ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

The Political Cliff

January 22nd, 2013

by Lawrence Grossman

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After the recent “fiscal cliff” theatrics in Washington, it is clear that the vast majority of Americans believes the real crisis is our government’s failure to act responsibly. Long before the fiscal cliff, we went over a “political cliff” when unwillingness to make practical economic decisions came to define the culture in Washington.

The political cliff is not the only reason we faced the so-called fiscal cliff, which was itself just the first drop-off in a more dangerous fiscal cascade. The true fiscal crisis remains to be averted, and we can’t count on the politicians to come up with a workable plan. They illustrated why with the recent “compromise” tax solution, which made our fiscal situation worse – it added $4 trillion to the forecast debt over the next decade, a 25% increase from today.

Cliff-dwelling politicians are sending our country toward insolvency. Averting this crisis requires unconventional yet bold thinking. I propose such a plan.

Before I explain my plan to restore fiscal solvency and sanity, however, let’s look at the depth of the current crisis.

The true fiscal challenge

The current trajectory of debt growth is unsustainable and, if unchecked, its future cost will become unbearable in just a couple of decades, during most of our lifetimes. We may see today a glimpse of our future in Greece, suffering with over 25% unemployment, radically increased costs of medical care, years of economic contraction, the collapse of their ability to borrow on the open market, the rise of racist and extremist political movements, and the ignominy of foreign oversight of its national finances.

The US national debt, which was about 33% of GDP in the post-war era through 1980, now stands at about 70% of GDP, and it is forecast to hit about 300% of GDP within 75 years. Unfunded future benefit promises (i.e., Medicare and Social Security) are variously estimated to range from 3- to 15-times the size of the national debt. Interest payments on the national debt are forecast to increase tenfold, from 1.5% of GDP in 2011 to 16% in 2086. The Medicare and Social Security trust funds are on track to be depleted in about 13 and 20 years, respectively; thereafter, benefits would be cut drastically (by about 25%) from today’s levels.

The Treasury Department’s latest Financial Report of the US Government states that “the continuous rise of the debt-to-GDP ratio illustrates that current policy is unsustainable.” The Treasury estimates that preventing the debt-to-GDP ratio from rising unsustainably over the next 75 years would require running primary surpluses (revenues less expenses, excluding debt service) of 1.1% of GDP. This compares to an average primary deficit of 0.7% of GDP today. The difference – the “75-year fiscal gap” – is 1.8% of GDP, and must be closed by some combination of expenditure reductions and revenue increases.

The Treasury’s report, released last year, also emphasized that these “base case” projections assumed that the Bush-era tax cuts would expire and end on December 31, 2012. Because they were made permanent by the fiscal-cliff compromise, the fiscal gap now resembles the Treasury’s “alternative” case estimate, which is about 8.3% of GDP on average over the next 75 years. The GAO estimates that, in that alternative scenario, “by 2040 more than half of all federal revenue will go to net interest payments” and waiting 10 years to address the issue “would increase the fiscal gap to nearly 10% of GDP.”

In US budgetary terms, this gap could be closed if projected levels of revenues and spending improved about 40-50% from currently planned levels.

These are the numbers that define our true fiscal challenge.

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