One thing that I have studiously tried to avoid is getting political. In fact, I tend to be apolitical about things when it comes to money management. I truly do not care which party is in control as there is, to quote CNBC pundit Jim Cramer, “always a bull market somewhere!” That’s not to say that I don’t care about what happens politically. I do care. It’s just that regardless of the outcome – whether I like it or not – I have learned that we can always find ways to turn lemons into lemonade.

This quarter, though, I have to get a bit political. We are in the middle of a crisis. We just witnessed two petulant groups of children fighting about raising the debt ceiling. Lost in this whole mess were too many actual facts. So, this quarter, let’s lay out some very basic facts surrounding the crisis in America. I’ll let you make up your own mind about the next step to take, though I would be interested in your feedback with comments regarding this letter on our web site.

The recent debt ceiling debates were infused with much political rhetoric. Further muddling the situation is the fact that much of what has happened in the past few years has been completely lost on folks as the real story has not really been told. So let’s set the record straight with some key facts here.

  • Let’s start with what the deficit ceiling is really all about. What it’s not about is future spending. What it does deal with is paying bills we have already accumulated. Think of this as “overdraft protection” as you are paying your bills for water, electricity, gas, cable and so forth. We’ve already committed to spending the money. We just don’t have the money to spend unless we dip into our credit line (debt limit).
  • Where did the large and growing deficit come from? When Bill Clinton left office, there had been four straight years of budget surpluses. In 2001, when Clinton left office and George W. Bush took over, the budget surplus was $127.3 billion. The very next year, we had a budget deficit of $157.8 billion – a turnaround of $285.1 billion. By the end of Bush’s term in 2008, the deficit was $455 billion, caused largely by two wars (Afghanistan and Iraq) that were not funded. In 2009, the year Obama took office, the deficit swelled to $1,416 billion. In 2010, the deficit actually fell to $1,290 billion, but is back on pace this year to be $1,410 billion.
  • The nearly $1 trillion jump in deficits in 2009 was largely due to the American Recovery and Reinvestment Act of 2009 (unofficially, the “stimulus bill”). This bill was signed into law in February 2009 in response to the mortgage meltdown of late 2008 and the ensuing credit crisis and recession. This bill was an attempt to “kick start” the economy to get it growing again. It was roughly modeled after our response to the Great Depression of the 1930’s. Some of the key provisions of this bill included:
  • Tax incentives for individuals ($237 billion or 30% of the total)
  • Tax incentives for businesses ($51 billion or 6.5% of the total)
  • Healthcare benefits with Medicaid being the largest recipient ($155.1 billion or 20% of the total)
  • Education for retraining workers ($100 billion or 13% of the total)
  • Aid to low income workers and retirees ($82.2 billion or about 10% of the total)
  • Infrastructure investment ($105.3 billion 13% of the total)

The total projected stimulus package was estimated to be $788 billion, though not all of the funds that were originally allocated have been spent. In fact, information about how the stimulus money has been spent and the direct results of this spending can be found at www.recovery.gov. For example, here in NC, $7.6 billion has been awarded for projects affecting 29,407 jobs (either kept or created).

The budget for 2011 (according to some politicians in recent heated exchanges on TV, there is no budget for 2011 from the President. However, you can see it for yourself at http://www.gpoaccess.gov/usbudget/fy11/index.html) totals just over $3.8 trillion with projected income of about $2.6 trillion, leading to a shortfall of an additional $1.2 trillion this year. Included in this budget is nearly $2.1 trillion for safety net programs including Social Security ($730 billion), Medicare, Medicaid, unemployment benefits and so forth. The budget also includes $846 billion for “security” including nearly $160 billion for the war in Afghanistan.

Now, we clearly cannot keep spending like drunken sailors. But we also cannot abide what is going on in Washington. The “Tea Party” bloc of Republicans offered up a bill labeled as the “cut, cap and balance” proposal. The idea was to cut the deficit, cap spending at no more than 18% of GDP (the total output of our economy) and pass a Constitutional amendment that requires a balanced budget every year. That sounds great, but if we return to the previous paragraph for a moment, we see that we have $2.6 trillion coming in and $3.8 trillion going out. Where exactly do you propose that we suddenly whack 32%? Should we cut all spending equally or just certain “sacred cows”? Cut, cap and balance doesn’t address this very thorny issue at all.

