Creative Destruction Fund

Earlier this week, I wrote a blog post on the impressive performance of productivity in the U.S. business sector (see “More Like a Deflationary Boom”). I noted that business productivity growth was rising sharply again and this was a recipe for disinflation and outright deflation. Companies have been restructuring aggressively to cope with harsh economic conditions, and the restructuring, amid increasing liquidity in the global economy, is beginning to pay dividends in the form of higher productivity and profitability. Accelerating productivity growth is great news for the economy and for financial markets.

While the private non-farm business sector has been busy restructuring and getting back into shape, the same cannot be said for the U.S. public sector.  From the looks of things today, it appears that the public sector is in dire need of restructuring. Let’s have a look at the numbers, shall we?

Over the next year, the U.S. Treasury will have to refinance $2 trillion in short-term debt and, in addition, raise another $1.5 trillion to finance the government deficit. That’s $3.5 trillion or nearly 25% of U.S. nominal GDP. Some analysts have looked at these numbers and argued that bankruptcy is around the corner.  We believe that is too harsh of an assessment. That said, given the daunting figures, one wonders where the money will come from to finance the multi-trillion dollars of U.S. government debt in the year ahead.

Overseas investors have been large buyers of U.S. government debt. Foreign investors own over 40% of U.S. government debt. As it stands today, the U.S. currently has insufficient reserves (gold, oil, and foreign currency) to cover the $880 billion the U.S. government owes foreign creditors so they may be  reluctant to continue buying large amounts of Treasury securities at current interest rates and exchange rates. That remains to be seen.

Meanwhile, back at home total domestic savings are in the range of $600 billion. They are not sufficient to cover the government shortfall. Warren Buffett, Bill Gates, Larry Ellison and all the other billionaires and multi-millionaires in America don’t have the funds to finance the U.S. government. A major tax hike is also a possible solution to help finance the deficit, but such a move right now risks aborting the economic recovery. In all likelihood, a major tax hike right now would be the equivalent of economic suicide and lead to the demise of the current administration.

If foreigners become increasingly reluctant to finance the debt, and domestic private savers don’t have the wherewithal, where is the money going to come from to finance it? Chances are, it will come from the U.S. Treasury and the Federal Reserve. The Treasury will print cash and the Fed will purchase government debt in the open market. In other words, the old fashioned printing press will be used to help keep the federal government in business. When strapped for cash, simply print more money!

Of course, there is a cost to having the U.S. Treasury printing more money and the Federal Reserve purchasing the debt in the open market. The cost is inflation. The excess liquidity from the printing press first finds its way into financial markets, which boosts the prices of financial assets. Interest rates remain low and equity multiples expand. Over time, the excess liquidity finds its way into wages and the prices of goods and services. As it does, inflationary pressures build. As inflation rises, the relative value of the dollar declines in the currency markets and investors flock to gold and other hard assets viewed as a hedge against future inflation.

Not surprisingly, many Federal Reserve officials have been arguing the need to keep the federal funds rate low for the foreseeable future. Lower short- term interest rates will keep U.S. government borrowing costs down, helping to keep the government’s deficit from rising further. Currently, 3-month Treasury bill rates are at 0.06% – just above zero. Also not surprisingly, the value of the dollar has been declining and the price of gold has risen. This is pretty much what one would expect from resorting to a printing press solution to financing trillions of dollars of government debt.

Whereas performance of the private sector in the U.S. appears to be consistent with a deflationary boom scenario, performance of the public sector is screaming inflationary bust. From our perspective, and I imagine the perspective of foreign and other creditors, the U.S. federal government is in serious need of restructuring – both financially and operationally. It has expanded beyond its financial limits. Privatizing GM, AIG and restructuring the mortgage market, which is on the docket, would be a good start. But much more restructuring is needed.

Absent a serious restructuring of the federal government, the burden of debt will become highly inflationary and act to erode the value of financial assets and offset the efficiency gains in the private sector, perhaps akin to what we experienced back in the 1970s or even worse. Needless to say, such an environment will not be conducive to a bull market in equities.

Whatever conclusions one wishes to draw from the U.S. government debt figures, and I certainly don’t have all the answers, it seems plain to see that now is definitely not the time for the current U.S. administration to consider expanding the size and scope of the federal government. America simply cannot afford it and to think otherwise is sheer delusion.

Come to think of it, I can’t remember a time when there has been such as large a divergence between U.S. private and public sector performance. One can think of it as a battle: Deflationary Boom in the private sector versus Inflationary Bust in the public sector. Who wins the battle will tell us a lot about how financial markets will perform in the future. I’m inclined to bet on the guys running the printing press, but I am pulling for the private sector to prevail. Holding gold and Google might be a good investment strategy as the battle rages on (Note: this is not an investment recommendation, although as a disclosure the writer holds positions in GGN and GOOG currently).