Reno Hayek Symposium

These prognostications from John Mauldin’s weekly letter:

More and more we read about the growing concern over $1-trillion-dollar deficits. Stanford professor John Taylor (creator of the famous Taylor Rule) jumped into the debate with a rather alarming op-ed in the Financial Times this week, echoing much of what I wrote last week, but with some real insights into what trillion-dollar deficits mean. Quoting:

“I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO [congressional Budget Office] to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

“Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth — probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.”

You can read the rest at (http://www.ft.com/cms/s/0/71520770-4a2c-11de-8e7e-00144feabdc0.html?nclick_check=1)

While Obama gives lip service to cutting the deficit in half, his actual budget increases it over the next 10 years. As I have been writing for some time, this is a very dangerous path. And it is one that the bond market seems to be concerned about, as interest rates are rising, even on mortgages that the Federal Reserve is buying in massive quantities in its effort to hold down rates and stimulate the housing market.

“The good news,” Taylor concludes, “is that it is not too late. There is time to wake up, to make a mid-course correction, to get back on track. Many blame the rating agencies for not telling us about systemic risks in the private sector that lead to this crisis. Let us not ignore them when they try to tell us about the risks in the government sector that will lead to the next one.”

Taylor is right that the massive tax increases necessary to fund these deficits and programs should not happen. But it is not clear to me that they won’t. A Democratic Congress is talking of adopting John McCain’s plan to tax health-care benefits. While this would be a tax on the middle class (on everyone) that Obama said he would not do, he is clearly willing to sign a bill that has such a tax.

The administration is starting to float trial balloons about a new VAT, or value-added tax. Many of my non-US readers will be familiar with VAT taxes, especially in Europe. A combination of a VAT and taxing health-care benefits would raise enough to get us to a deficit of “only” a few hundred billion. Take away the Iraq war and you get even closer. You can make an economic case that a VAT tax would be preferable to an income tax.

However, the administration is not talking about a substitute but an additional tax. There is momentum in the heavily Democrat-controlled Congress for large new health-care programs. While there is resistance to large deficits on the part of a few moderate Democrats, there is a chance they could be brought on board with a tax or a series of new taxes that would offer the potential to pay for the new programs. (Even though everyone knows that the cost overruns on new health-care benefits will be much larger than estimated.)

As much as it grieves me to say it, a tax on health-care benefits or a VAT tax large enough to hold the proposed deficits to something under 3% of GDP would be preferable to running decade-long trillion-dollar deficits, which would destroy the US economy and the dollar and do severe damage to the world economy. (For the record, I am assuming the Bush tax cuts are history.)

But while a large tax increase would keep the economy from crisis and collapse, it is not without very serious consequences. It will put a serious crimp in economic growth. It will lock in European growth rates and European-like unemployment rates. And we will be using those tax increases to fund new spending and will still not have solved the future problems with Social Security and Medicare, which are going to require massive increases in spending in another 5-7 years. Which of course means that either a cut in benefits or another round of growth-crippling tax hikes is down the pike.

A third path would be to simply go ahead and raise taxes on the rich, say no to increased spending on programs until we can afford them, hold the line on any new spending, and see if we can reintroduce the gradual budget control that was the result of the stand-off (and to some extent cooperation) between Gingrich and Clinton.

I put about a 5% probability on the third scenario happening. Better than the chances of a snowball in hell, but not much. The first disaster scenario is about a 35% probability, which is quite scary. If we do choose such a path, then short the dollar, buy gold, and invest abroad. It will be a very tricky and difficult environment.

I assign a 60% probability to the middle path. Maybe it’s my basically optimistic nature and I am simply being naive, but I am hopeful that cooler heads will prevail and we will not run continual massive deficits larger than the growth of GDP. While that means rather large tax increases, since the current leadership wants to create massive new health-care entitlements and will do so, I would rather have to simply overcome higher taxes in my business rather than deal with a collapse of the dollar, high unemployment, high interest rates, and an extremely sluggish economy.

Each scenario will create a different investment environment. Ironically, the middle scenario could be good for the dollar over the long term. But it will be hell on corporate profits from US sources. Given the above, it seems like a 95% chance that we should start looking at investing a significant percentage outside of the US and Europe. Think Canada, Australia, Asia (not Japan), Brazil, South Africa, etc.

Normally, politics does not have all that much of an impact on the stock market. As an example, both Democrats and Republicans can take credit for the ’90s, but it was really the dynamic of the free market that worked in spite of government. Same for the Bush years. While the tax cuts did help, it was the free market and increasing leverage that were the dominating factors.

This time it will be different. The choices we make as to how to fund, or not fund, the increases in spending that are our clear and sad destiny, will have a major impact on not just the US but the world economy. As US consumers have been a major part of the growth of the developing world, and especially Asia (China), a slowing of consumption in the US will mean a very slow recovery for the rest of the world. It will happen, but the choices made by politicians this year will have many unintended consequences. Just as deciding we would take a major part of the corn crop and turn it into expensive ethanol raised the price of tortillas in Mexico, raising taxes in the US will mean lower global consumer spending and trade. It is a very tangled web we weave.