The second part of that proposal, capping spending at 18% of our total economic output, sounds simple enough, but the reality is far different. In fact, if we look at spending under past presidents, we see that the average spending (as percentage of GDP) was:

• Carter 21.1%
• Reagan 22.3%
• George H.W. Bush 21.8%
• Clinton 19.4%
• George W. Bush 20.5%

So, this 18% spending cap is an artificially low level. This says nothing about how bad an 18% cap on spending would be in the event of recessions. And, going one step further, if our economy were to slow down again, we would be forced by this bill to reduce government spending which would further exacerbate the situation. This would cause a further shrinkage in GDP causing more cuts in spending and so forth. The government needs the ability to spend more than we take in on certain occasions but we need to do this wisely and prudently.

This type of government intervention is very similar to what happened after the Great Depression of the 1930’s. There are many who argue that government intervention did little to bring the U.S. out of the depression and it was only our gearing up for World War II that led to our recovery. This is partially true, though this does little to dissuade the argument for government intervention during recessions. In fact, if we look at a timeline of the government response to the Great Depression, we see that Keynes was indeed correct in his calls for deficit spending.

In 1932, the year Roosevelt was elected, our economic output fell 13% and unemployment hit 23%. The following year, when Roosevelt took office, the free-fall in the economy slowed as production fell only 2.1% though unemployment did reach almost 25%, the worst during the Depression. Roosevelt started implementing many of the suggestions of noted British economist John Maynard Keynes to spend, though he ultimately ignored one of Keynes’ key suggestions – to borrow and spend (create a deficit). In 1934, as a side note, Sweden became the first country to emerge from the Great Depression. They had followed Keynes’ call for deficit spending. Back in the U.S., by 1937, the unemployment rate has fallen to around 14%, but Roosevelt was obsessed with keeping to a balanced budget so he cut spending for the year. That led to another recession starting during the summer of 1937. The following year, unemployment rose to 19% and total economic production fell around 4.5% for the year. It was finally the borrowing of nearly $1 billion to build up our military that dragged the U.S. out of the Depression.

As we can see, deficit spending is sometimes critical to a country’s short-term and long-term health and well-being. This does not mean that we need to have deficits forever. The idea is to borrow short-term to invest for the long-term. You also need to spend the money appropriately. Many politicians are calling for continued tax cuts as a way to boost our economy. Often, these politicians will continue their argument by pointing out that the stimulus bill did little to spur economic growth. However, if we look at the bill, you will note that over one-third of the bill involved tax cuts. Politicians who point out the stimulus bill failed to jump start the economy tend not to point to the tax cuts in the stimulus bill that didn’t work.

I don’t think anyone would argue that we are at a critical juncture in our history. What happens from here is going to be a defining moment in where America is headed. Our problem is not that that we have debt outstanding or that we have deficit spending. Our problem is that we have too much debt to continue deficit spending for much longer. From all of the rhetoric, one would think we were the most indebted nation on the planet. We are the worst from the standpoint of nominal debt – that is the total dollar amount of debt outstanding. However, on a relative basis, we are far from the worst. In fact, if you measure our debt as a percentage of our GDP (total economic output) we rank eighth in the world based on the debt-to-GDP ratio. Now, that’s not anything to brag about (Greece and Italy are numbers five and six on the list), and the key is the direction we are headed. Currently we are climbing the list and that is not what we want to happen. This means that we do need to reign in our spending and pay down our debts. No one – Democrat or Republican – would argue with this simple fact. We need a more sustainable level of debt-to-GDP ratio. Historically, a ratio less than 90% has been very sustainable (currently, we are at 100.2%). The compromise we got for raising the debt ceiling doesn’t address the issue of this growing debt. There are really only two ways to get our fiscal house in order – cut spending and raise revenues – and both of these methods need to be put on the table in our county’s fiscal discussions. There are some hard decisions to be made and everyone is going to need to sacrifice. At least now, when the debates rage, you will have a better idea of what is fact and what is rhetoric.

As always, I am honored that you have entrusted us to manage a portion of your assets. If you ever have any questions or need any information, please feel free to contact us.

Sincerely,

Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095