U.S. Government policy makers, not known for their grace, have a delicate balancing act to narrow the government deficit fast enough to prevent our economy from falling into a debt trap. A debt trap refers to the Hobbesian choice that if we do not reduce debt enough we will experience an extended period of much slower growth than historical norms and if we reduce it too fast we will fall back into recession. Neither outcome is appealing. Ten years ago total U.S. Government debt was $5.6 trillion. Today it is $12.2 trillion. The Congressional Budget Office estimates that it will rise to $17.4 trillion in 2015. Keep in mind that government spending is at a 50 year high relative to the size of the U.S. economy. And relative federal tax receipts are at a 50 year low. The consequence of that differential is a $1.4 trillion federal deficit in 2009 and an anticipated $1.3 trillion deficit for 2010. The decisions made this year in Washington will likely affect us for the next decade.
Professors Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard are about to publish an interesting study. They examined 44 countries spanning about 200 years covering numerous political systems, institutions, exchange rate mechanisms, and historic circumstances. Their findings conclude that there is not a positive correlation between government debt and economic growth. To the contrary, when public debt is greater than 90% of GDP (we are currently at 84%), average growth rates are reduced by 2%.
The results of this serious study confirm common sense conclusions and explain why we are seeing political push back against additional public borrowing. As government debt rises, policy responses slow economic growth. Eventually, taxes will increase and government spending will be reduced. Government debt service will go up dramatically. Ongoing deficits mean increased borrowing requirements. Additionally, interest rates currently subsidized by the Federal Reserve will normalize at higher levels and will also reflect a higher premium demanded by investors. Higher taxes, a reduced capacity by the government to spend on productive endeavors and higher interest rates will constrain consumption and private investment.
If we anticipate 2% GDP growth over the next decade, unemployment will be a chronic problem. 3.3% GDP growth is associated with a stable unemployment rate. Depression era programs to contain unemployment may become politically expedient, further delaying a required deleveraging to bring debt levels consistent with healthy economic growth. Fear of inflation arising from a combination of high growth and high debt seems premature in 2010.
So what should investors be looking at in a challenging economic climate? Investment models based on the last 30 to 40 years will not help. Last year?s dollar weakness, with favorable consequences for many risk assets, is likely to be replaced by dollar strength for a good part of the year, particularly if geopolitical concerns mount. A rising dollar will put a lid on commodities. Dividends, due to pressure from stockholders, will likely increase. A 3% dividend yield on the market, currently a quaint historical footnote, may regain its relevance as a healthy market indicator (it was 5% in the late 1970s). Volatility will likely be with us for some time, providing patient investors opportunities to pick up undervalued growth companies. There will also be selective opportunities globally, where some economies are healthier than in the U.S. and with better growth prospects.
However desirable, it is unlikely that our policy makers in Washington will strike that delicate balance reducing debt enough to promote economic growth without suffering through another recession. The odds favor an extended period of slow growth and high unemployment.