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 US 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 (Fed). 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 chicken, 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, 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.
Axel Merk
We have long argued that investors may want to take
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