James Paulsen: Investment Outlook (October 8, 2013)

James Paulsen: Investment Outlook (October 8, 2013)

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While Washington Argues ... Adam Smith Solves Problems!

The current fiscal drama highlights the cultural obsession this country has with its government. The 24- 7 media blitz covering the pending debt ceiling deadline feeds an American mindset which impatiently looks to our government with disdain and fearful hope to solve what are perceived as the biggest challenges faced by our country. Since the results are seldom satisfactory, both sides of the political aisle are often in a perpetual state of chronic disappointment and utter astonishment at the seeming dysfunction exhibited by “leaders” which are supposed to guide us into the future. Moreover, in the wake of watching how the sausage is actually made in a democracy is a great deal of trepidation. Unfortunately, based on a mistaken belief all hope is lost if our leaders are lost, this often depresses economic animal spirits and directs investors toward inappropriate portfolio decisions.

Certainly, the U.S. government and its leaders play a critical role in American life, economic and otherwise. However, the widespread impression the precise actions or inaction of the U.S. government is pivotal in whether and how well economic problems facing this country are solved is exaggerated. Although government decisions are not irrelevant, their impact on the overall economy are typically soundly overshadowed by actions of the “invisible hand.”

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Indeed, four major economic problems faced by the U.S. economy are in the process of being mostly solved by laissez-faire. These include restoring financial health to the U.S. government, developing a long-term plan for addressing the economic impact of aging developed world demographics, promoting a course for U.S. energy independence, and finally, reformatting the U.S. health care insurance system. We offer these illustrations to suggest most worry too much about the drama which is our government. For more than 200 years, the cumulative actions of millions of independent economic agents have been able to find solutions to seemingly overwhelming economic problems often made worse by government missteps. Relax a little. For while Washington argues and begins the new fall season with yet another fiscal cliffhanger, Adam Smith is busy solving many of the big economic problems of our day.

Problem #1—U.S. federal deficits are out of control?

Since the government deficit ballooned in the wake of the 2008 recession, intense public and political discussion has been devoted to what should be done to fix this country’s fiscal woes. The country has looked anxiously to Washington for a “grand bargain!” Although the government has been hopelessly frozen by gridlock and nonsense, fortunately, Adam Smith has been slowly but steadily addressing and improving federal budgetary problems.

As illustrated in Exhibit 1, although widely under appreciated, worsening public deficits are not typically a result of overspending (as suggested by the political right) nor under-taxing (as suggested by the left). Rather, deficit blowouts are primarily determined by the frequency and magnitude of recessions while deficit improvement results mostly from persistent (even if slow) recoveries. As shown, the budget deficit has ballooned following every recession of the last 50 years (its magnitude depending on the severity of each recession). Likewise, economic recoveries have consistently improved deficits as the invisible hand has revived taxable activity and lessened recessionary-induced outlays. Undoubtedly, secular budgetary issues remain problematic today. U.S. government social programs like social security and health care need to be better aligned with aging demographics if they are to remain solvent. However, despite these challenges, Exhibit 1 shows most of the contemporary budget problem is cyclical in nature (and being solved by the invisible hand) rather than structural.

Similar to the 1990s (or any other recovery in the post-war era), the deficit is melting away today under the tutelage of Adam Smith. As a percent of GDP, the deficit has improved from about 10.5% at its worst after the 2008 crisis to only about 4% currently. While some of the improvement in the last year has been due to sequester (maybe 1%), most is due to the magic of the invisible hand in restoring the government to financial health during recoveries. Importantly, Adam Smith has now corrected the deficit enough to bring it in line with overall nominal GDP growth. We expect nominal GDP growth to be near 5% next year. Since this growth rate is now in excess of the deficit, the widely feared debt-to- GDP ratio should soon start declining again!

You can read or download the entire report in the slidedeck blow.