By H.J. Huney:
The United States Federal government has zero debt.
This might sound untrue, bizarre, or even insane at first.
You've seen all the scary charts about the U.S. Federal debt load,
and it's difficult to conceive of the idea that there's something
untrue or misleading about it. Yet our Federal government does not
have debt in a meaningful sense, and I will explain why.
The U.S. Federal government is a sovereign issuer of its own
currency. This makes it different from you and me, or even major
American companies like Microsoft (
) and Wal-Mart (
). It even makes it different from the state governments, like
Missouri and California, as well as eurozone nations like Greece,
Spain, and Italy. Since the United States can print its own
currency, it cannot default unless it deliberately chooses to do
For this reason, even if we call U.S. Treasury securities (
) "debt," they have very little in common with debt securities such
as mortgages and corporate bonds. U.S. Treasury securities have
more in common with equity than debt.
While the U.S. government might not have "debt" in a meaningful
sense, that does not mean its fiscal decisions do not have a major
impact on the economy. Since deficits create new money in our
monetary system, that also means they create inflation. Inflation
redistributes wealth across the economy, leading some to benefit
substantially, while harming others even more so.
My goal in this article is to explain the U.S. monetary system
in a simple fashion, and also show which investments will benefit
in various different scenarios. My view is that the U.S.
government, regardless of whether Barack Obama or Mitt Romney is
President in 2013, will continue to exhibit an inflationary bias,
making investments that thrive in that environment more ideal.
What is a U.S. Treasury Security?
First off, however, we should ask the basis question, "if a U.S.
treasury security is not debt, then what is it?" The most accurate
way to describe a treasury security might be to call it "
equity security with fixed common stock dividends
When you buy a U.S. Treasury, the company you are investing in
is the United States government, and by association, the U.S.
economy. This means that economic growth is important to Treasury
security holders, but it's not necessarily the most important
aspect of the investment. Dilution is just as important. The more
shares a company issues, the less valuable each share becomes.
To understand how U.S. Treasury securities work, let's envision
a corporation that needs a cash infusion, and decides to raise
equity capital. The equity shares they create are a bit atypical in
that they guarantee a 3% dividend payment yearly, payable in common
stock. The corporation is also free to issue stock at any time it
likes with virtually no restrictions (i.e. no anti-dilution
In this scenario, while your return depends on many factors,
there are two that are particularly vital. The first is growth of
profitability. The more profitable the corporation becomes, and the
more future growth is expected, then the higher market value of the
company becomes. This results in a greater value for common stock
The second important factor is stock issuance. The more stock
the corporation issues, the less valuable each share becomes. Let's
run through a quick example.
Let's say we buy 100 shares of XZ Corporation at $1 each. There
is a 5% common stock dividend paid at the end of the year. The
total market value of the company is $1 million, and there are 1
million shares of stock outstanding.
The company's first year is a massive success. The market value
of the company increases to $1.2 million. Let's say the company
does not issue any equity during the year, but has to issue 50,000
more shares at the end of the year for its dividend payments. That
means each share is now worth $1.14 and we now own 105 shares,
rather than 100. Our total investment value increased from $100 to
$120 [105 shares X $1.14].
The company's second year is a disappointment. The market value
of the company falls to $1.1 million. The company issues no new
equity during the year, but once again, needs to issue 5% more
shares at the end of the year to pay its dividends. That brings the
total of shares up to 1,102,500. Each share is now worth about $1
again, but our shares increased to 110.25, making our total
investment worth $110.
Those two examples are straightforward enough, but the third
year becomes more complicated. The company experiences phenomenal
growth and the market value of the firm increases 25%, all the way
to $1,375,000. Only problem is that in order to achieve that
growth, the firm had to increase the share count by 50%, raising
equity capital from outside parties. Once you factor that in, and
the 5% common stock dividend, the number of shares increases to
1,736,438. The value of each share falls to 79 cents, and our
number of shares increases to 115.75. This makes our total
investment worth about $91.67.
Notice that in spite of the phenomenal growth in Year 3, the
overall value of our investment fell 16.7%! In fact, we lost more
money in the "great year" (Year 3) than we did in the poor year
(Year 2). This is why dilution is so important.
The scenario above is very similar to how U.S. Treasury
securities function. Your return is dependent upon economic growth
(national profitability), as well as dilution (creation of new
The U.S. Always Has a Balanced Budget
Now for our next radical proposition:
the U.S. government always has a balanced budge
In accounting, there is a basic equation: Assets = Liabilities +
Equity. With the U.S. government, there is a similar equation:
Expenditures = Taxes + New Money. "New Money" can also be thought
of as inflation.
