Debt! (Fire!)

 Event
At some point over the one-to-two months the debt level of the federal government will likely exceed the current debt ceiling. The federal government is currently politicking their way towards a federal budget, with the focus on cutting around $40 billion from non-entitlement non-defense spending. This portion of the budget accounts for about 12% of the federal budget. Unless some compromise is reached before the end of the week the federal government shuts down. Of course the predictable fingers from the left and the right are pointing at the other side. As a reminder, this is just the opening act in what promises to be a brutal battle over entitlements, tax rates, and government services.

Worst case scenario, a government shut down and the debt ceiling is not raised, which implies the U.S. Treasury cannot legally issue additional debt to finance the expenditures of the country. This scenario likely leads to some rather unpleasant outcomes, like higher interest rates and drastic cuts in entitlement programs that hastens an economic slowdown. Best case, a budget compromise is realized that appeases the majority, the debt ceiling is raised, and politicians tackle the rest of the budget in a responsible manner. This scenario likely extends the current bubble period and buys the country another year to deal with the fundamental problem - debt.

Analysis
So what is likely the road forward after this is resolved in DC? To start, let's focus on the root of the problem - debt. The Total Debt Outstanding for the U.S. government has increased to almost 100% of the annual GDP. This level has increased over the past 30 years from well under 40% in the early 1980's. This path is clearly unsustainable.

For U.S. consumers the picture is even bleaker. About three quarters of the U.S. economy is driven by consumer purchases, thus any change in consumer spending has a material impact on the economy. True, debt levels did decrease during the recession (likely causing the recession), but in the last quarter they started to rise again (likely helping the perceived recovery).

What has encouraged the U.S. consumer to start loading up on debt again? Easy money. The Fed has flooded the economy with money to offset a tighter lending environment by banks, lower interest rates, and to stimulate economic growth. The following graph is startling:

Note: Adjusted Monetary Base is defined as the sum of currency in circulation outside Federal Reserve Banks and the U.S. Treasury, deposits of depository financial institutions at Federal Reserve Banks, and an adjustment for the effects of changes in statutory reserve requirements on the quantity of base money held by depositories.

Adding fuel to the fire - the majority of banks are loosening lending standards, thus providing greater incentive to consumers to increase debt levels.

Summary

The U.S. economy is driven by consumer spending. The consumer has started to again increase debt levels in order to maintain a consumption level able to drive economic growth since income and asset appreciation has not grown dramatically. The Fed has completed Herculean efforts to keep the economy moving by convincing the consumer to keep buying. At some point the music stops. Sagflation (flat-to-negative real growth + volatile prices) settles in further as fundamental deflationary forces driven by deleveraging are battled by active inflationary actions taken by the Fed. Bubbles form and pop, politicians seesaw policy between extremes, and businesses suffer in an increasingly unstable world. How long the Fed can keep the music playing is anyone's guess, but the end game is likely debilitating inflation pressures, severe economic retrenchment, or both. Sagflation.


The challenge will be to identify investment strategies in this world.