Most investors are probably paying rather close attention to these charades in Washington. As the debt ceiling inches closer, Congress still hasn’t come to a deal. I do expect, however, that they will come up with a typical last minute solution. I usually keep politics out of this blog, but inevitably, sometimes politics and investing mix.
It’s important as investors and US citizens to remain calm and look at the facts about this. I’ve seen a ton of incorrect information out there. An overreaction to the debt, especially from Congress (or the voters that elect Congress), would be more economically problematic than the debt itself. For value investors, a depressed Mr. Market may be coming to your door daily to offer you some good bargains.
History of the Contemporary US Debt
Although the US has almost always had debt, our contemporary debt situation began seriously accumulating in 1981, towards the beginning of Ronald Reagan’s term as president. Before that, both Republican and Democrat controlled legislative and executive branches had steadily decreased debt as a percentage of GDP from World War II. But after 1981, starting with Reagan’s significant decrease in the top marginal tax rate and sustained or increased spending, debt as a percentage of GDP began quickly increasing. Both Republican and Democrat controlled executive and legislative branches led to an accumulation of debt over these last 30 years, beginning with Reagan’s first term. An exception is that at the end of Democrat Bill Clinton’s term as president when Congress was controlled by Republicans, the US had a budget surplus and had managed to decrease debt as a percentage of GDP. More recently, the debt is due to tax cuts, two wars, and an unfunded portion of Medicare under President Bush, and recession-reduced tax revenues and stimulus spending under President Obama. US leaders and voters need to understand that if you cut taxes, you need to proportionally cut spending, or if you increase spending, you need to proportionately increase taxes, at least over the long term. Short term variances are ok, but we can’t have it all.
National Debt by Presidential Terms, and Congress Majority- Wikipedia
Facts about the Current US Debt
-The US currently has about $14.3 trillion in debt. A significant percentage of this is owned by the government itself (such as the Social Security fund), another significant percentage of this is owned by US citizens and companies, and increasingly, a percentage of this is owned internationally.
Federal Debt Basics- US Government Accountability Office
-The US has the most debt out of any country. But when it comes to debt as a percentage of GDP, which is a much more important metric, the US is far from the highest. Many other developed countries have higher debt as a percentage of GDP than the US, but still, ours is higher than it should be.
List of Countries by Debt- CIA World Factbook
-The US is nowhere close to financially defaulting. We would only default if lawmakers decided to default. It would be like being completely in a position to pay your bills, but deciding to pay them late and incur the penalties.
-Overall, America has more than $50 trillion in private household net worth, and $14.3 trillion in public debt, so the public debt to private equity ratio is below 30%. If we exclude debt owned by the government, US corporations, and US citizens, that number drops further. If this were a business, it would be a good figure. The problem is, the US government doesn’t really have that equity unless it taxes for it. The interest coverage ratio (federal income divided by interest expense) can be estimated to be between 10 and 20, depending on what time period I use. Currently, interest rates are low, but as they rise, the interest coverage ratio will shrink. Overall, an interest coverage ratio of above 10 would be very solid for a company. But we want interest as close to zero as possible for the federal government, because any positive interest means that a portion of our taxes, perhaps 5-10%, go to interest payments, which is deeply unsatisfying. Essentially, the US has a reasonable balance sheet as long as problems are fixed fairly quickly. If the trillion dollar deficits or even “only” multi-hundred-billion dollar deficits continue, a larger and larger chunk of our spending will be on interest until the situation becomes unsustainable.
US Household Net Worth-Reuters
US Revenue and Expenditure- Wikipedia
-The US Debt situation is fundamentally different than the European Debt situation. The US currently has a perfect AAA credit rating because a) the balance sheet is worsening but still fair, b) it can print its own money, c) it can raise taxes as lawmakers see fit. This is why US debt is basically a proxy for “risk free”. In a worst case scenario, the US can slowly inflate its way out of the current debt (but would still have to fix its deficit, which is largely indexed to inflation), which would of course have disadvantages. To avoid bad inflation or hyperinflation, there needs to be confidence in the integrity of the currency, so it’s better to balance the budget and let slow GDP growth shrink debt as a percentage of GDP, which would naturally include moderate inflation. Many European countries, on the other hand, have joined their currencies in to the common Euro. This means that if any country grows its debt too high, it doesn’t have full control of the situation, and needs other European countries for help. Both areas have their balance sheet issues, but they are fundamentally different.
What Will Happen if the Debt Ceiling is Reached with No Solution?
