, with silver not far behind, which is one of the reasons we continually hold a portion of the portfolio in gold, albeit small. Bitcoin may also become an alternative. It’s hard to be sure of that with such a short history, but it could become any port in a storm if the US does not become more fiscally responsible.  We are not heading for the hills, but we are raising the topic to let you know it has risen to a higher level of concern and we continue to track progress, or lack thereof, for our investors.

Have a great week!

What We’re Reading and Watching

CBO Director Testimony to Congressional BudgetCommittee – February 14, 2024 (5 min video)  

Yes, the East Coast has Earthquakes

Another hot jobs report jolts Wall Street, jeopardizing rate cuts during election year

US Critical Materials makes gallium discovery at Sheep Creek in Montana

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By: thinkhouse