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 January 2011 What About the Debt? The 111th Congresses' Spending Spree will Have Long Lasting Effects
But the one question that virtually everyone is asking is, “What about the debt?” The 111th Congress couldn’t create any jobs, but they surely created debt. The failed 2009 stimulus package, two extensions of jobless benefits, and the health care plan that will drive up costs for years to come all contributed to drive the national debt to unprecedented levels. Greece and Ireland were forced to turn to the European Union for assistance under similar circumstances, but the U.S. doesn’t have such a safety net.
So what's in store for 2011? Will the recovery pick up steam and finally cut into the unemployment rate? Will the Fed be able to terminate the "reflation" efforts before igniting the inflationary spiral? Or will higher interest rates dampen growth enough to produce a slow, sluggish economy? One thing's fairly certain: The national debt will play a major role in whatever occurs.
What We Know If a normal household found itself in this dire circumstance, it would be dire indeed. Long before reaching this point, all credit would have been cut off and foreclosure proceedings would be underway. But this isn't the case for the federal government because unlike poor private schmucks who have to live within their means, it can print money to at least temporarily meet its obligations.
That's precisely what the Federal Reserve is doing now. Although it's the Treasury that literally controls the printing presses, the Fed is accomplishing the same thing by purchasing virtually every dollar worth of debt issued by the government for at least the next three months. When the Fed buys Treasury notes and bonds (which are debt obligations of the U.S. government) on the open market, it's exchanging cash for government debt. It becomes a creditor of the government. This paper shuffle essentially monetizes the country's debt more effectively than the Treasury's printing presses ever could. And that's why some market watchers (generally the Keynesians among them) wave off any problem arising from soaring government debt. Instead they argue increased spending -- no matter how financed -- is precisely what is needed to prod the economy back to growth. They often cite the fact that as a percentage of GDP, the national debt really isn't that troublesome. They cast warnings or potential consequences as just more kooky right-wing spin. Perhaps most convincingly, they point to the previous peaks in the national debut and the fact that economic Armageddon never materialized. That may be pretty soothing, do you really believe it? Is it really possible for a nation to continuously rack up higher and higher obligations with no economic impact? That certainly wasn't the case for Greece and Ireland (and perhaps not Portugal and Spain, either), so why should it be true for the U.S.? Maybe it's time to separate what we know from what we're told to believe.
Different this Time? That's something we can only speculate on at this point, yet there are other things we can already see happening. For example, despite the Fed's best efforts to hold short-term interest rates down, the yield curve is beginning to steepen. This occurs when yields on longer-term Treasuries rise faster than those on shorter-term debt. On the one hand, you might not be too surprised by this given the Fed is focusing its efforts on the short end of the curve, yet even the specific securities it's targeting -- 10-year Treasury Notes -- are already seeing their yields rise. In December 2010 alone, the 10-year Treasury climbed over one percent -- a major movement in the generally staid bond land. The Fed may be getting a better deal from the lower prices (which move inversely with yields), but the primary goal of interest rate control suffers. The Fed is in uncharted waters with this program, and yes, that's something that's different this time. The housing market provides another key difference. Unlike recent recessions where housing prices remained relatively stable, this time they continue to languish after collapsing in 2008's financial crisis. The Fed's losing battle against the 10-year Treasury rate is even more discouraging when you realize that's the peg for the popular 30-year mortgage rate. As the 10-year Treasury yield rises, so does the cost of purchasing a home. That's not particularly good news for a market that's attempting to struggle to its feet -- and that's why it's so far failed. Here's a related problem for the housing recovery: It's inevitable interest rates will continue to rise. After holding at historical lows for over a year, even the Fed can't keep them down. Eventually -- and evidently sooner rather than later -- they will begin to return to more natural levels. But as they do, rising mortgage rates will make housing even more expensive. In addition, those who bought their homes when rates were near their lowest levels will have even less incentive to upgrade when loan costs are higher. With so many foreclosures and short sales still dominating the market, they'll have an even tougher time selling their existing home. In previous economic recoveries, home sales and prices held steady or even rose, this again is something that's different this time. Here's another difference: Banks aren't -- and indeed, can't -- lead the economic recovery. Historically, performance of the financials has been highly correlated with both the broad equity market as well as the overall economy. It only makes sense that the businesses that provide the fuel for growth would benefit most as the economy heats up. But today, many financials still carry the same soured debt they did when the credit market collapsed in 2008. Until that's finally purged, it will continue to act as dead weight on longer term performance. Sure, some financials did quite well last year, but 2010 is over and the initial bounce has ended. While it's true a widening yield spread will actually improve margins (borrow at low short-term rates, lend at higher long-term ones), it won't make much difference if financials are still trying to rebuild their damaged balance sheets.
It also won't help if no one wants to borrow at those higher rates. Few businesses will be interested if the economy continues to crawl along at its current sluggish pace. There's little need to borrow to invest in capital or increase production when no one's buying your goods. The global economic slump hurts here, too, given U.S. companies have become more dependent on international sales. In the past, a weak dollar -- a side effect of soaring debt -- would actually help increase exports, but this time our trading partners are less inclined to spend when they can't rely on the U.S. to buy their products. Unlike the U.S. consumer (and Congress), they realize they should be more frugal when times are tough.
About that Debt As rising rates hold the housing market down and prolong the time it takes for financials to clean up their problem loans, little progress can be made elsewhere in the economy. Yes, stocks posted a second consecutive surprisingly good year last year, but he odds are stacked against a third. Two years ago stocks were arguably oversold in the aftermath of the financial crisis. The rally of 2009 got them out of the depths and back towards fair value. Last year's climb -- particularly the fourth quarter run up -- was based on some real hope and change resulting from the mid-term elections. But now it's time for the next Congress to take over and it's unlikely they'll be much more courageous than their predecessors. They may be less prone to cause additional damage to the economy yet there's precious little they can do to help at this point. Given that, stocks look a little overbought. Arguably, most of the good news -- what we actually know rather than what we'd like to believe -- has already been priced in. At these levels, surprises are more likely to be negative rather than positive. There are times when stocks trade apart from their actual intrinsic value or even their anticipated future growth. Investor optimism (or pessimism) becomes overblown and shares are carried with it. Recently, the late 1990s was a good example of overly bullish trading while the collapse in 2008 demonstrated the opposite. After two years of double-digit gains, stocks are once again divorced from their fair value. You'd have to be extremely bullish about the prospects of a strong economic recovery to be an aggressive buyer at today's levels. Unfortunately, there's little reason for it. As long as structural problems remain in the financial and real estate market, it truly is different this time. You'd have to look back to the 1930s' Great Depression to find a parallel. This doesn't mean another depression lurks around the corner or double-dip bear market is at hand. What it does mean, however, is recovery will struggle along until the structural problems are corrected. The rapidly mounting national debt doesn't help, and indeed, poses another structural flaw that may haunt us for years to come. It took a decade before a sustainable recovery started from the Great Depression. Japan is still struggling to gain positive momentum in the wake of its 1990s financial crisis. The U.S. may be more lucky, but $14 trillion dollars of debt and counting certainly won't help. Search this site! Just enter you key word or words:
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S 2010 CAME TO A CLOSE evidence was mounting that the recovery was finally taking hold. Although the unemployment rate remained near its recession high, new jobless claims were on the decline. Surprisingly strong holiday sales indicated the consumer was not only ready to spend, but ready to spend heavily. The Bush era tax cuts were extended removing that potential drag from the economy. A more business-friendly Congress will also be a plus.