-Nobody can really be sure, because this is unprecedented and rather silly. The August 2nd date may not be the exact date the problem occurs. In reality, the US reached its debt ceiling a few months ago, but has been able to juggle its books to make a bit of room. This room is expected to run out sometime in early to mid August, and the conservative figure is August 2. The US is still bringing in revenue, but not enough to cover its obligations, so some things will go unpaid, whether it’s treasuries, social security, nonessential government options (government shutdown), armed forces, etc, until the debt ceiling is increased.
-If the US credit rating is downgraded, either because it defaults, or because it cuts services to pay the debt, or because it doesn’t extend the debt ceiling far enough, or because the budget remains grossly imbalanced, it will mean the US will have to pay a higher interest rate on its debt. This essentially means higher taxes or lower spending for citizens. Various private interest rates could increase as well. In addition, this would sadly mean that the bonds of four non-financial US corporations that currently are rated “AAA” (Johnson and Johnson, Microsoft, Exxon Mobil, and Automatic Data Processing), would be considered “less risky” than US treasuries. (Disclosure, I own JNJ and XOM stock.)
-Individuals, governments, or companies that rely on the integrity of US treasuries could be greatly affected. This is perhaps the most problematic, and least understood, area of this situation.
-There are already problems. The Federal Aviation Administration has already partially shut down without notice for nearly a week now. Congress wouldn’t agree on tiny details of the FAA reauthorization (they concern unions and a few subsidies to small airports; partisan issues), so all research, development, and construction of the FAA is currently shut down without notice. The House of Representatives slipped in some new things into the bill, which includes a union-weakening measure and an elimination of subsidies, and the Senate rejected it. 4000 federal engineers, scientists, programmers, and managers are out of work with no pay and with virtually no warning. In addition, thousands of private contractors that provide engineering services and work along with those federal employees, or that provide construction services on airports around the country, are immediately halted. There are over $2 billion of contracts affected, and there are literally empty construction sites on airports right now, and empty offices with expensive equipment sitting there. This wasn’t specifically due to the debt ceiling (instead it was due to irresponsible partisan politics), but it’s a smaller taste of what can happen. 4,000 federal workers and 70,000 contractors/construction workers are affected.
The Airport Jobs We Desperately Need: Congress’ Failure has Consequences
We Need an FAA Bill Exension
4,000 feds and 70,000 construction workers
How Do We Fix the US Debt Situation?
I’m certainly no wiz, and there are many potential paths to take, but there are some things worth considering.
-The debt problem cannot be fixed simply by refusing to increase the debt ceiling. Without raising the debt ceiling, the US would literally have to balance its budget over a matter of days or weeks, which would mean increasing taxes or decreasing spending by over a trillion dollars per year. The current debt represents our previous promises, not our future ones. Spending would have to align with the volatility of US revenue. This would mean either enormous and abrupt tax increases, or enormous and abrupt cuts to social security, medicare, defense, and various domestic spending.
-The debt problem, however, can be fixed over time. If the budget is balanced over the next few years, then debt as a percentage of GDP will decrease as the GDP increases. The largest spending areas right now are Social Security, Defense, Welfare, and Medicare and Medicaid.
-Social Security currently has a trust fund of over $2 trillion due to surpluses, at least on paper. Receipts have exceeded expenditure. The problem, however, is that when social security was started, the date of retirement was approximately the same as the average life expectancy. The number of people paying into the system was much larger than the number of people withdrawing. As people live longer (into their 80s rather than 60s), and as a large generation retires, the ratio of payers to withdraws will continue to decrease. To keep social security sustainable, there are numerous options. People can pay more into it, the income cap can be increased, cost of living increases can be reduced, and/or the retirement age can be increased. The other problem is that other areas of the government have “borrowed” from social security to pay for other unfunded things, so although social security is not entirely broken, it is rather broke.
-Welfare has spiked recently with the recession. It used to be in the ~$300 billion range but now it is in the ~$500 billion range. This can decrease if the economy improves. It can also be decreased by making it harder to receive benefits to try to keep out people who don’t really need them.
-The US spends around $700 billion per year on the armed forces. This is a huge chunk of our total spending, and a huge chunk of the total worldwide defense spending. The US has less than 5% of the world population, but spends somewhere around 40% of the total world’s annual military expenditure. In addition, defense spending as a percentage of GPD is larger than almost all large and developed countries.
