By
Axel Merk
:
Good news: Vice Presidential candidate Paul Ryan may put the
focus of the presidential campaign on the sustainability of the
U.S. budget. Bad news: Ryan's plan delivers some tough medicine; if
the European experience is any guide, "austerity" makes bad
politics. What are the implications for the U.S. dollar?
The Ryan budget addresses a key Achilles heel of the U.S.
budget: Medicare. Make no mistake about it: no matter who wins the
election, Medicare as we know it won't be around for the next
generation. Why? Because economists agree that the debt to GDP
ratio would explode to unsustainable levels: there are not enough
rich people in the U.S. to tax to "fix" the problem. The basic
problem: the U.S. healthcare system (before and after the
healthcare reform) defines entitlements, but essentially does not
have a fixed budget. Not surprisingly, costs are out of control, as
the private sector is incentivized to deliver ever more services,
ever more expensively.
What happens when the market recognizes that budgets may be
unsustainable can be seen in weaker eurozone countries: the cost of
borrowing rises, bonds fall. Unlike the eurozone, however, the U.S.
has a significant current account deficit; as such, a crumbling
bond market might put substantially more pressure on the U.S.
dollar than the eurozone debt crisis has put on the euro.
The Ryan plan wants to bring down the size of government to 20
percent of the economy by 2015 (compared to 23 percent in the
President's budget). The plan will prevent the looming tax
increases, but may increase other taxes ("closing loopholes" is the
politically acceptable way of selling tax increases to the public)
as the tax code is simplified. The plan also does not cut defense
spending.
Given that entitlement spending (Social Security, Medicare and
Medicaid) will continue to rise in the coming years, if for no
other reason than those in or close to retirement won't see cuts to
their benefits, substantial cuts elsewhere are necessary to meet
the plan's objectives. Unlike other long-term budget projections so
commonly adopted by politicians, the cuts are not back-loaded, but
gradually phased in.
All in all, it is not surprising Paul Ryan may excite part of
the Republican base. Purists point out that he is no Ron Paul, the
Congressman and former presidential candidate who has suggested
draconian cuts to the defense budget, as well as the elimination of
more departments than former presidential candidate Rick Perry
might be able to list.
In some ways, Ryan is an Obama of the political right, promising
to bring America back on the right path. However, as is so often
the case anywhere in the world, the change people vote for might
not materialize.
They will try to start with a repeal of Obamacare, a key element
of the Ryan plan. We have little doubt that should Romney/Ryan win,
they will introduce a bill to repeal the healthcare bill; however,
political realities exist beyond winning the White House. As
always, campaign promises should not be taken at face value. If
Republicans don't control the Senate after the election -- key to
getting major legislation passed -- Romney/Ryan may very well claim
to have kept a campaign promise and blame Congress for not acting.
The faces may change, but the politics don't.
As indicated, both Romney and Ryan want to preserve defense
spending. They express a willingness to keep spending on programs
that are deemed valuable and important. Funny how every politician
always wants to cut wasteful spending, but preserve the good type
of spending. What falls into what bucket is in the eye of the
beholder. Trouble is that, when all is said and done, money is
spent, be it on "good" or "bad" programs.
And it's not just defense. Romney has spoken out on preserving
student loan subsidies. Student loans are not merely a problem for
a few starving students, but is quickly ballooning into a burden
affecting even the upper middle class. From the first quarter of
2005 until the first quarter of 2012, total student debt has grown
from $363 billion to over $900 billion. As delinquency rates have
also been rising, politicians on the left and right are eager to
help out.
Now tell those whose benefits get cut that sacrifices are
necessary to make the budget sustainable for future generations.
Cutting benefits in a democracy is rather difficult. After all,
there will be plenty of valid political arguments that the cuts are
hitting the wrong people and that "my" benefit is the one worth
preserving. As a result, a change in tone tends to be more likely
than a change in substance. We have in the past argued that real
reform in the U.S. may not come until the bond market provides the
appropriate "encouragement" -- except, of course, that such
encouragement means major pain, coupled with turbulent markets.
And, as indicated, a misbehaving bond market might also have dire
consequences for the greenback.
It is fine to hope to get a sustainable budget that broadly
spreads the pain (so as to not further polarize American politics);
however, hope is no investment strategy. Our baseline scenario is
that the market may continue to give the U.S. the benefit of the
doubt, i.e. not dump U.S. Treasuries en masse. That base line
scenario also suggests continued sluggish growth, with a continued
heavy hand of the Federal Reserve. Incidentally, Paul Ryan has also
spoken out against what he calls a "bail out" of U.S. fiscal policy
by the Federal Reserve. That's because the Fed's Treasury purchase
programs have helped finance the deficit.
Should the U.S. economy show signs of more earnest growth, all
bets are off for the bond market. A lot of yield chasers have piled
into the long end of the yield curve, i.e. long-term bonds. In the
event that the market prices in more economic growth, we expect a
bond selloff. The canary in the coalmine might have been the bond
selloff early in the year.
We consider it entirely possible that good economic news can
trigger a chain reaction that will put the Treasury markets into
the driver's seat, letting policy makers once again appear to be
running around like headless chickens, as we have unfortunately
seen all too much in recent years (from politicians across the
political spectrum, as well as central bankers). The muddle through
grinding might, with hindsight, be considered the easy part; the
tough time may come once all the money that has been printed
actually "sticks." While Fed Chairman Bernanke claims he can raise
rates in 15 minutes, we remain skeptical that the Fed can continue
to micromanage the economy, given all the leverage and liquidity
that is in the global economy.
When we look at the world, we like to plan scenarios and assign
probabilities. The baseline scenario suggests more of what we have
been experiencing -- loose monetary policy, attempting to inflate
our way out of our challenges: a "kicking the can down the road"
scenario with the bond market giving policy makers the benefit of
the doubt, a gradual erosion of purchasing power, a weak dollar and
strong gold.
But just as the baseline scenario of any budget blueprint might
be more dream than reality, there are plenty of things that can go
wrong. Even the most prudent plan cannot ignore the reality that
there is too much debt in the world; when push comes to shove,
politicians have tended to favor inflation over austerity.
This report was prepared by
Merk
Investments LLC
, and reflects the current opinion of the author. It is based upon
sources and data believed to be accurate and reliable. Opinions and
forward looking statements expressed are subject to change without
notice. This information does not constitute a solicitation or an
offer to buy or sell any investment security, nor provide
investment advice.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
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