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An Intractable Fiscal Problem

Gluskin Sheff

David Rosenberg

June 18, 2010

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We get it. The United States is not Greece. Nor is it any European country. It is the U.S.A. We get it. Best political system. Best economy. Most ingenuity. Reserve currency. We get it. And, the U.S. is never going to default on its obligations because it is, in fact, the world’s reserve currency and as such has full control of the printing press. And, nothing above was meant to be facetious.

As hedonistic as it is, the U.S. economy is the most flexible and adaptable economy, and for a whole host of reasons. At the same time, the national balance sheet is grim. The national debt/GDP ratio is about to pierce 100% and that does not include the state/local government morass nor the wave of off balance sheet items and underfunded liabilities, which would then take that ratio north of 500% (also see Gillian Tett’s article in today’s FT — Look at State Finances for the Real U.S. Budget Squeeze). That is the grim truth.

Even with low interest rates, the massive debt bulge has become so large that interest charges on the public debt are within three years of absorbing over 30% of the revenue base, which then makes it that much tougher to reverse course. In other words, the fiscal problem is becoming increasingly structural and we are already at the stage where even if the economy were running flat out at full employment, the deficit would still be over 7% relative to GDP. At some point, this will begin to impede economic progress.

Look at the chart below — when you add up the entitlement programs, you know — the ones you can’t cut back on, and interest payments on the grotesque debt load, we have 65% of total government spending that can’t be touched. In the next decade, under status quo policies, this “mandatory” share of the spending pie goes to 72%. Tack on the defense budget, my friends, and we are up to 88% of federal government outlays that are next to impossible to reverse. So tell me — we are going to reverse this seemingly intractable runup in the public debt to GDP ratio by slicing 12% of the spending pie that is discretionary? It won’t be enough, even if all that 12% remainder ‘pork and barrel’ spending were eliminated altogether.


So guess what the future holds … higher taxes: very likely a national sales tax. It works in Europe. It has also worked in Canada. Japan is planning to double its national sales tax from 5% to deal with its fiscal challenge (see page A11 of the WSJ). It stands to reason that a federal consumption tax will have to be part and parcel of any U.S. strategy to solve what is increasingly becoming an intractable budgetary deficit. The only question is when, and which politician is going to have the kahoonas and face the nation with the fiscal realities of the present and future. Alan Greenspan weighed in on the topic in today's Wall Street Journal, rather appropriately concluding that “our economy cannot afford a major mistake in underestimating the corrosive momentum of this fiscal crisis. Our policy focus must therefore err significantly on the side of restraint." Also see what other central bankers are saying now about the sad state of fiscal affairs globally on page B4 of the NYT (Cut Budgets to Stimulate, Central Bank Tells Europe).

Indeed, while many a Keynesian will point to the need for a government-led demand boost (see That 30s Feeling by Paul Krugman on page A25 of the NYT), the problem is that when the deficits and debts become structural, what is known as the “Ricardian equivalence” sets in and this means that the fiscal stimulus does more harm than good for the economy.

Unfortunately, while the bailouts saved insolvent banks (oh, we’re not Japan at all) the stimulus from this Administration involved a series of short-term quick fixes that provided no long-term multiplier impact. At least FDR put people to work — not merely to pay them to be idle. At least Eisenhower built highways -- with a long-run payback.

So, the consumer discretionary part of the stock market goes into the penalty box for a few years. It’s not as if re-regulation isn’t going to do the same thing to the financials! In the end, fiscal probity will bring back economic and financial stability. Bring it on.


We often cite one of our favourite equity valuation metrics, the Shiller P/E ratio (we are fans of it as it uses a very long history, back to the 1880s and uses real-10-year earnings). At 20x, the Shiller P/E is pointing to a market that is 20% overvalued versus historical norms (our calculations).

A reader pointed us to two other metrics from Smithers & Co. They also use the cyclically-adjusted P/E (composed of Robert Shiller’s data) but by their interpretation of the data, the market is 46% overvalued. Another metric they calculate is the Tobin q (using historical data back to the 1900s and Flow of Funds data starting in the 1950s). Here this metric is saying that the market is 50% overvalued

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(c) Gluskin Sheff








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