Military Spending by Country- Global Security
-Corporate tax accounts for a fairly small percentage of US revenue, while individual taxes are a major component. We have a trade deficit, meaning we import more products than we export. This trade deficit mainly became a problem during President Clinton’s term (the timeline is rather correlated to the signing of the North American Free Trade Agreement), and continued under President Bush and President Obama. Corporations have benefited, because they can get cheaper labor and fewer restrictions on environmental damage elsewhere. But, if inflation-adjusted labor rates decrease domestically, that increases the divide between socio-economic classes and reduces the tax base. Government regulation and/or consumer decisions to spend more consciously, can potentially help address this issue.
-Medicare and Medicaid currently are causing part of the deficit. It’s the same fundamental problem as social security- an aging population. Worse yet, the life expectancy is lower than many other highly developed countries, and the infant morality rate is higher than many other highly developed countries, and yet we pay more per capita, and as a percentage of GDP on healthcare, than most all other countries. There is a ton of improvement potential here.
Health Care Spending by Country
Infant Morality Rate- CIA World Factbook
Life Expectancy- CIA World Factbook
-The US has maintained rather consistent taxation as a percentage of its GDP over contemporary history, but has significantly lower taxation than other developed countries. Taxation has become less progressive, as the top marginal rate has significantly decreased, and dividend and partnership taxation has decreased. This how someone like Warren Buffett can pay a lower tax percentage than his secretary. Nonetheless, the upper middle and upper classes have most of the tax burden, mainly because they have most of the wealth. When discussing taxation, it’s important to compare the situation to the past, and to compare it internationally, to see what’s working and what is not. The United States currently attempts to provide services to its citizens that roughly correspond to the low end of other developed countries (social security, medicare, disability, high standards for medicine and food, but no universal health care, and rather low subsidy for higher education), yet taxes at levels that correspond to the upper end of developing countries. There needs to be a decision- either tax and provide the services of a developed nation, or tax and provide services at the high end of a developing nation. We can’t provide the services of one, and pay for it with the taxes of another.
15 Charts about Wealth and Inequality in America- Business Insider
Worldwide Tax as Percentage of GDP- World Bank
Tax Revenues Fall in OECD Countries
-Discretionary domestic spending is actually a fairly small part of the US budget, and so is foreign aid. These areas can be looked at and streamlined.
Summary
There are a variety of ways to fix the deficit, and it will require compromise, moderation, and reason. As previously mentioned, if the budget can be balanced, then debt as a percentage of GDP will decrease over time. I do not think the government will default, and in the off chance that it does, it would be due to leadership failure rather than due to necessity.
As for dealing with the current situation, the same answer pretty much always applies. Make sure you are diversified in terms of number of companies, number of sectors, and asset class (stocks, bonds, etc). Look for opportunities to buy on weakness; companies that may lose value if the markets react poorly to US silliness, but that you believe are good long term investments. Remain focus and fact-driven, and allow any potential market irrationality to help you rather than hurt you over the long term. Portfolio values may temporarily fall, but remember, for net buyers of stock, markets with low value are better than overvalued markets. As always, buy quality companies at reasonable prices.
There are some mixed signals on the economy. One one hand, jobless claims were reduced. But, if the research, development, management, and construction of the FAA federal employees and contractors remains shut down, and if other government agencies have to shut down, this will undo itself. In addition, Emerson Electric warned about a slowing economy in the US and Europe. Being a cyclical business, Emerson tends to have a pretty strong understanding of economic conditions. Emerson reported that orders are still growing, but that they “moderated”, and the stock price fell 7%. (Disclosure, long EMR). Housing is still not showing strong signs of improvement.
I’m interested in reader opinions- what do you think of the deficit, the debt, the current debt ceiling debate, the partial FAA shut down, the investing opportunities, and the current state of the world economy?
Other Weekend Reading
Dividend Stocks 101: The Essential Guide
If you’re new to the site, check out this key resource.
Carnival of Personal Finance 319
I was included in a blog carnival this week.
Master Limited Partnerships: The Perfect Dividend Stocks
The Dividend Growth Investor presents some dividend ideas.
Ensure your Dividends with Insurance Stocks
Dividend Mantra presents some insurance companies.
Should you Fear US Treasury Bonds?
Andrew Hallam presents some facts about America’s situation, from a non-American perspective.
defensiven
Good post, clearifying. Ive read that US is in a better position then many other debt-burdened countries because the population is younger.
Im probably prejudiced but I see the US economy as more dynamic and “healthy” compared to many other debt-burdened countries. Greece cheated their way into the EMU and has widespread tax evasion. Ive read examples of hospitals with no gardens but numerous gardeners and a department with a purpose of preserving a lake which has been dry for decades.
defensiven
Many of the worlds leading companies come from the US. This power seems to continue with recent success stories as Apple and Starbucks. An excellent sign in my view.
