Saturday, June 19, 2010

Breakfast With Dave

¹²Breakfast With Dave

By David A. Rosenberg | 18 June 2010
Chief Economist & Strategist Economic Commentary

An Intractable Fiscal Problem
We get it. The United States is not Greece. Nor is it any European country. It is the U.S.A. We get it. Best political system. Best economy. Most ingenuity. Reserve currency. We get it. And, the U.S. is never going to default on its obligations because it is, in fact, the world's reserve currency and as such has full control of the printing press. And, nothing above was meant to be facetious.

As hedonistic as it is, the U.S. economy is the most flexible and adaptable economy, and for a whole host of reasons. At the same time, the national balance sheet is grim. The national debt/GDP ratio is about to pierce 100% and that does not include the state/local government morass nor the wave of off balance sheet items and underfunded liabilities, which would then take that ratio north of 500% (also see Gillian Tett's article in today's FT— Look at State Finances for the Real U.S. Budget Squeeze). That is the grim truth.

Even with low interest rates, the massive debt bulge has become so large that interest charges on the public debt are within three years of absorbing over 30% of the revenue base, which then makes it that much tougher to reverse course. In other words, the fiscal problem is becoming increasingly structural and we are already at the stage where even if the economy were running flat out at full employment, the deficit would still be over 7% relative to GDP. At some point, this will begin to impede economic progress.

When you add up the entitlement programs, you know— the ones you can't cut back on— and interest payments on the grotesque debt load, we have 65% of total government spending that can't be touched. In the next decade, under 'status quo' policies, this "mandatory" share of the spending pie goes to 72%. Tack on the defense budget, my friends, and we are up to 88% of federal government outlays that are next to impossible to reverse. So tell me— we are going to reverse this seemingly intractable runup in the public debt to GDP ratio by slicing the 12% of the spending pie that is 'discretionary'? It [wouldn't] be enough, even if all that 12% remainder 'pork and barrel' spending were eliminated altogether.

So guess what the future holds— higher taxes: very likely a national sales tax. It works in Europe. It has also worked in Canada. Japan is planning to double its national sales tax from 5% to deal with its fiscal challenge (see page A11 of the WSJ). It stands to reason that a federal consumption tax will have to be part and parcel of any U.S. strategy to solve what is increasingly becoming an intractable budgetary deficit. The only question is when, and which politician is going to have the kahoonas and face the nation with the fiscal realities of the present and future.

Deflation Dynamics
It truly amazes us how so few people in the business get it. Everyone has inflation on the brain because everyone has spent his or her entire professional lives living with it. Or maybe because the double digit inflation rates of the 1970s and the 1980s are seared in everyone's memory.

Go back and read the Homer and Sylla classic on the History of Interest Rates. Outside of wars, deflation is the norm, not the exception. [[But that's only under a 'hard' money currency regime.: normxxx]] The exception has been the experience of the post-WWII era. The U.S. inflation rate peaked in 1980 at nearly 15%. By the summer of 2007, it was down to 3%. It had gone from 15% to 3% even though the baby boomer balance sheet exploded. The aggregate nonfinancial debt-to-GDP ratio surged from 135% to 220% over this timeframe, and yet the inflation rate collapsed by 12 percentage points. The reason were all due to classic supply-related shocks— globalization, capital deepening, massive gains in technology, productivity, freer trade, lower marginal tax rates, which spurred the trend towards secular disinflation.

However, in mid-2007, the secular credit expansion came to a thundering halt. Deleveraging is the new secular trend, and since we entered the other side of the credit mountain, the inflation rate is down to 2% and the core rate of inflation is 90 basis points south of zero. Imagine that— when the oil price was at $10 a barrel back in 1998, the core inflation rate was 2.5% and today, at $75 a barrel, the rate is below 1%. Now that is a deflationary stylized fact, if there is one.

U.S. CPI: Boring On The Surface But Deflation Pressures Lurking
Yesterday's CPI data was very tame with total CPI falling 0.2% MoM in May (as expected), taking the year-over-year rate down to 2.0%. There were no surprises either with core CPI (excludes food and energy), rising just 0.1% on the month, keeping the annual rate at 0.9%, the lowest since the mid-1960s. While the headline was on the boring side, there was a distinct deflationary undercurrent in the details, which we expect to continue in the face of a terribly weak housing market and an economy that is operating with considerable slack.

Philly Fed: Employment Details Worrying
One of the early June reads on the regional state of manufacturing was disappointing, with the Philly Fed Business Outlook Survey falling to 8% from 21.4%, the lowest in nearly a year. This suggests that manufacturing activity is still expanding but at a much slower pace.

Key Jobless Claims Data Point To Softer Private Payrolls
We watch the weekly jobless claims numbers each week with interest but yesterday's numbers were especially noteworthy given that they coincide with the reference week for June payrolls. Initial jobless claims for the week rose 12k to 472,000, missing expectations while the four-week moving average ticked down to 463,500.



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