I
have an amnesia of sorts. I remember almost nothing of my distant past –
a condition which at the brink of my 69th year is neither fatal nor
debilitating, but which leaves me anchorless without a direction home.
Actually, I do recall some things, but they are hazy almost fairytale
fantasies, filled with a lack of detail and usually bereft of emotional
connections. I recall nothing specific of what parents, teachers or
mentors said; no piece of advice; no life’s lessons. I’m sure there must
have been some – I just can’t remember them. My life, therefore, reads
like a storybook filled with innumerable déjà vu chapters, but ones
which I can’t recall having read.
I had a family reunion of sorts
a few weeks ago when my sister and I traveled to Sacramento to visit my
failing brother – merely 18 months my senior. After his health issues
had been discussed we drifted onto memory lane – talking about old
times. Hadn’t I known that Dad had never been home, that he had spent
months at a time overseas on business in Africa and South America? “Sort
of, but not really,” I answered – a strange retort for a near
adolescent child who should have remembered missing an absent father.
Didn’t I know that our parents were drinkers; that Mom’s “gin-fizzes”
usually began in the early afternoon and ended as our high school
homework was being put to bed? “I guess not,” I replied, “but perhaps
after the Depression and WWII, they had a reason to have a highball or
two, or three.”
My lack of personal memory, I’ve decided, may
reflect minor damage, much like a series of concussions suffered by a
football athlete to his brain. Somewhere inside of my still intact
protective helmet or skull, a physical or emotional collision may have
occurred rendering a scar which prohibited proper healing. Too bad. And
yet we all suffer damage in one way or another, do we not? How could it
be otherwise in an imperfect world filled with parents, siblings and
friends with concerns of their own for a majority of the day’s 24 hours?
Sometimes the damage manifests itself in memory “loss” or repression,
sometimes in self-flagellation or destructive behavior towards others.
Sometimes it can be
constructive
as when those with damaged goods try to help others even more damaged.
Whatever the reason, there are seven billion damaged human beings
walking this earth.
For me, though, instead of losing my mind,
I’ve simply lost my long-term memory. It’s a damnable state of affairs
for sure – losing a chance to write your autobiography and any semblance
of recalling what seems to have been a rather productive life. But I
must tell you – it has its benefits. Each and every day starts with a
relatively clean page, a “magic slate” of sorts where you can just lift
the cellophane cover and completely erase minor transgressions, slights
or perceived sins of others upon a somewhat fragile humanity. I get over
most things and move on rather quickly. The French writer Jules Renard
once speculated that “perhaps people with a detailed memory cannot have
general ideas.” If so, I may be fortunate. So there are pluses and
minuses to this memory thing, and like most of us, I add them up and
move on. If that be the only disadvantage on my life’s scorecard – and
there cannot be many – I am a lucky man indeed.
The ring of fireIn last month’s
Investment Outlook I
promised to write about damage of a financial kind – the potential debt
peril – the long-term fiscal cliff that waits in the shadows of a New
Normal U.S. economy which many claim is not doing that badly. After all,
despite approaching the edge of 2012’s fiscal cliff with our 8% of GDP
deficit, the U.S. is still considered the world’s “cleanest dirty
shirt.” It has federal debt/GDP less than 100%, Aaa/AA+ credit ratings,
and the benefit of being the world’s reserve currency – which means that
most global financial transactions are denominated in dollars and that
our interest rates are structurally lower than other Aaa countries
because of it. We have world-class universities, a still relatively
mobile labor force and apparently remain the beacon of technology – just
witness the never-ending saga of Microsoft, Google and now Apple.
Obviously there are concerns, especially during election years, but are
we still not sitting in the global economy’s catbird seat?
How
could the U.S. still not be the first destination of global capital in
search of safe (although historically low) prospective returns?Well,
Armageddon is not around the corner. I don’t believe in the imminent
demise of the U.S. economy and its financial markets. But I’m afraid for
them. Apparently so are many others, among them the IMF
(International Monetary Fund), the CBO (Congressional Budget Office) and
the BIS (Bank of International Settlements). I hold on my lap as I
write this September afternoon the recently published annual reports for
each of these authoritative and mainly non-political organizations
which describe the financial balance sheets and prospective budgets of a
plethora of developed and developing nations. The CBO of course is
perhaps closest to our domestic ground in heralding the possibility of a
fiscal train wreck over the next decade, but the IMF and BIS are no
amateur oracles – they lend money and monitor financial transactions in
the trillions. When all of them speak, we should listen and in the
latest year they’re all speaking in unison.
What they’re saying
is that when it comes to debt and to the prospects for future debt, the
U.S. is no “clean dirty shirt.” The U.S., in fact, is a serial offender,
an addict whose habit extends beyond weed or cocaine and who frequently
pleasures itself with budgetary crystal meth. Uncle Sam’s habit, say
these respected agencies, will be a hard (and dangerous) one to break.What
standards or guidelines do their reports use and how best to explain
them? Well, the three of them all try to compute what is called a
“fiscal gap,” a deficit that must be closed either with spending cuts,
tax hikes or a combination of both which keeps a country’s debt/GDP
ratio under control.