Matt
Well, it’s hard for me to make comparisons, but yes, I do think America’s economy, as a whole, is in pretty good condition, relatively speaking. It’s sort of a mix- corporate profits and balance sheets are pretty good, innovation is still strong, but American workers are struggling with a 9+% unemployment rate.
The US has a debt burden, but if the core problems were addressed and fixed within a few years, the debt situation could be brought under control, as described.
I do think the US should take some measures to ensure their strength in some areas, though. The last space shuttle landed, so until the next generation of rocketry, the US can’t put people in space. In addition, the US isn’t taking as strong of a leadership position as it should (based on its size and history of technical innovation) with regards to renewable energy. If the US were to allow renewable energy systems to be counted with regards to Master Limited Partnerships, I think that would seriously boost the profitability and the spread of solar farms, wind farms, etc.
ken
Matt
A very well written and informative article that in your usual style cuts through the white noise of the 24 hour media cycle. I have been reading your articles for quite some time now and always appreciate your thoughtful and non partisan analysis.
Keep up the good work mate
Ken
defensiven
As you mention GDP growth is a key to managing debt. Some budget cuts might not be so wise longterm. If the US is to compete with emerging markets there might instead be need of increased government spending on education as knowledge grows in importance (production including unskilled labor moves).
On a side note im amazed to read that leading republican polticians forbid any kind of tax increases.
Dan
Thanks for the great article Matt. You often read many articles or see many stories that are colored by an ideological bias and presented in a hyperpartisan fashion (both sides); it’s refreshing to read one that presents the important aspects of this complex political/investing issue in a true “fair and balanced” way.
By the way, tooled around on your website quite a bit and found it a valuable source of dividend investing info along w/ some other sites (dividend ninja, dividend mantra, etc.). Ya gotta like the “cool” cyber monikers you guys choose for yourself.
Take care.
Dividend Mantra
Great article, as always Matt. Excellent information and completely black-and-white. I don’t really align myself Republican or Democrat…I align myself with great ideas, no matter where they come from. I love your ideas.
Every empire eventually comes to an end, and some people are wondering if we are entering a sunset phase. I don’t know about that. I think we have so many things going right for us, and it’s really sad that our political warfare manages to escalate to such a level.
There are a lot of things that need to be fixed and tough choices need to be made. I look at a lot of past promises that are now becoming present obligations as troublesome. SS was never meant to fund a 30-year job-free lifestyle. If the retirement age needs to be raised and taxes to fund it need to be increased, then so be it. Cost-of-living adjustments may need to be scaled down too. Pensions and unfunded healthcare obligations are quickly becoming an epidemic. I was just reading an article in Fortune about the San Fransisco pension crisis, and how the unions are trying to defeat any changes..as they want the money promised to them. My uncle, who is a police officer, is retiring this year at the age of (I believe) 49. He is going to be cashing pretty large checks ($50k+/yr) for the rest of his life. That’s an expensive promise to one person. The promises are unending.
What do you do? Like I said, tough choices are going to have to be made. Taxes are going to have to be raised that put us in line with the type of services we expect to be provided. Certain benefits are going to have to be scaled back. I promised myself a sushi dinner this weekend…but my grocery bill is past its peak. So…sushi gets canceled. My budget just got balanced.
BTW, thanks for the mention! I really appreciate it.
P.S. My commentary and examples are meant to be slightly humorous. Although the example about my uncle is real.
Pey
Dividend Mantra,
I agree wholeheartedly with your views about your uncle. I’m sure he’s a great man and has dedicated his life to bettering our communities and keeping the world a safer place. I don’t doubt he deserves every penny he’s earned and the pension promised to him as well. I’m just very worried about how we’re going to pay for it.
Matt,
It’s safe to say I learned more about the state of our economy and the debt ceiling in your article than all the news over the past few weeks combined (Though Jon Stewart’s “The Daily Show” comes in at a close second). Your article was stunningly educational.
It’s great to read that, on a macroeconomic scale, the situation our country is going through may not be as dire as everyone believes. You’re very correct in that we hold significant assets in this country and even though our debt levels have slipped beyond what we all think is acceptable, it’s important to keep in mind that things have not become so bad that we can’t fix our issues. The time to act is now.
