YCG Investments
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The National Debt Road Trip

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Federal debt is out of control. We’re all well aware that unemployment is rising and capital gains are becoming capital losses as the stock market falls. What’s this translate to? Plunging tax revenue – it dropped 34 % over the past year to $138 billion – the biggest decline in 28 years. At the same time, following Keynesian economics, the government is becoming the spender of last resort through a huge $787 billion stimulus package (and I would bet there will be more stimulus packages on the way) and purchasing more “toxic” assets. To fund the difference, in part they are increasing taxes which will discourage investment (and in turn real growth) and also take money out of the free market to be inefficiently allocated by the government. But mainly, to fund the deficit, they are financing by selling future tax revenue, i.e., issuing more debt. They are increasing debt faster than you can finish reading this sentence. My brother sent me a really funny, informative, and frankly scary clip on YouTube that illustrates this point: The National Debt Road Trip.

Currently, U.S. national debt totals about $11 trillion (this doesn’t include the off-balance sheet entitlement liabilities and “investments”), which represents about 80% of GDP. The U.S. annual deficit has been about $400 billion and is now estimated to balloon to a $1.7 trillion budget gap for 2009 – a couple more years of this and debt to GDP will rise to over 100%! Can you imagine if the U.S. represented an individual going to the bank seeking out a loan? They’d laugh in that person’s face. This begs the question, who’s going to buy all this debt from us?

For years, the U.S., has been seen as a safe investment and thus has been able to raise money via treasuries at low rates. As debt to GDP skyrockets, America’s investment grade rating will certainly drop. At what point will foreigners demand higher rates sending inflation upwards? The Chinese, the largest holder of U.S. treasuries ($768 billion), have already expressed concerns and have stated their willingness to search out other avenues for reserves. They are suggesting the world adopt a new international reserve currency.

Thus, it seems the government is going to be forced to print money, which is exactly what they’re doing. The U.S. monetary base has more than doubled over the past year!

Eventually, this debt will need to be paid, and I don’t see fiscal surpluses surfacing anytime soon. We would need to see real economic growth coming from all this government spending and we would need to see the mortgage assets the government has purchased in exchange for this debt to be worth more than what they paid, otherwise we will have only compounded the deficit problem. Thus, the only option I think the government will have to be able to cover all this interest expense and actually extinguish the maturing debt will be to issue more debt. Interest rates will then increase (either because foreigners demand it to compensate them for the risk of default or because the government buys their own debt by increasing the money supply) and this starts a debt spiral where they need to issue more bonds to cover increasing interest payments.

The Fed is not stupid. It recognizes the inflationary pressure it’s creating and Bernanke says they stand ready to reign in the money if inflation becomes a problem. But I don’t know if he has the tools. Even if he did, I don’t think he has the guts to stop inflation if it risks an economic recovery…I believe he’d rather inflate us out of the problem. I’m not implying major inflation is coming tomorrow. In fact, with unemployment rising and consumer spending slowing, deflation is likely in the short-run. But we can’t assume this will be a deflationary depression like the Great Depression. Remember, that era began with little debt. This is more reminiscent of Germany in the 1920’s who had a depression in combination with high debt which led to hyperinflation. Right now gasoline is being poured all over (money supply increasing), and eventually a match will light (monetary velocity increase).

I just can’t see how we’re going to get out of this mess without inflation. It seems increased taxes are inevitable, for as Milton Friedman put it, “Inflation is taxation without legislation.”

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | July 14, 2009 | Permalink

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