Even if the budget is not balanced in one sense of the world
(i.e. expenditures being greater than taxes), it is balanced in
another sense (i.e. "inflation tax" makes up the difference). The
only problem is that we tend to ignore the inflationary part of the
equation. When we talk about the budget, most people see this:
We see "new debt issued" and assume the debt must be paid back
at a future date. In actuality, this is what we should actually
In the example above, there are $3 trillion worth of
expenditures, but only $2 trillion in (explicit) taxes. This is
balanced by $1 trillion in new money. This $1 trillion is an
implicit tax and shows up in the U.S. economy in the form of
So while the budget might not be "balanced" in the sense that
direct taxes are lesser than expenditures, it becomes automatically
balanced by the creation of new money.
Total Tax Burden = Total Spending
This leads to an important takeaway. The total tax burden is not
the sum of "direct taxes." Rather, the total tax burden for the
U.S. economy is actually equal to total government
The chart below shows Federal expenditures as a percentage of
GDP since 1948:
(click to enlarge)
Based on this, over the past four years, we've had the highest
Federal tax burden in the past century, with the exceptions of
World War I and World War II. We can also view this showing the
three major inputs:
- Explicit Taxes
- Inflation Tax (Budget Deficit)
- Total Tax Burden (Expenditures)
(click to enlarge)
This chart makes it abundantly clear that while the explicit tax
burden is slightly below the 65 year long-term average, the
inflation tax burden is historically high.
The takeaway here is that in a monetary system similar to the
one in the U.S., where a nation is a sovereign issuer of its own
currency, explicit taxes, such as income and corporate taxes are
only one part of the total tax burden. Whether we collected $4
trillion in tax revenues (and ran a $1 trillion budget surplus) or
collected zero in tax revenues (running a massive $3 trillion
budget deficit), the total tax burden would be exactly the same.
The only difference would be in regards to who pays the burden,
which is the next issue we will explore.
The Winners and the Losers, Part I
This brings us to our most important question: who are the
winners and losers in this system? The answer to this question
depends on a few factors. There are three basic budget dispositions
that we should examine first off.
Direct tax revenues exceed expenditures. This results in monetary
contraction. Investments that perform well in low-inflation and
disinflationary environments will be the most optimal.
Direct tax revenues equal expenditures. This results in no monetary
change via fiscal policy.
Expenditures exceed direct tax revenues. This results in monetary
inflation. Investments that perform well in high-inflation and
growing inflation environments will be the most optimal.
Since a truly balanced budget (i.e. one where government direct
taxes equal expenditures) does not create new money, we will
consider that option neutral. Of course, degree is important here,
too. A government deficit that is equal to 0.2% of GDP is not
nearly as egregious as one that is 8% of GDP.
The chart below showcases some of the beneficiaries of deficit
and surplus policies.
(click to enlarge)
Some of these might be obvious, and some less so. Also, I'm
being liberal with the term "beneficiary" in some cases. For
instance, while real assets are typically the best investments in a
rising inflation environment, that does not necessarily mean they
"benefit" from fiscal deficits. Merely, that their real value is
not adversely harmed by an increase in the money supply.
The less obvious ones might be the beneficiaries of the surplus
policies. I'd argue that tech and R&D are big beneficiaries. In
a sense, this is the inverse of real assets benefiting with
Let's say I invest in a start-up tech company that engages in a
lot of R&D. This company likely has very little or no debt, and
will possibly have to secure more rounds of equity funding to
continue its research. Only problem is that with growing inflation,
the initial investors lose out. Hence, we see fewer investors
interested in R&D and we see companies that are already
engaging in R&D as being more reluctant to seek more financing.
This situation is reversed with surplus policies that help
strengthen the U.S. Dollar. New rounds of funding are not nearly as
dilutive, and therefore, companies are more likely to seek out more
Not coincidentally, the tech boom occurred in a time of low
inflation and government surpluses. Indeed, in a prior article I
housing market improvement
, I created the two charts below. The first shows the difference
between M2 moneys supply growth and nominal GDP. The second shows
M2 money supply growth as a 3 year average. Notice that the early
and mid 90s form the lowest points on both charts, showing
extremely low money supply growth that was far outpaced by GDP
growth. Technology and R&D booms may be more likely to occur in
that sort of environment.
