Investing Caffeine

Debt: The New Four-Letter Word

June 10, 2009 at 5:30 am 7 comments

D-E-B-T, our country’s new four-letter word, used to be a fun toy the masses played and danced with to buy all kinds of goods and services.  Debt was creatively utilized for all types of things, including, our super-sized McMansions purchased with Option ARM (Adjustable Rate Mortgage) Countrywide loans; our 0% financing car binges (thanks to now-bankrupt Chrysler and General Motors); and our no-payment-for-two-years, big screen plasma TVs (financed at now-bankrupt Circuit City). Eventually consumers, corporations, and governments realized excessive debt creates all kinds of lingering problems – especially in recessionary periods. We are by no means out of the woods yet, but consumers are now spending less than they are taking in, as evidenced by a positive and rising savings rate. This slowdown in spending is bad for short-term demand, but eventually these savings will be recycled into our economy leading to productive and innovative value creating jobs that will jumpstart the economy back on a path to sustainable growth.

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In our hot-cold society, where the pendulum of greed and fear swing dramatically from one side to the next, we are also observing an unhealthy level of risk aversion by financial institutions. This excessive caution is unfortunately choking off the health of legitimate businesses that need capital/debt in order to survive.  As we continue to see a pickup in the leading indicators for an economic recovery, banks should loosen up the credit purse strings to provide capital for profitable, growing businesses – even if there are hiccups along the way.

National Debt “Blob” Must Be Slowed

In the famous 1958 sci-fi horror film, “The Blob”, a gelatinous, ever-growing creature from outer space threatens to take over the town of Downingtown, Pennsylvania by methodically engulfing everything in its path. Steve McQueen eventually learns that freezing the Blob will halt its progression. In our country, entitlements, in the form of Medicare and Social Security, serve as our 21^st century Blob. As the chart above shows, entitlements have expanded dramatically over the last 40 years and stand to expand faster, as the 76 million Baby Boomers reach retirement and demand more Social Security and Medicare benefits. Clearly the current path we are travelling on is not sustainable, and beyond breakthroughs in technology, the only way we can suitably address this problem is by cutting benefits or raising taxes. We only dug ourselves in a deeper financial hole with the enactment of Medicare Part D (prescription drug benefits for Medicare participants).  I must admit I have great difficulty in understanding how we are going to expand health care coverage for the vast majority of Americans in the face of exploding deficits and debt burdens.  I eagerly await specifics.

With an enlarging national debt burden and widening deficits, the U.S. is only becoming more reliant on foreign investors to finance our shortcomings. This trend too cannot last forever (see chart below). At some point, foreigners will either balk by not providing us the financing, or demanding prohibitively high interest rates on any funding we request – thereby negatively escalating our already high interest payment streams to bondholders.

Regardless of your political view, the problem pretty simply boils down to elementary school math. The government either needs to cut expenses or raise revenue (taxes or growth initiatives). Politically, the stimulative spending path is easier to rationalize, but as we see in California, eventually the game ends and tough cuts are forced to be made.

Let’s hope the painful lessons learned from this financial crisis will steer us back on path to more responsible borrowing – a point where D-E-B-T is no longer considered a dirty four-letter word.

Entry filed under: Financial Markets, Fixed Income (Bonds), Government, Politics. Tags: debt, entitlements, federal debt, GDP, government debt, medicare, social security.