Posted: May 27, 2009 12:25 PM

Washington's Grim Economic Prospects

We need to engage in a serious conversation about the United States' long-term economic health. My periodic reading of the financial tea leaves is causing a significant loss of sleep. Over the last week, a variety of sources have begun to openly suggest Washington is headed for runaway inflation--and is poorly prepared to do anything about the problem.

Let's start with the warning signs. On 21 May 2009, the Wall Street Journal published a story headlined with "Dollar May be Set for Nosedive." According to the Journal, a survey of prominent currency watchers revealed a diminishing interest in U.S. Treasury notes. The cause for this loss of appetite? The threat of inflation and low interest rates--in short, the prospect of a poor return on one's investment.

On the same day, the New York Times reported China is becoming increasingly picky about which American debt it is willing to purchase. While the Chinese--like most foreign investors--bought U.S. Treasury notes at a remarkable clip over the last year, this pace appears to be slowing. Why the race to Treasury notes? Quite simply, investors sought to place their funds where they would not lose money. As markets outside the U.S. begin to recover these low-return investments are becoming increasingly less interesting. This means smart investors are looking for other options.

The Chinese are clearly part of that crowd. Over the last six months Beijing has begun trading its long-term U.S. Treasury notes for short-term equivalents. That is to say, China is moving her funds from the higher-yielding 10-year Treasury notes to less lucrative 12-month U.S. government securities. The reason for this move: fears inflation will erode the value of the longer-term investments. By moving to the one-year notes, Beijing provides herself a means of rapidly cashing out investments that are failing to meet expectations.

The real kicker, however, came when Standard and Poor's Rating Service warned London that Britain may lose its coveted AAA credit score. Concerned that London's stimulus spending will spur inflation--anyone else see a trend yet?--Standard and Poor's essentially put the British government on notice. Get your finances in order, or face the possibility of having to pay more to borrow money in the future. This was no idle threat. Over the last year Iceland, Ireland, and Spain have been confronted with diminished credit ratings.

Could the same thing happen to the United States? Yes, according to Bill Gross, co-chief investment officer of Pacific Investment Management Company. In an interview with Bloomberg Television, Gross predicted Washington will "eventually" lose its AAA rating. The probable cause of this decision--the size of our annual budget deficit and a mounting national debt.

To be fair, the Obama administration is painfully aware of this problem. On 14 May, the President admitted "the long-term deficit and debt that we have accumulated is unsustainable--we can't keep on just borrowing from China." On 21 May, Treasury Secretary Geithner made a similar statement. "It's very important that this Congress and this president put in place policies that will bring those deficits down to a sustainable level over the medium term."

OK, it seems as though cooler heads may prevail in the long run. But don't draw too much solace from these comments. We face a debt problem that is literally unfathomable to the average American. Yes, yes. I'm sure you are aware of the $1.8 trillion deficit Washington is expected to put on the books this year. And I'm pretty sure the average American knows our national debt has reached approximately $11.3 trillion ($37,000 for every man, woman and child in the country). What I don't think most Americans understand is the size of our unfunded liabilities--the $99.2 trillion the U.S. government currently owes to Social Security and Medicare. Do the math with me...$11.3 trillion plus $99.2 trillion equals $110.5 trillion. That's right. $110.5 trillion.
We are in big trouble.

I'm not alone in coming to this conclusion. Richard Fisher, the president of the Federal Reserve Bank of Dallas, has been warning we are headed for a disaster. And his potential solutions should leave you shuddering. One course of action, "a permanent 68% increase in federal income tax revenue." A second option--according to Fisher--as a means of keeping Social Security and Medicare fully funded Washington could cut all discretionary spending by 97%. In short, eliminate most of the national budget for defense, education, and the environment.

Is there as way out of this conundrum? Well, maybe. The problem is balancing a reduction in spending and higher Fed interest rates with a political desire to revive the economy and generate jobs. Hack spending too quickly and the voters are going to head for the polls in 2010 looking for new representatives. Fail to halt inflation and our foreign creditors are going to look elsewhere--causing interest rates to climb here at home...again resulting in an electorate searching for new candidates.

Quite simply, we need to tighten our belts and Washington should begin to dampen expectations about a rapid--or full--recovery. Americans are going to have to resign themselves to the fact approximately 20% of their net worth has gone up in smoke. Furthermore, we need to start planning on paying higher taxes and expect less from the government safety net. In many senses we are going to have to follow the example set by millions of Chinese households--spend less, save more, and plan to be increasingly self-reliant. That conversation needs to start happening now, and continue to future generations. Or, we can prepare our children to be less well-off than their parents.

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