Let’s begin this conversation with a less-than-serious look at how our banking system works. This short video will shift your mood: http://www.youtube.com/watch?v=M_3T-Af57Pg&NR=1.
With your state slightly altered, you may be able to see how Washington works, with an insider to guide you.
Chances are you’ve been a little dismayed about what you’re seeing in Washington these days. Not only are the two parties constantly bickering at each other, but they are blocking progress. That situation may be a great thing under normal circumstances, but at a time when there are so many major problems to be solved, gridlock doesn’t seem to be the ideal solution.
That’s why so many financial advisors were interested to hear what David Gergen said when he spoke at a major industry conference in Salt Lake City. Gergen has worked for both Democratic and Republican presidents, and has managed to keep an insider’s view of Washington. In his view, are things really as bad as they seem?
Gergen told the audience that, despite all the bickering, both sides of the aisle see the current debt crisis through the same basic filter. “People in Washington basically agree on the nature of the problem and its consequences,” he said, “which are outlined in the theories proposed by economists Ken Rogoff and Carmen Reinhart.”
Rogoff and Reinhart’s influential book, entitled “This Time It’s Different,” looks at various debt, fiscal and economic crises in different countries around the world over a period of several hundred years. Their conclusion is that the most crippling economic scenarios play out a familiar pattern. First, you have a financial crisis, and the government throws a ton of money to end it. “But then,” said Gergen, “you have thrown so many resources at the problem that it moves from a financial crisis to a fiscal crisis, because the government had to borrow so much to stop the financial crisis. And it is how they address the fiscal crisis that determines their long-term well-being as a country.”
The book also outlines some danger zones. If public debt grows larger than 60% of the size of the country’s economy, you start to enter a danger zone. “At that point, you really need to deal with the problem or you are moving into deeper water,” said Gergen.
If the debt level reaches 100% of GDP, the country moves into a danger zone. Its economic growth rate goes down at least a percentage point, and creditors (think: China) begin to get nervous and demand higher rates on their government bond investments. Borrowing costs go up, adding to the problem, and the lower economic growth rate lowers tax revenues, making it harder to pay down the debt, which then sends the whole situation into another round of still higher borrowing costs and lower economic growth. Consider the current situation in Greece. Each time the EU negotiates a settlement, the country starts to impose economic hardships that depress the GDP and the tax revenues miss the target; then the rating agencies highlight the problem and the debt becomes harder to pay off as interest rates rise, causing Greece to re-negotiate … again!
Gergen noted that since World War II, U.S. government debt has generally run about 38% of America’s Gross Domestic Product; this is a ratio that Rogoff and Reinhardt would call a healthy range. This last year, we reached the 60% level. Under the government’s current trajectory, we might hit that 100% level in less than a decade.
Both Republicans and Democrats want to avoid that scenario, which is the good news. The bad news is that they disagree on how to do it. “There are two ways to address the problem,” Gergen told the audience. “You can cut spending, or you can raise revenues.” [Or, as we like to say, lighten the load or strengthen the donkey.] “Spending is 25% of GDP right now. The Republicans want to get that down to 21%, the Democrats want to cut but not that far, and they both want to cut different things.” To make up the difference, the Democratic leadership wants to raise taxes on upper-income Americans; the Republicans want to maintain the current tax rates.
Is there any hope? Gergen noted that a bipartisan committee headed by Republican ex-Senator Alan Simpson and Democratic former White House chief of staff Erskine Bowles has mapped out a way to reduce total government debt by $4 trillion, cutting spending by two dollars for every dollar of tax increases. A so-called “Gang of 6” in Congress that included both liberal Democrats and Conservative Republicans was working on an alternative proposal, but that fell apart a week before Gergen spoke. A third group, chaired by Vice President Joe Biden, is still holding meetings.
Overhanging any negotiations, and making them more complicated, is the debt ceiling limit, which will be breached on August 2, throwing the U.S. in technical default on all of its bond obligations. “[U.S. Treasury Secretary Tim] Geithner would like to get this resolved well before August 2, so as not to rattle the markets,” Gergen told the audience. “The Wall Street folks are warning the people in Washington not to play with the debt ceiling, that any loss of confidence in the U.S. could be a big deal. Recall the economic collapse in the US when Lehman Brothers fell and basically created a financial sinkhole that we have yet to extricate ourselves from. Meanwhile, the Republican leadership thinks they’ll get a better deal as they approach August 2nd, and some Republicans think there may not be a problem if the negotiations go past August 2nd.” Yes, and Hank Paulson (US Treasury Secretary under the last years of the Bush Administration) thought there was a chance for an economic collapse if Lehman Brothers went bankrupt, but they thought the risk was manageable. You know what is said about 20/20 hindsight.
The silent party to these negotiations and the ones paying the bills, the general public, seems not to understand the severity of the issue, Gergen said. “In recent polls, 60% of them think we should not raise the debt limit,” he told the audience. Here is the scary part. Without raising the debt ceiling the US would have to cut all spending except maybe Social Security, Medicare and Medicaid. We would not have enough “cushion” to pay for Defense, and only maybe Congressional salaries.
In the long run, Gergen said, if Congress manages to address the debt issue responsibly, it could make America stronger. “Otherwise,” he said, “it will be very bad news.” Because the political risks of taking action that might alienate the public, both Congress and the White House seem to prefer kicking the government debt issue down the road for 18 months, deferring any serious action until after the 2012 elections, which Gergen finds dismaying.
“We’re playing right close to the edge on this,” he told the group. “This is dangerous stuff for our politicians to be playing with.” He described it as one of the most serious issues he has seen in Washington in the last 30-40 years. This situation brings to mind the game of Chicken in the 1955 movie “Rebel without a Cause.” You know the scene well. There are two teens driving stolen vehicles (someone else’s money) towards a cliff. One teen gets his clothes stuck on the steering wheel and dies! Let’s hope that does not happen while we are passengers.
But, as a passenger, are there any actions to take to help prevent falling off that cliff? We believe there are. On an individual level, being aware of your own spending and minimizing your own debt levels will provide a financial buffer to mitigate the storms of a national or international debt crisis. On a state and national level, vote for politicians who are making a serious attempt to resolve the debt issue. Awareness and a commitment to resolving the problem, both long and short term, will keep us on the top of the cliff, perhaps driving safely on the road, instead of stuck on the steering wheel.
