Written by Nathan White, Paragon’s Chief Investment Officer
Taken from Paragon’s 2Qtr 2011 print newsletter 

Debt Ceiling Debate

As July unfolds, the debt ceiling debate will take center stage. The current fiscal path in unsustainable, and we will someday experience the Greek tragedy now unfolding if we fail to enact any reforms. The main reason why the current recovery has been so sluggish is due to the continued debt overhang. It will act as a drag on the economy until the bad loans and debt are mostly cleared out. The problem with enacting reforms is that it is not politically popular because no one ever wants their benefits cut (that’s why the Greeks are rioting).

The markets always like to be bailed out in the short-term to avoid pain and hard decisions, similar to how we might react with our personal choices. The government is always willing to reinforce this behavior out of political panic and opportunity. The average interest rate on Treasury borrowing is 2.5 percent. If rates were to normalize up from the Fed’s artificial level, it would add hundreds of billions to the annual interest expense putting more pressure on the deficit.

The President’s budget predicts over four percent GDP growth every year for the next three years. These growth figures are so overly optimistic and out of line with general consensus, they are laughable.   Missing these rosy economic projections by even a percentage point with the President’s proposed budget would add trillions to the national debt in just a few short years thereby exacerbating our debt situation.

We are at an interesting crossroads where irony abounds. The healthiest situation for fiscal soundness is to enact reform now before it gets out of hand, but because it is not a problem now and requires some (very mild) short-term pain (i.e., entitlement reforms/cuts) there is not a great will to do so. In the short-term the bond market would like the debt ceiling raised to avoid any disruptions in payments of principal or interest. However, to continue to raise the debt ceiling without any real fiscal reforms will spell disaster for the bond market in the long-term.

Picking Savers’ Pockets

If the government does not like to make outwardly hard decisions, how can they tackle the enormous deficit and debt overhangs? This is where you come in. The government does not need to tax you more outright or cut your benefits – that would be to obvious and politically unfeasible. According to economist Carmen Reinhart of the Peterson Institute for International Economics, the option then becomes what is called financial repression. Financial repression involves keeping nominal (i.e. published or quoted) interest on government bonds lower than inflation. It is basically a form of picking the pockets of savers, and it is already happening.

The Consumer Price Index as of the end of May was running at 3.6 percent. I am sure you are well aware of the rate you get on savings, which is pretty much zero. This means that your cash just sitting around or at the bank is worth 3.6 percent less than a year ago.  This spread directly benefits the government at your expense. It inflates away the value of the debt. This type of action for 10 years could reduce the Debt/GDP level by 30 -40 percent! Voila, it’s like magic! They just stealthily increased your tax burden without you directly noticing. You will feel it over time in the form of a lower standard of living where things just never really seem to get to where they were before.

Although economic growth is slowing, it is still growth, and corporate profits are still very impressive providing support for further equity gains. All Congress and the President have to do is pass real fiscal reform along with the short-term debt ceiling increase, and the markets would smile.

Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.