As a young guy who’s just starting out in this investing world, I’ve already decided dividend paying stocks of all all yields, shapes and colors, is the way I would like to faithfully increase my net worth. Therefore, after hearing our country is far from being down and out financially, I can’t help but think we’re entering a period of extreme value mode where deals and bargains may be found around every corner. I’m keeping my cash reserves moderate and I’m ready to pick up any deep value plays with considerable margins of safety. I’ve noticed the market as a whole hasn’t swayed nearly as dramatically as everyone had expected but, with that said, I’ve noticed huge declines in single stocks on my watchlist. We’ll likely look back and realize how amazing of an opportunity this truly was.
Thank you again, Matt, for sharing your non-partisan, incredibly educated opinion about the state of our economy with us. I’ve said it before and I’ll say it again: I just wish you had more time to keep writing. It’s a shame to hold all that talent for yourself!
My Own Advisor
Thanks for the great read Matt!
As a Canadian up here in the Great White North, I find it fascinating to watch what is going on south of the border with our friends.
On a more blunt note, I just hope the political drama stops and folks (read in, politicians) get their acts together and remember why they were elected for office in the first place.
The “crisis” will get solved, it has too, and the U.S. could return to economic supremacy if they take some drastic measures now for future generations. Unfortunately the only accelerated path to get there is a heavy does of taxes for higher-income earners and spending cuts. Just like your household budget, you can’t spend what you can’t afford.
The age of consumerism has caught up with you guys (we’re not very far behind in Canada mind you….) and instead of mass consumption, the simple answer for a successful market and economy lies with mass production.
Have a good weekend, I’ll be watching the events unfold with you.
Mark
business daily
I call the practice calculated deception.We now have a president who is threatening Americas seniors with a cutoff of their Social Security benefits unless Congressional Republicans agree to increase taxes as part of a deal to increase the debt limit claiming insufficient funds otherwise. But the 2011 Annual Report of the Social Security Board of Trustees and the Presidents own 2012 budget show that even without increasing the debt limit or taxes the federal government will have more than enough money to pay all Social Security benefits as well as all interest on the national debt.The Social Security Trustees Report shows that payroll tax revenues of 573.4 billion will flow into Social Security this year under current law. But federal revenues apart from payroll taxes would total 1.363 trillion more than enough to pay the Social Security interest due and this years net interest on the national debt of 206.7 billion.With total Social Security benefits including retirement and disability equaling 720.5 billion this year that leaves a deficit of 31.2 billion still to be covered.
Matt
It looks like, as expected, they’re coming to a last minute deal. Even when the immediate “crisis” is resolved, I encourage everyone to stay informed about the issue of the debt. If the crisis goes away, the debt and the deficit remain.
Mantra,
Yes, difficult choices will need to be made. This only has to be a sunset for America if that’s what voters and lawmakers decide. There’s nothing in the mix that says it has to be. Personally, I’m in favor of making entitlement programs better rather than scaling them back.
Advisor,
Definitely- consumerism hit the fan. This is what occurs when people take out loans they cannot afford, have no savings, and live paycheck to paycheck. The deficit and the economy, in my opinion, need to be solved with a combination of better policies and increased personal responsibility.
Pey,
Sounds like you are well-prepared to succeed financially. Part of the problem over the last decade or two is that savings rates have dropped dramatically. Part of this recession was caused by bad loans, but for every lender making a bad loan, there is a person accepting a bad loan; taking on a loan they have no business accepting. Those that save, invest, and live within their means contribute to the success of the country rather than to its detriment.
Business Daily,
The two issues with paying interest and social security if the debt ceiling were not agreed it is as follows:
-It doesn’t necessarily matter whether there is enough income for both SS and interest over the course of a year or a month (there is). The problem is, if the debt ceiling cannot be breached, even for short periods of time, then unless they get enough cash every day to meet these obligations (they probably don’t), then they can’t legally pay them. It becomes a cash flow issue rather than a lack of overall money. Cash flow for the government per-day is volatile. This would be unprecedented because it would be illegal to pay and illegal to not pay these things.
-Even if SS and debt interest are paid, that leaves an enormous amount of things unpaid. Payment for armed forces, payment to keep the Food and Drug Administration going, payment to keep air traffic controllers in the towers allowing us to have a planes in the air, medicare, veterans benefits, etc. It would be irresponsible for the government to allow any of that to shut down or go unpaid (we already have a partial FAA shut down, but at least they are still keeping planes in the air).
Everyday Dividends
Great article. I am surprised that few dividend bloggers were talking about the debt ceiling, but you came up with a really good one.