The deadline to raise the debt limit is now just a few weeks away.
Both sides have completed their focus groups, refined the key words they want to endlessly repeat (i.e. “millionaires and billionaires” or “corporate jets”), and have staked out their positions.
The winner in this battle will be, as in most political compromises, no one.
The eventual debt limit deal is doomed to completely fail. Sure, it will provide some short-term relief. Maybe it will even reduce the pervasive and growth-sapping uncertainty holding back GDP growth. But any positive benefits will be short-lived.
Whether taxes are raised, two or three trillion dollars of spending is cut, or some combination thereof, the eventual debt limit deal will in hindsight be viewed as a total failure because it will have failed to bring spending in line with tax collections.
Investors realizing this now – at the height of the debate - have the chance to position themselves to safely sidestep the consequences.
No Default Here
Although we don’t know much of what the politically inevitable debt limit extension compromise will look like, we can predict a lot of how it will all play out and the impacts of it all with a large degree of certainty.
The first and most critical thing to understand is there is no way the U.S. government is going to default.
Politicians are trying to make this dramatic as possible. They all want to be the hero of a last minute deal. As a result, they’re likely to take the negotiations to the last possible minute, but there will be no default for a number of reasons.
First, if there’s no deal, the interest can be easily covered by regular tax collections.
Second, you can’t believe the talking heads. Many of them are nothing more than fear-mongers claiming the government is on the brink of default if the debt limit is not raised.
They’re wrong. The real money (a.k.a. the bond market) isn’t buying it and you shouldn’t either.
As of Friday, credit default swaps (CDS) against one-year U.S. Treasury notes (the equivalent of an insurance policy against a default) was trading for 50 basis points. To put that in perspective, Ireland CDS last traded for 880 basis points and Greece CDS was 2,200 basis points. The U.S. CDS, valued a fraction of the countries truly on the verge of default, show the market sees very little risk here.
With the risk of default already eliminated, we should turn to how the deal will eventually come together.
Only One Way Out
The eventual debt limit increase deal will likely include spending cuts, tax increases, or some combination thereof. It’s too early to rule anything out (we’ve seen many times before what happens when last-minute “emergency” deals are made).
We do, however, have a basic framework for a deal for both spending and taxes.
On the spending side, we know they’re looking at cutting between $1 trillion and $4 trillion. The latest reports include $2 trillion in spending cuts over the next decade.
These cuts are from expected spending over a decade. So cutting $2 trillion is actually quite small. The $2 trillion cut works out to $200 billion per year. That’s only about 1.4% of GDP. Simply put, not much when the deficit is right around 10% of GDP. But it gets worse.
The tax side of the equation is much more challenging. Although it looks like tax hikes may have been avoided this time around, if and when they do come they won’t be helpful.
The populists have targeted tax increases on high income earners, oil companies, and corporations with private jets. These taxes, according to best-case scenario estimates, would generate as much as $1 trillion in additional tax revenues.
But the tax increases won’t provide the solution to bringing the deficit down to a reasonable level.
Alexander Hamilton, when writing in >National Priorities shows Hamilton’s predictions were absolutely right:
The chart shows that with the exception of two very special situations (the 40% annual inflation which “paid back” a lot of WW II debt and the surge in capital gain taxes during tech bubble, government revenues have never exceeded 20% of GDP.
The tax collection plateau of 20% of GDP held up when top marginal tax rates were at much higher levels. The government collected less than 20% of GDP when the marginal income tax rates were 90%, 70%, 50%, 28%, 31%, 39.6%, and 35%. It didn’t matter what the top tax rates were, tax collections never increased beyond 20% of GDP.
The chart also reveals where the real problem lies – in spending.
Spending as a percentage of GDP has been volatile over the last few years. It rose to more than 40% of GDP in WW II. It fell to less than 15% after the war. Recently, spending has surged to past 25% of GDP – a peace time record.
Given the size of spending cuts currently being negotiated, the government’s spending levels will remain well above the 23% of GDP threshold while tax revenues will be somewhere below 20% of GDP.
Of course, this is just part of the problem. There’s a much bigger one that most people won’t realize for a long time to come.
The Move to Make Now
If history is any example, the spending cuts will never reduce spending nearly as much as initially estimated. Many of the spending cuts will likely be so far into the future they don’t matter. Does cutting $2 billion from the food stamps program in 2017 really impact today’s budget?
Also, as proven above, any expected income from tax increases will fail to live up to expectations as well.
At this point though, the situation is not good. But we can see all this coming and get prepared for it now.
When it comes to the final deal, we expect it to include:
1. Future spending cuts – they will cut all sorts of spending in the “out years.” These cuts will only show up in estimates, but won’t result in any real spending cuts for years.
2. Tax increases offset by tax cuts – no one wants to increase taxes this close to an election. As a result, any increase in taxes will likely be offset by tax cuts elsewhere, i.e. tax hikes on oil companies coupled with tax credits for hiring new workers
3. Creative accounting (cost shifting) to lower levels of government – Washington won’t make tough decisions until they’re forced to do so. As part of the eventual deal, they’ll likely just force more costs onto local governments to make the governors and state legislatures the “bad guys” in all this. This way they can cut the federal budget without shrinking the totals size of government.
There are still a lot of wild cards that will be included, but the safe money is on a very bad deal that will be a complete failure over the long run.
Spending cannot continue to be at 25% of GDP (24% if $2 trillion in spending cuts are made) while tax collections remain at or well below 20% of GDP. Something has to give.
The ongoing gap between spending and revenues will be filled by debt. That debt, over time, will be inflated away.
Don’t let the surprise last-minute-saving fool you. The debt limit debate may be over soon, but the costs of it are likely to be paid for years to come by taxpayers, savers, and investors through inflation.
Good investing,
Andrew Mickey
Chief Investment Strategist, Q1 Publishing
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