Don’t Believe This Whopper From Washington Economists

There is a titanic boxing match playing out in financial markets right now. Who wins will determine everything from the health of the economy, to the performance of your investment portfolio, to the standard of living of your children and grandchildren.

In one corner, we have the private sector. It can be volatile and prone to excess, but it also meets virtually any human want or need that can be profitably supplied: food, clothing, shelter, healthcare, Justin Bieber records, etc.

In the other corner is the public sector. It is unwieldy and inefficient, but it meets our other needs: national defense, basic research, public infrastructure, regulation, social services, etc.

I couldn’t be more excited about all the innovation and increased efficiencies coming out of the private sector: new products, new medicines, new technologies. To the extent that it flourishes, the economy, the stock market and your portfolio will do just fine.

The problem is the wildly dysfunctional public sector. In particular, federal spending has so far outstripped revenue that the public debt has more than doubled over the last few years, ballooning to more than $17 trillion. (And that doesn’t even include the more than $126 trillion in unfunded liabilities for Medicare, Medicaid and Social Security.)

But the really scary part is this: A growing chorus of economists and pundits now argue – seriously – that the federal deficit doesn’t really matter and, in fact, we should be spending hundreds of billions more right now.

It’s not just the usual loons on the left saying this. Everyone from Nobel Prize winner Paul Krugman (OK, one of the loons) to former Treasury Secretary Larry Summers are pressing the case for letting the deficit “solve itself” over time by stepping up economic growth.

Dangerous Thinking

This kind of thinking can have dangerous repercussions for the economy, the stock market and your investment portfolio.

For starters – let’s be real – if Washington were able to make the national economy jump we wouldn’t be in the fourth year of an anemic recovery.

Also, let me correct an oft-heard misstatement of fact, the one that says the federal budget deficit is already coming down.

Wrong.

The annual budget deficit is coming down. The total budget deficit is going up, by several hundred billion dollars a year. The way economists like Krugman put it, it sounds like we’re paying the debt down like we did briefly in the ‘90s. That’s not happening.

And while the annual deficit has fallen to about 4% of GDP from 10% in 2009, spending on entitlements has continued to soar, as it will inexorably in the years just ahead as more baby boomers retire.

I’ll concede that if the budget deficit grows more slowly than the overall economy, that’s a positive. But a couple huge risks still loom.

The first is that we go back into an economic funk. That would reduce corporate profits and national income. That, in turn, would dramatically reduce tax revenue, causing the deficit to balloon again.

The second problem – a virtual certainty – is higher interest rates down the road. Interest accounts for 6% of federal spending today. But a huge portion of this is short-term notes and bills yielding virtually nothing. That’s a boon for now. (Unless, of course, you’re a saver.) But when rates rise, so will the cost of carrying trillions in debt.

And forget all the rosy economic growth forecasts and revenue projections coming out of the Congressional Budget Office. No one can tell you how the economy will perform next year, much less over the next 20. This is pure crystal-ball gazing.

In short, the numbers don’t add up and can’t be made to. Only a fantasist can seriously believe “this is not a crisis.” And yet a lot of seemingly intelligent people are saying just that to the folks in power in Washington, and thereby lessening pressure to cut runaway spending.

Protect Yourself

What do you do as an investor? That depends. If you are somewhere between financially secure and independently wealthy, you might begin by making your asset allocation as conservative as you can stand.

If you are younger, have a longer time horizon or a higher risk tolerance, you should position your portfolio now for eventual nastiness down the road. That means diversifying beyond equities, buying only high quality issues and running trailing stops behind each of your individual stocks.

I’d love to suggest that voters will eventually throw out the bums in Washington who are jeopardizing our future. And, indeed, a new NBC/Wall Street Journal poll out this week suggests that nearly two-thirds of potential voters say they would consider voting for someone other than their incumbent.

Don’t believe it. Congressional representatives went into last year’s election with the lowest public approval rating in history.

The result? Ninety-one percent got re-elected.

Good investing,

Alex


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