Most recently, concern has shifted to the âfiscal cliffâ â the combination of automatic tax increases and spending cuts that will go into effect at the beginning of 2013 if nothing is done before then by the seemingly gridlocked government (more on this later). Finally, most business people probably want Mitt Romney to be the next president, but heâs behind in the polls. The sum of these doubts is contributing to the sluggish expansion weâre seeing. (Of course, one of these days deferred spending could give way to invigorated investment in capacity.)
Itâs easy to view problems like these as insoluble and part of a self-feeding vicious circle. When people who are overly indebted reduce their spending, their collective action weakens the economy. The weak economy discourages businesses from hiring and expanding, and thus it stays weak. Itâs essential, however, to remember that it can be just as wrong to see things as hopeless as it is to consider an environment risk-free. One mustnât overreact in either direction.
Potential economic pluses do exist, and they tend to be overlooked in downcast periods like today. These include the incipient housing recovery; the possibility of energy self-sufficiency; the fact that U.S. manufacturing has slimmed down and our Chinese competitors have seen costs rise; and the fact that the U.S. still leads in higher education, creativity and entrepreneurship.
For me, the bottom line of all this is that we arenât looking at a period of prosperity. A recovery is underway and is likely to continue, but it is more likely to be lackluster than vigorous. Most Americansâ financial memory consists of V-shaped recoveries and periods of good feeling like the 1990s, when they couldnât think of reasons not to borrow and spend. Five years from now, I think people will still be asking, âWhen will the economy get going? When will we get back to good times?â
Black Swans, Landmines and Long-Term Problems
In addition to this unexciting general outlook, I (like most others) can reel off a litany of current and potential problems like Iâve never seen before. Each one deserves a memo, but â as I said â Iâm trying to be economical with your time and attention.
Europe represents a problem of enormous proportions, huge risk and limitless uncertainty. The nations and banks of Europe â and especially Portugal, Italy, Ireland, Greece and Spain (the PIIGS) â partook liberally of the excessive ability to borrow described above. They squandered the proceeds in a variety of ways, ranging from excessive benefit programs for citizens to ill-fated investments. They owe amounts they canât ever repay and will have trouble servicing in times of economic weakness. Theyâll be forced to spend less in the period ahead, but that will further weaken their economies and add to the pain felt by their citizens. The results have included unrest and may continue to do so. And yet â despite attempts at austerity and delevering â in many countries the ratio of total public and private debt to GDP is now greater than it was five years ago (according to Jamil Baz of GLG Partners).
People ask all the time what will happen in Europe. I tell them the situation is enormously complex, murky and uncertain, but Iâm absolutely sure of three things: (a) I donât know, (b) nobody knows, and (c) if you ask an expert for advice and follow it, youâll probably be making a mistake.
When people invest in an Oaktree fund, itâs on the basis of a limited partnership agreement that spends a few pages on what weâre going to do and dozens more on things like the rules weâll follow and what happens if we donât. I get the impression that in the case of the European Union, politicians wrote the first section based on glowing hopes but forgot about the rest. When faced with conditions like these, in my view, thereâs absolutely no alternative to saying we have no idea what the future holds. Period.
Since the nuts and bolts stuff was omitted, thereâs no schematic diagram or instruction manual for Europe. There are no procedures for ensuring nations donât run excessive deficits, or for moving a member state out of the European Union. Any actions that are taken will require unanimous decisions on the part of elected officials from nations with divergent interests. Taking all of this together, I feel there can be no certainty about:
- what should be done to fix the problem,
- what can be done,
- what will be done, and
- what the ramifications will be, especially the second-order consequences.
I imagine Europeâs leaders will muddle through, continuing to do the absolute minimum that suffices at the last possible moment. There will be palliatives, but solutions will be hard to achieve (the latter would require the nations of Europe to significantly surrender sovereignty). Last week the European Central Bank announced a program of bond buying, and this was viewed positively. Buying bonds will keep borrowing costs down for as long as itâs practiced, but it wonât solve the problems. The important tasks facing the peripheral nations are much greater: cutting deficits and policing them, reducing the excessive debt burden that was allowed to build up, and restoring growth and competitiveness. Thus the problem is likely to drag on for years, assuming it doesnât flare up into a global crisis. Everyone hopes Europe will do whatâs needed, but hope isnât much of a plan.
The U.S. fiscal situation is less acute, less immediate, and easier to duck given that we can print the worldâs reserve currency . . . but little better. In fact, in some ways it is more dangerous because the problems are more back-end loaded and perhaps less overt.
Our politicians, too, used easy money to give everyone everything: generous benefit programs as well as significant tax reductions (and major stimulus programs when needed). Entitlements, interest and other mandatory expenditures consume all of the taxes collected; forget about the rest of government spending â on things like defense, education, transportation and scientific research. We face huge annual deficits and ballooning national debt.
As an aside, one reason our deficit situation isnât worse today is the ultra-low level of interest rates, which constitute a tremendous subsidy of the government by savers. Even with these low rates, interest on the federal debt consumes roughly 10% of all federal taxes collected. Imagine what the deficit would be if the 10-year Treasury note were at 7% rather than less than 2%.
Entitlement programs are the biggest problem, primarily Medicare (healthcare for the elderly), Medicaid (healthcare for the poor) and Social Security (retirement benefits). Politicians in years gone by granted benefits without much thought to the rate at which they would grow and where the money to pay them would come from. Benefits have been expanded or indexed to inflation, and the post-war Baby Boomers, with their much-increased life expectancies, are bound to create an incredible burden; the national debt of $16 trillion is dwarfed by unfunded future benefits, the present value of which is variously estimated at an additional $50-90 trillion.
We have problems at the state and local level, in addition to the federal. The federal government is pushing burdens off to states and reducing funding; at the same time the soft economy is cutting into state and local tax collections and increasing citizensâ needs. I recently read about a city that had to choose between policemen, firemen and teachers for the layoffs through which to balance its budget. In other words, the city has been providing a level of services that it canât afford. Painful austerity is unavoidable; neither firemen, policemen nor teachers can be easily dispensed with. Also, for years state and local politicians have promised public employees retirement and health benefits without regard for how they would be paid. Pension plans that are currently underfunded by $1-3 trillion represent a ticking time bomb. Weâve seen a spate of municipal bankruptcies this year, and I believe more are coming.
