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Financial Armageddon: Should a Rational, Thinking Person Be Worried?

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Here are the numbers and the assumptions behind them. You be the judge.

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MINYANVILLE ORIGINAL You've probably seen them in your email, or even on TV – I'm talking about the "approaching financial Armageddon" forecasts. People must be responding to them, because they keep on appearing in my email – several per week, and others I know get them too.

Some of these forecasts discuss the explosion in the Fed's balance sheet (i.e., money printing), while some talk about the risk to the dollar's status as the world's reserve currency and what that means for interest rates and the borrowing ability of the US Treasury. In reality, all of these worries boil down to the deficit, the debt, and the ongoing unfunded promises made by governments, especially the US federal government.

So, should a rational person be concerned with the histrionics of the predictors of doom? After all, even a broken clock is right twice a day.

To answer this, look at the table below, which shows the six largest categories of federal expenditures in '00, '12, projections for '16, and their associated compounded annual growth rates, or CAGR. Much of this data comes from the website, USdebtclock.org. Caution – that website is not for the faint of heart.



The six expense categories shown account for nearly $3.1 trillion of spending in 2012, represent more than 86% of total Federal spending and account for 137% of taxes collected.

These six spending categories are critical when trying to understand the nature and extent of the structural deficit. Just looking at the growth rates (the columns entitled CAGR), it is hard to believe that Medicare/Medicaid spending will slow from their 12-year growth rate of 8.2% per year given the demographics of the US population and the fact that the baby boomers are just beginning retirement. And, it seems reasonable that Social Security will also advance much more quickly than the 5.4% growth rate it has shown of the past 12 years.

It seems a stretch to believe that Congress will rein in the growth of the federal government itself such that the cost of Federal Pensions stays flat between now and 2016. How likely is it that Congress the current 99 weeks of unemployment compensation back to 52 weeks? Finally, while possible, I believe it is also a stretch to believe that spending on Defense will actually fall over the four-year period.

All in all, the projection of expenses I've shown in the table for 2016 appears to be quite optimistic. But, let's go with it.

Americans in general will tell you that they oppose bigger government, at least in the abstract. But in poll after poll, when asked where Congress should make significant cost cuts, almost no specific programs are named by a majority of Americans. For example, in a recent poll, when asked which of 16 federal programs should have lower spending, only one, Foreign Aid, got a majority of respondents. Even a majority of Republican primary voters only designated four programs (Foreign Aid, Environment, Housing, and Unemployment benefits) for the knife. This really isn't too surprising given that the number of income tax paying Americans is barely over 50%.

Assuming that these six categories again account for 86% of federal spending in 2016, then total spending will be approximately $4.3 trillion. The following table shows what the federal deficit will be and its relationship to 2016 GDP (estimated to be $17.0 billion, a 3% compound annual growth rate, or CAGR, from 2012) under differing growth rates of federal tax collections.



Looking at it this way shows that the problem is truly daunting. To even get to a 5.8% deficit/GDP ratio (middle column), which keeps the Federal cash budget at a $980 billion deficit (right hand column) (to say nothing of the $3.5 trillion of unfunded liabilities that accrue to these social programs every year), it will take 4 years of 10% revenue increases (left hand column) each and every year. Some of this could come from economic growth, but even if growth occurs at 3.0%, the average current American taxpayer will be faced with a 7% annual growth rate in their taxes even if they didn't make a single penny more in income.

Some analysts fret about the "fiscal cliff" we're approaching. This will occur on 1/1/13 when the Bush tax cuts are scheduled to expire along with the 2% payroll tax reduction for individual Social Security contributions. Some analysts put the impact of these at a 3% to 4% reduction in GDP.

Using a ratio of income taxes collected/personal income in 2000 (prior to the Bush tax cuts) and applying that to 2012 personal income projections implies that the federal government would collect about $300 billion more in taxes when the Bush tax cuts expire if economic activity were otherwise unchanged -- a heroic assumption. Since economic activity is likely to go down, $300 billion is probably optimistic.

In addition, the reinstatement of the 2% Social Security tax on individuals will add about $160 billion to tax revenues (again, assuming no decline in economic activity). The table below is similar to the one just discussed, but it assumes that the Bush tax cuts have been eliminated, the payroll taxes are reinstated, and economic activity is not negatively impacted. The tax revenue growth rates (left hand column) begin in 2013, after the "fiscal cliff" has occurred.



As you can see from the table, reinstatement of the Bush tax cuts and the payroll tax reductions alone do little to solve the issue, as the deficit remains at $1.54 trillion (9.1% of GDP) if no further tax increases occur. To get to a 4.9% deficit/GDP ratio ($830 billion deficit) would require a compounded annual increase in taxes of 8% after 2013 -- that is in addition to the tax burden resulting from the expiration of Bush and the payroll tax reductions.

This will clearly keep the economy in a no growth or recessionary mode. And, if America resists the tax increases, then deficits will balloon, interest rates will rise as the rest of the world spurns the dollar, the Fed will continue to print money and purchase the debt that can't be placed externally, a nasty inflation will likely set in (if it hasn't already begun -- look at food and energy prices), and we will find ourselves in a Greek-type tragedy.

To date, all the previous congresses and presidents have kicked the can down the road – forcing their future counterparts to deal with the debt and deficit issues. The US has not even had an official budget for the past three years, and spending continues to rise. The only way out is to significantly cut the growth of the four social programs listed in the table above (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions). Which congress and president will do that?

To my way of thinking, it's not just irrational kooks predicting financial armageddon. Looking at the numbers and the assumptions, we should be too.

Editor's Note: Dr. Robert Barone is a Managing Partner / Portfolio Manager of Universal Value Advisors.
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