Debt, Deflation and Danger

The U.S. government now has such a supersized stake in the economy and so much to lose if things go sour, political leaders of all stripes have virtually outlawed failure of any kind, prompting them to manipulate markets like never before.

In 1928, when my father first went to work on Wall Street, he warned his clients about a new and dangerous scourge about to strike the U.S. economy and financial markets — deflation.

Today, I'm warning you again.

The similarities between then and now are striking: Massive, devastating declines in the price of commodities like copper, foods, grains and energy. Booming stock prices. And a gaping disconnect between the two that seemed to defy all logic.

But it's the big differences between now and then that have me worried the most — especially when it comes to the role the U.S. government plays in the economy.

Compare key facts about then and now, and you'll see what I mean ...

Federal debt: When my father first warned of deflation's potential impact in 1928, the total debt of the U.S. government was just $17.6 billion. Today, it's over $18.6 trillionover one thousand times more.

Federal spending: Back then, the federal budget was less than $3 billion. In 2015, it's $3.7 trillion — also more than one thousand times more.

Even taking into consideration the huge growth in the U.S. economy over the past nine decades, the size of government today is far, far larger:

Federal debt: In 1928, the national debt was less than 17% of GDP. Today, it's over 100%.

Federal spending: In 1928, the government spent less than 3% of GDP. Today, it spends over 21%.

And even these shocking comparisons grossly understate how the government has grown:

Federal debt: When my father was a young man, Social Security, Medicare and veterans' benefits didn't exist. There were virtually no entitlements. So the federal government's financial obligations were limited almost entirely to the funded federal debt. In contrast, today Washington is drowning in $127 trillion of unfunded liabilities, according to Forbes.And even these shocking comparisons grossly understate how the government has grown:

Add those to the government's debt load, and suddenly it's 807% of GDP. In other words, the true federal debt balloon is over eight times larger than the entire U.S. economy.

Federal spending: Robert Higgs, Senior Fellow in Political Economy for the Independent Institute, demonstrates how government spending makes up a far bigger chunk of the economy than official calculations seem to indicate.

Using data from the Federal Reserve Bank of St. Louis and the Bureau of Economic Analysis for the five years through 2014, he calculates that all types of federal government spending represented 35.8% of GDP.

Further, if you compare it to a more relevant measure of the economy (personal consumption outlays), the government is responsible for a whopping 52.2% of the economy. Plus ...

"Even this," he writes, "fails to indicate how great the government's presence in our lives really is, however, because governments at every level impose a vast number of legal and regulatory requirements that must be met out of the people's own resources."

Wayne Crews, Vice President for Policy at the Competitive Enterprise Institute, estimates that compliance with regulations costs Americans $1.863 trillion in 2013, or another 13% of GDP. Add this to the heap, and you can see how expenditures by or for the government are now close to two-thirds of the entire U.S economy.

All this leads to two unmistakable consequences:

Consequence #1. Uncle Sam as master puppeteer. The U.S. government now has such a supersized stake in the economy and so much to lose if things go sour, political leaders of all stripes have virtually outlawed failure of any kind, prompting them to manipulate markets like never before.All this leads to two unmistakable consequences:

For many years, their list of taboo events that "must never happen" included (1) another Great Depression, (b) big financial failures and (3) national bank runs.

Now, on top of these, the Fed is attempting to counter (1) sharp stock market declines, (2) low inflation, (3) international market turbulence and (4) even normal, cyclical declines in the economy.

But for Uncle Sam, it’s like quicksand. The more he struggles, the deeper he’s stuck.

Consequence #2. Out-of-control corporate debt. During the Great Recession, in order to save the government from bankruptcy, the Federal Reserve felt it had no choice but to buy up the majority of government bonds offered for sale, while driving interest rates to nearly zero. This, in turn, opened the floodgates to corporate debt bubbles that are even larger than the federal debt bubble.

Totally Unprecedented Convergence of Circumstances

We have never seen anything like this before in U.S. history.

Sure, we've had other periods when the U.S. government was up to its eyeballs in debt —during the American Revolutionary War when Benjamin Franklin borrowed money from the French ... and again during World War II, when the U.S. government issued billions in war bonds.

And yes, we've also seen periods of deflation — particularly the commodity deflation in the late 1920s and the financial asset deflation that followed.

But what we've never seen — until now — is the convergence of huge government debts AND the real threat of deflation at the same time.

This is absolutely critical for a number of related reasons:

First, deflation makes it far harder for all borrowers, including the government, to pay off debts. They earn less income. They collect less in taxes. And as the value of each dollar owed goes up, the real burden of their debts looms larger and larger.

Second, deflation can drive the economy into a vicious cycle of cutbacks. People learn to expect lower prices ahead. So they become far less willing to spend money at today's higher prices. And the less they buy, the more prices go down.

Third, nearly everything falls — corporate profits, personal income, and government tax revenues from both.

Connect the dots and you'll see how, suddenly and without warning, the government is squeezed in a massive vice.

And you'll see how deflation could directly threaten the great bubble of government debt that has accumulated over the decades.

This head-on collision between deflation and debt is the grave danger we will face in the years ahead. And it's the one economic certainty that most of today's political leaders (and candidates) fail to grasp.

Don't fall into that same trap. Stay alert to the collision of deflation and debt. Understand how it can impact not only your investment portfolio, but nearly every asset you own, and nearly every kind of income that you count on. 

 

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