Deficits and Inflation
There is a great Saturday Night Live skit from a few years back called “Dont Buy Stuff You Cannot Afford.” .
The general premise for those of you who dont have time to watch the video is a guy selling a great new financial book to help people get out of debt. The name of the book shares the name of the skit mentioned above.
The reason I mention this skit is it is something that is regarding a subject matter that permeates many facets of our lives today. Over the last 20 years or so, our culture and financial system has promoted the 0% down no payment for 36 month plans, the no interest for 5 year-no documentation required mortgages, the $10,000 credit card limits for 18 year old college students with less than 10k a year in income, etc. For the most part, our government has adopted the same mindset since around 1950. My aim today is to highlight the problem, point out the solution, and more importantly evaluate our options as investors.
Throughout our history as a country we have gone through many ups and downs politically and economically. Along with these ups and downs we have gone through periods where the government has had to borrow money to make some things happen, and we have experienced periods where the government did not have to borrow money and we were able to pay down our debts. Currently we owe more than 300% of our annual earnings. While we spend more and more money that we don’t have, we are also increasing the money supply to unprecedented rates. The Money supply has increased at least 100% in the last year. The chart below shows us our history with debt since 1920.
You will notice from this chart that we have been able to pay off debts in the past. For example going into WWII our countrie’s Total Debt was near 300% of what it earned annually. Starting at the end of WWII our income as a country skyrocketted as most of the world depended on us for goods, and we were slowly able to reduce our debt.
Our history also includes periods of tough economic decisions because of debt. When Paul Volker took the helm at the Federal Reserve in 1979, we were facing an enormous National Debt. The only solution to the debt problem was determined to be to earn more or spend less. In this particular case both options were determined to be necessary. Taxes (while first decreased by Reagan) where quickly increased to increase the national revenue and government spending was quickly cut. The combination of these two things allowed us to begin reducing our annual deficit. However, the country was also experiencing significant inflation at this time.
You see, when we create money out of thin air by changing monetary policy we are putting ourselves at risk for inflation. If an orange costs $1 today and there are $100 for people to spend then the orange is priced relative to the $100 people have to spend. If there are now $200 for people to spend and nothing whatsoever has changed demand wise, then that orange should be priced at $2 because it is still priced relative to what people have available to spend. You may ask how did we go from having $100 available to having $200 available. Well, the answer may surprise you. We simply said there is now $200 available to spend. If this sounds illogical its probably because it doesnt make any sense. How can we simply say we now have $200 to spend? Well, the answer is simply because the Federal Reserve controls the printing of money in this country and are assigned the task of managing the flow of money.
We are now in the position of having very large annual deficits, an enormous national debt, and an ever-increasing money supply. So what do we do?
A. What can we anticipate until we do something about this?
1) The value of the dollar should start to go down.
2) Inflation should start to increase
3) We will have to start paying higher interest on our debt as we become less attractive because of our high debt.
–How does this affect us investment-wise?
We should anticipate increasing inflation over the next 3-5 years. Investment-wise we should move away from CD’s and Money Market accounts and look at Treasury Inflation Protected Securities. (TIP, VIPSX, www.TreasuryDirect.gov)
We should anticipate increased taxes on income, investments, and anything else possible over the next 3-5 years. While this will hurt in the short run, it is a definite need in the long run. We can not continue to reduce taxes while spending more. What we have effectively done in the last decade is equivalent to a business owner who is making 200k a year and has expenses of 215k a year increasing his expenses from 215k to 230k and reducing his income from 200k to 150k and assuming everything was going to work itself out. Its just not going to happen.
B. What is the solution?
1) We have to increase taxes to be able to pay our debt.
2) We have to reduce spending so that we have more money left to pay the debt.
3) We have to increase interest rates to be able to continue to borrow money in the short run.
So the conclusion of this blog for the time being is
1) expect all of the things in Item B to take place in the next 3-5 years. They have to. If they do not happen, we have a big debt problem that will be almost impossible to tackle.
2) being prepared for the above items allows us to make good investment decisions today to take advantage of those potential changes.
With all of that said, these are just the thoughts of one person. I do not claim to know everything there is to know about the topic. I would recommend you talk to your financial professionals before making any decisions.
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