The fiscal gap differs from the “deficit”
in that it includes future estimated entitlements such as Social
Security, Medicare and Medicaid which may not show up in current
expenditures. Each of the three reports target different
debt/GDP ratios over varying periods of time and each has different
assumptions as to a country’s real growth rate and real interest rate in
future years. A reader can get confused trying to conflate the three of
them into a homogeneous “fiscal gap” number. The important thing,
though, from the standpoint of assessing the fiscal “damage” and a
country’s relative addiction, is to view the U.S. in comparison to other
countries, to view its apparently clean dirty shirt in the absence of
its reserve currency status and its current financial advantages, and to
point to a more distant future 10-20 years down the road at which time
its debt addiction may be life, or certainly debt, threatening.
I’ve compiled all three studies into a picture chart perhaps familiar to many
Investment Outlook
readers. Several years ago I compared and contrasted countries from the
standpoint of PIMCO’s “Ring of Fire.” It was a well-received
Outlook
if only because of the red flames and a reference to an old Johnny Cash
song – “I fell into a burning ring of fire –I went down, down, down and
the flames went higher.” Melodramatic, of course, but instructive
nonetheless – perhaps prophetic.
What the updated IMF, CBO and
BIS “Ring” concludes is that the U.S. balance sheet, its deficit
(y-axis) and its “fiscal gap” (x-axis), is in flames and that its fire
department is apparently asleep at the station house.To
keep our debt/GDP ratio below the metaphorical combustion point of 212
degrees Fahrenheit, these studies (when averaged) suggest that we need
to cut spending or raise taxes by 11% of GDP and rather quickly over the
next five to 10 years. An 11% “fiscal gap” in terms of today’s economy
speaks to a combination of spending cuts and taxes of $1.6 trillion per
year! To put that into perspective, CBO has calculated that the
expiration of the Bush tax cuts and other provisions would only reduce
the deficit by a little more than $200 billion. As well, the failed
attempt at a budget compromise by Congress and the President – the
so-called Super Committee “Grand Bargain”– was a $4 trillion battle plan
over 10 years worth $400 billion a year. These studies, and the updated
chart “Ring of Fire – Part 2!” suggests close to four times that amount
in order to douse the inferno.
And to draw, dear reader, what I
think are critical relative comparisons, look at who’s in that ring of
fire alongside the U.S. There’s Japan, Greece, the U.K., Spain and
France, sort of a rogues’ gallery of debtors. Look as well at which
countries have their budgets and fiscal gaps under relative control –
Canada, Italy, Brazil, Mexico, China and a host of other
developing (many not shown) as opposed to
developed countries. As a rule of thumb,
developing
countries have less debt and more underdeveloped financial systems. The
U.S. and its fellow serial abusers have been inhaling debt’s
methamphetamine crystals for some time now, and kicking the habit looks
incredibly difficult.
As
one of the “Ring” leaders, America’s abusive tendencies can be
described in more ways than an 11% fiscal gap and a $1.6 trillion
current dollar hole which needs to be filled. It’s well publicized that
the U.S. has $16 trillion of outstanding debt, but its future
liabilities in terms of Social Security, Medicare, and Medicaid are less
tangible and therefore more difficult to comprehend. Suppose, though,
that when paying payroll or income taxes for any of the above benefits,
American citizens were issued a bond that they could cash in when
required to pay those future bills. The bond would be worth more than
the taxes paid because the benefits are increasing faster than
inflation. The fact is that those bonds today would total nearly $60
trillion, a disparity that is four times our publicized number of
outstanding debt. We owe, in other words, not only $16 trillion in
outstanding, Treasury bonds and bills, but $60 trillion more. In my
example, it just so happens that the $60 trillion comes not in the form
of promises to pay bonds or bills at maturity, but the present value of
future Social Security benefits, Medicaid expenses and expected costs
for Medicare. Altogether, that’s a whopping total of 500% of GDP, dear
reader, and I’m not making it up. Kindly consult the IMF and the CBO for
verification. Kindly wonder, as well, how we’re going to get out of
this mess.
Investment conclusionsSo I
posed the question earlier: How can the U.S. not be considered the
first destination of global capital in search of safe (although
historically low) returns? Easy answer:
It will not be if we continue down the current road and don’t address
our “fiscal gap.” IF we continue to close our eyes to existing 8% of GDP
deficits, which when including Social Security, Medicaid and Medicare
liabilities compose an average estimated 11% annual “fiscal gap,” then
we will begin to resemble Greece before the turn of the next decade.
Unless
we begin to close this gap, then the inevitable result will be that our
debt/GDP ratio will continue to rise, the Fed would print money to pay
for the deficiency, inflation would follow and the dollar would
inevitably decline. Bonds would be burned to a crisp and stocks would
certainly be singed; only gold and real assets would thrive within the
“Ring of Fire.”If that be the case, the U.S. would no
longer be in the catbird’s seat of global finance and there would be
damage aplenty, not just to the U.S. but to the global financial system
itself, a system which for 40 years has depended on the U.S. economy as
the world’s consummate consumer and the dollar as the global medium of
exchange. If the fiscal gap isn’t closed even ever so gradually over the
next few years, then rating services, dollar reserve holding nations
and bond managers embarrassed into being reborn as vigilantes may
together force a resolution that ends in tears. It would be a scenario
for the storybooks, that’s for sure, but one which in this instance,
investors would
want to forget. The damage would likely be beyond repair.
William H. Gross
Managing Director
