A Debt Deal That Will Not Change Anything

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Congress approved a last-minute deal to raise the U.S. debt limit.

Congress approved a last-minute deal to raise the U.S. debt limit and avoid a catastrophic, technical debt default. The deal will raise the U.S. debt limit by at least $2.1 trillion and significantly cut Federal spending in coming years. Agreed-to spending cuts will amount to at least $917 billion over the next 10 years. On top of that, a Congressional committee will work out a plan that would cut the deficit by an additional $1.5 trillion. The additional funding provided with the increase of the debt limit should give the U.S. government enough funding to operate until 2013, which means that a new debt deal needs to be made after the next election.

It was a very intense battle between Democrats and Republicans, and the possibility of a debt default created a lot of uncertainty in recent weeks. This uncertainty was felt very directly in financial markets and caused global stock markets to move lower and the U.S. dollar to lose further ground against most major currencies. With the debt deal now in place, can we expect a recovery rally in the weeks ahead and hope that everything will be just fine again? What is needed to improve things in the long run?

 

One-Year Chart for DOLLAR INDEX SPOT (DXY:IND)
US Dollar Index

Unfortunately, there are a lot of factors that suggest we have to be prepared for more market volatility and economic uncertainty. The problem is, in my opinion, not so much the debt limit and the spending cuts that now have been agreed to. The main problem is that the latest battle about the debt limit has caused severe damage to the confidence international investors have in the U.S. This comes at a time when the need for foreign investment and capital is bigger than ever before.

Also, it seems that neither Republicans nor Democrats are truly happy about the deal negotiated, although each party tries to sell it as a victory. But clearly, the spending cuts are not enough for Republicans, and Democrats are not happy because there are no tax hikes included in the deal.

While the problem can be viewed from different angles, the actual public debate about how to solve the debt limit problem is what’s causing real economic damage. For a few weeks, investors around the world kept their eyes on the U.S. debt crisis and the political fight about it. Raising debt limits is something that has happened many times in the past few decades. Just since the early 1960s, this happened more than 70 (!!) times, and most of the time it was not a big deal. But this time it was a different situation. The sheer debt number, which has now exceeded $14 trillion, is scary enough; but it always needs to be seen in the overall context, that means in comparison to the size of the gross domestic product. Here, the story gets really alarming.

The size of the overall Federal debt has now exceeded the size of GDP and continues its strong upward trend. It is now approaching levels not seen since the late 1940s. In the ’50s, ’60s and ’70s, the size of the debt burden fell to levels of less than 40 percent of GDP, but since the early ’80s, this trend has reversed. The only time since then when the debt level (as percentage of GDP) was falling was in the late ’90s, primarily driven by strong economic growth.

The current debt level ranks among the highest in the world. Of course, there are other nations that look even worse — for example, Japan (225 percent); or economic heavyweights such as Saint Kitts and Nevis (185 percent), Lebanon (150 percent) or Jamaica (123 percent). Other major economies such as Germany and France do not look much better with debt levels of about 80 percent. The difference to a country like Japan is that most of its debt is being held by Japanese investors; therefore, it is able to finance that debt domestically. Also recently, China has started to make significant investments in Japanese government bonds while cutting back heavily on its purchases of U.S. Treasury bonds, a further indication that investors are becoming reluctant to buy additional U.S. debt.

Despite the fact that the U.S. debt deal is a step in the right direction, the problems are far from over. The deal reached now is not perfect, but it was the best possible compromise that could be made given the current circumstances. But in the future, further spending cuts will need to be made, and the debate about future tax increases will most likely be the next big battle in Washington. The problem now is that the increased spending cuts will hurt the economy even further at a time when the economy is not able to generate enough jobs and prevent the jobless claims from going up. Also, private households are in a long-term process of deleveraging, which will keep consumption growth at moderate levels.

In order to bring down the unemployment rate, the economy would need to grow at a rate of at least 3.5 percent. Right now, it looks like GDP growth is going to drop below the 2 percent mark in the near future, possibly dropping back to zero later next year. A lackluster economy will also result in lower tax income, which will make it harder for the government to service its debt.

How can this problem be solved? Is it even possible to do something about it? In my opinion the answer is “yes.” This situation can be improved dramatically in the next 10 years, if Republicans and Democrats work together to define and execute a plan that makes sense economically and truly works in the best interest of the people. The problem with the current discussion is that very few people differentiate between spending and investment. Investment means spending money on something that adds true economic value over time. People are willing to pay taxes, but they need to see benefits for it in return. Foreign investors will keep lending money to the U.S., but they need to see that this money is spent wisely and not just wasted.

For example, let’s look at the enormous cost of defense. The U.S. is currently spending about $700 billion per year for its armed forces. In total, the wars in Iraq and Afghanistan have cost almost $3 trillion in recent years and, at the end of 2010, almost 5 percent of GDP was defense-related spending.

 


Figures based on 2010 budgets (SIPRI)

That is more than 10 times what Russia spends on defense, although in terms of percentage of GDP, Russia spends more than 4 percent. Most major countries today spend between 1.5 percent and 2.5 percent for its armed forces.

 

Therefore, it is not surprising that a big portion of the agreed-to spending cuts come from defense, but even after these cuts the amount of money spent on defense is enormous. It is understandable that a growing number of Americans disagree with this spending policy and feel that money should be used to improve things at home rather than spending it on wars in countries like Iraq and Afghanistan.

While the U.S. is spending too much in some places, it is not investing enough for other items, especially infrastructure-related projects. Infrastructure is the kind of investment that tends to truly add economic value in the long run and provide benefits for everybody. Clearly, looking at the condition of today’s infrastructure (roads, bridges, electricity grids), it becomes obvious that there is tremendous need for such investments. Also, finding investors for such projects will be a lot easier.

What the United States needs is a sound long-term economic development plan, much like the Marshall Plan in the late ’40s. It has to be a sound economic development plan that cuts spending in areas that do not make sense economically and encourages spending in areas that result in true economic value long-term (infrastructure, education, etc.), and such a plan needs to be supported by both major political parties. The investment spending created through such an economic development plan would immediately provide benefits for everybody, increase economic activity and, therefore, also create jobs and eventually increase tax revenues without the need to hike rates. In order to work out and implement such a plan, Republicans and Democrats need to work together for the benefit of all Americans.

So, unfortunately, it doesn’t look like we see a strong positive market reaction to the announcement of the debt deal. The U.S. dollar is not recovering, and global equity markets are not rallying on the back of the news. The main reason is the lack of confidence people have in the future development of the economy. The deal reached now might look like a long-term deal to politicians; but from an economic point of view, it is another quick fix that fails to address the structural problems of the economy. For this situation, there are no quick fixes, only sound long-term plans. The execution of such plans will yield positive economic results in the future. Such a plan gives people a common vision of what can be achieved. This might be wishful thinking, but it’s the only real way to a better future.

–Daniel Zurbrügg

Daniel Zurbrügg

is the Managing Partner of Alpine Atlantic Global Asset Management, a Swiss-based independent investment management firm. The firm provides clients with independent investment management, asset protection and family office services and is the issuer of the global investment newsletter Echo From The Alps. With a global network of partners, Alpine Atlantic's aim is to provide clients with true "turnkey" solutions for global investing. Prior to setting up Alpine Atlantic, Daniel held various positions with other banks and financial companies. Daniel is a Chartered Financial Analyst and regular guest speaker at international investment conferences.