(click to enlarge)
(click to enlarge)
For this same reason, companies with low / zero debt are
beneficiaries in a surplus environment, as well. Companies with
high debt benefit from deficit environments, because their debts
are partly devalued. Whereas, in a surplus environment, companies
with high debts actually see their debts increase in real
Banks and insurers benefit from deficit environments, because
they are essentially high-debt companies. Banks may lend out money,
but they do so by borrowing first.
The Winners and Losers, Part 2
There is of course, a second part of the equation here. By
examining surplus and deficit policies, we are looking at which
investments benefit with monetary contraction / stability versus
monetary expansion. However, direct tax burden is also important.
Unfortunately, it's difficult to create quite as neat of a chart
for this one, given the vast multitude of options. Instead, we'll
simply look at a few scenarios that have been proposed by both
major Presidential candidates, and examine who the winners and
losers might be.
Simplified tax code.
Biggest winner would be the American economy. The Laffer Center
tax complexity costs $431 billion annually
. To put this in perspective, this is roughly equal to about 2.9%
of the entire U.S. economy. Mitt Romney's tax scheme would appear
to simplify the tax code to some extent, but it's unclear how much
this will be the case. The biggest losers here would be companies
), Jackson-Hewitt, and tax lawyers. Homebuilders, real estate, and
financial institutions might also be losers in one sense, since the
mortgage tax deduction might get chopped in this proposal, but this
might be partly offset by a general economic boost.
Higher income taxes.
Biggest winner might be companies that benefit from tax deductions
and exemptions. This would include homebuilders (
). The biggest loser would be the American economy. With higher
income taxes, economic growth would fall.
Higher investment taxes.
Investment taxes are similar to income taxes, except whereas income
taxes have a more general affect, investment taxes will certainly
hamper investment more severely. Since investment is the primary
way jobs are created, this will likely result in higher
unemployment and weaker economic growth.
Medical device companies are the biggest losers under Obamacare, as
there will be a
2.3% tax imposed on medical devices
. However, Obamacare also includes a host of other taxes increases,
including a 3.8% investment tax (capital gains and dividends).
Higher defense spending / cuts to other
This one is somewhat obvious, but the biggest beneficiaries of
higher defense spending would be defense contractors, such as
(GD). This is a Romney proposal and it would seem to come with cuts
in some miscellaneous programs, so difficult to pinpoint which
investments might be harmed. However, coupled with Romney's other
proposals, I would suggest that this will benefit defense
contractors, but harm homebuilders, real estate, and possibly
companies with high debt. My reason for saying this is that these
seem like idea areas to simplify that tax code.
If we were to take the "fiscal cliff" route, we would actually
still have a deficit, so some of the gloom-and-doom proclamations
are exaggerated. However, this route will hit defense spending
particularly hard, and will also result in significantly higher
income and investment taxes. However, the inflation tax (i.e.
fiscal deficit) would be reduced. Since this option lowers spending
(and hence total tax burden), it might be beneficial in one sense,
but it would come at the expense of employment, with significant
investment tax increases.
The mainstream view on government fiscal policies is not wholly
incorrect, but could use significant refinement. It's a mistake to
view U.S. government treasuries as "debt," because they more
closely resemble hybrid equity securities. Budget deficits don't
result in greater debt, but rather a higher inflationary tax
burden. Budget surpluses don't lower the debt, but rather create
The total tax burden is equal to total expenditures. Direct
taxes are meaningless to the total tax burden (which is direct
taxes + indirect taxes), but they do determine how that tax burden
is allocated. It's vital to understand this in order to truly
understand how investment will be impacted by policy decisions.
From watching the Presidential campaign unfold, my view is that
both Barack Obama and Mitt Romney will continue the indirect
inflation tax. Obama has consistently favored increasing spending.
While Romney has talked about deficit reduction, he has also talked
about increasing military spending, so it's unclear to me that he
would eliminate the deficit either. My guess is that the inflation
tax will remain higher under Obama than Romney, but maybe not by
On top of continuing the inflation tax, President Obama is
likely to implement new investment and income taxes, as well. Mitt
Romney appears likely to continue the large inflation tax, but less
likely to impose new investment and income taxes.
Based on the continued likelihood of new money creation via
Federal budget deficits, I believe that real estate, banks, and
insurers will benefit regardless of who is President in 2013.
Defense contractors and capital investment will benefit more under
Romney. Real assets, and high-debt companies are more likely to
benefit under Obama.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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