Inside Investment: In deep voodoo
The decision by Standard & Poor’s to place the US on credit watch with a “negative outlook” is a watershed. With politicians unwilling to attack spiralling welfare costs, a bond crisis might be just around the corner.
In the 1990s, a vocal presence in the discourse about the US economy and persistent budget deficits was the irascible Texas billionaire and presidential candidate H Ross Perot. With his many charts and trademark voodoo stick he would rail against the political establishment. When he confronted arch-rival George HW Bush in televised presidential debates he would shake his stick as vigorously as his head and remark: "It’s just plain sad."
Bush, you may recall, had years earlier accused Ronald Reagan of "voodoo economics" before proclaiming the US budget "in deep doo-doo". The phrase had come back to haunt him. Perot urged Americans, and urges them still, to "roll up our sleeves and look under the hood" to better understand the country’s problems. In the light of Standard & Poor’s recent "negative outlook" for the nation’s credit quality, it is indeed time to take a look.
The nation is at an impasse. The US federal government can be thought of as largely a welfare payment system with a big army, navy and airforce attached. Of total federal spending of $3.72 trillion, 19% goes to the military, with the substantial balance of 64% going to what the Statistical Abstract of the United States calls "payments to individuals".
It will be interesting to see how severe the crisis will have to become to spur the country’s inept leaders to action. Acrimony is likely to increase
These include the oft-debated Medicare and Social Security benefits but they do not stop there. Although these programmes were originally designed for retirees, a closer look shows that many other programmes have been grafted on over the years. Social Security pays $590 billion to retirees each year but also spends $124 billion on disability income and another $44 billion on supplemental security income for disabled workers who are not retired.
In fact, so-called disabled workers are now 5% of the total workforce a figure that will reach 10% before long. (It would appear that our working population is engaging in extreme sports to an unprecedented degree despite the obesity problem.) "Medicare and other medical" now totals $883 billion a year, of which approximately half goes for people who are not retired. This is before the cost of the Patient Protection and Affordable Care Act (nicknamed Obamacare), which is conservatively estimated to add a further $100 billion a year.
Food stamps are now distributed to more than 40 million Americans at a cost of $100 billion, housing assistance now adds $68 billion, and "other public assistance" a further $188 billion. Homeless shelters now provide almost 500,000 beds, the prison population has risen to 1.6 million, and nursing homes house 1.4 million. The Veterans Administration provides benefits for 23 million former servicemen at an annual cost of $96 billion.
It used to be said that Social Security was the third rail of US politics and that to touch it would bring certain death. There are now so many deadly third rails that US leaders dare not move. The various rails are, of course, financed through borrowing; the Chinese and other competitors have taken away US jobs but at least they have had the common decency to lend the money to pay for US benefits.
It should be remembered when looking at the federal budget that most public services such as schools and road maintenance are the responsibilities of states and localities to the extent that when the federal government shuts down, no one really notices. All in all, it looks as if about 100 million of the 300 million people in the US are on some sort of public assistance or support, including some of my own friends and relatives.
These programmes cannot be curtailed without a full-blown sovereign debt crisis in the Greek fashion. We are only two years away from the next presidential election and president Barack Obama would be unwise to alienate these important constituencies. The Republican House, for its part, has sworn not to raise taxes even a smidgen.
Another bomb lies in the budget, of course, and it is interest expense, as the Greeks, Portuguese and Irish know. Last year interest expense was $425 billion gross and $188 billion net. The growth in debt over the next two years should easily take us to $225 billion net interest expense and one could easily imagine a range of $500 billion to $1,000 billion in a market panic.
A political compromise seems no more likely in Washington than it did in Greece before the crisis. The new Congress is committed to cutting government spending but avoiding tax increases. The White House is open to tax increases but seems only interested in cutting the defence budget, which is now too small a part of the whole to solve the problem.
How will this play out? The most likely prospect is an impasse leading to increased nervousness over the summer followed by a bond market crisis. It will be interesting to see how severe the crisis will have to become to spur the country’s inept leaders to action. Acrimony is likely to increase, much as was seen recently in the state of Wisconsin and on the streets of London.
Clearly, bond holders will not prosper in such an environment and the stock market is likely to be volatile. Cash and natural resources might provide safe havens. As Bush the Elder would say, we are in deep doo-doo, and its foul odour will not be dispelled by a simple wave of Perot’s voodoo stick.
Lincoln Rathnam, PhD, CFA, is an investment professional based in Singapore and Boston. In a career spanning almost 30 years he has managed equity, debt and venture capital portfolios and was a pioneer investor in emerging markets in the late 1980s