Budget Battles Ahead

By: Axel_Merk

William Poole writes: I began writing this note on New Year’s Day; the holiday season is over all too early for me as I contemplate the coming year. Along with other investors, I have many worries, but at the top of my list is the budget battle that will be fought in Washington, every state capital and most capitals of high-income countries abroad. As I finish this note, Republicans are now in charge of the House of Representatives.

The U.S tax battle on the federal level was fought and resolved a few weeks ago, but only temporarily. In early December, President Obama’s Deficit Commission (officially, National Commission on Fiscal Responsibility and Reform) presented its report, with the provocative title “The Moment of Truth.” Unfortunately, the report seems to have dropped out of the news already.

I have read a huge amount of recent press commentary on what lies ahead, but some key issues are missing.

• The Deficit Commission argues that government promises made must be kept; however, it will be impossible for the federal government to keep all its promises. The same is true for many state and municipal governments and for governments abroad. I will focus on the U.S. federal government but similar issues arise with other jurisdictions. The essential fact of the fiscal condition of the U.S. government is that promises now on the books cannot all be kept because there are no tax rates consistent with the functioning of a market economy that will raise sufficient revenue. If you doubt that statement, spend some time reading budget projections by the Congressional Budget Office and the work of Lawrence Kotlikoff, an economist at Boston University.
• The deficit was not created in a year and will not be fixed in a year. Churchill, in his first speech to Parliament as Prime Minister in 1940 promised, “Blood, Toil, Tears and Sweat.” The British people knew what was ahead. I fear that our political leaders are not preparing people properly for what is ahead. Governments will have to take away or cut back numerous popular programs. Many innocent people who thought they had benefits coming to them will be sorely disappointed—indeed, badly hurt in some cases.
• One of the Commission’s most interesting recommendations was that federal revenues should be capped at 21 percent of GDP. That recommendation received little public comment, and the Commission did little to argue the case for it. Our leaders need to set clear targets for spending reduction year by year to provide more discipline in Congress. Perhaps the Obama budget document will do just that. But, I am not optimistic. The budget issue must be framed in terms of the path of spending and not just the path for the deficit, because it is spending commitments in current law that are leading to fiscal ruin.
• How did we get into this mess? Accounting is a dull subject to some, but is part of the answer. Without full accrual accounting, governments have been able to make promises for the future that are never reflected in current budgets. Now the bills are coming due. In the past, each year’s legislative actions should have led to a current budget item reflecting the actuarial increase in promised future outlays. Instead, the future commitments were systematically hidden. We desperately need a reform of government budget accounting.
• Tea party activists are much in the news. Are tea party leaders prepared to govern? Can the House Republican leadership provide enough inspiration so that tea party leaders will accept the responsibility of getting control of government budgets over the coming decade? As many have noted, it is now put up or shut up time on government spending; we need specifics for what is to be cut.
• Ronald Reagan understood the future dangers of the Social Security and Medicare Systems, but backed off his efforts to deal with the problem. He believed, correctly in the 1980s, that defeating the Soviet Union and restoring growth to the U.S. economy were higher priorities. U.S. leaders today have multiple priorities but government finances have moved up the list. Other priorities can be addressed only within a framework of sustainable government finance.
• Of all the budget issues, the most difficult is Medicare. The Affordable Care Act passed last year probably made the problem worse. We are well along the path of Soviet style central management of medical care. The Soviets could not make central planning work and we will not be able to make it work either. But understand this: a system with more private responsibility for medical care will mean that those who have not planned well or who are unlucky will not have ready access to government-provided care. We offer shelter to the homeless, but not a free 15-room mansion. We can offer basic medical care to everyone but not state-of-the art modern medicine to every member of an aging population. Churchill prepared the British for what was ahead, but where are the U.S. leaders who are preparing us for what is ahead?
• What is the political strategy of the two political parties likely to be? In a matter of weeks, there will be a battle over the debt ceiling. In 1995, the battle over the debt ceiling between Speaker Gingrich and President Clinton led to a government shutdown. That outcome was widely viewed as a political disaster for the Republicans, which would seem to put President Obama in a strong position. What leverage do the two sides have this time? Can President Obama simply hang tough knowing that failure of the House to pass a debt ceiling increase will lead to U.S. default? Or, can Republicans frame the issue so that Obama is held responsible for default because of his refusal to negotiate and compromise? What is the likely strategy of the House leadership in dealing with the adamant tea partiers? These questions are extremely important for investors trying to figure out the likely course of events. As I read the mainstream press, I really do not understand who holds which cards.
• What we do know is that the situation cannot be understood without knowing what the political games are. Each political party wants the other go first in proposing budget cuts, so the proposals can be criticized before the relevant interest groups. Whether these games will converge to genuine progress remains to be seen.

It seems to me naïve to expect significant progress in reducing the long-run federal deficit this year. Jockeying for position ahead of the 2012 Presidential election will explain much of what we are likely to observe. Still, it does not seem too much to ask that our leaders develop broad principles for dealing with the deficit. Why shouldn’t Republican leaders embrace the Deficit Commission’s target of capping federal revenues at 21 percent of GDP? Arguing that spending and revenues should be “lower” without any specifics whatsoever is not responsible governing. Nor is it responsible for Democrats simply to want “more” to fill “unmet” social needs. If 2011 does not see some effort to develop specifics of some sort, then the nation will not make any genuine progress in dealing with the deficit.

It is logical that the House will first defund projects and programs primarily supported by Democratic constituencies. Wind energy subsidies might be an example, as they please environmental groups. However, such programs have already created vested interests, such as companies that build and service wind turbines. Whacking away at such programs will enable Congress to claim progress on reducing spending, but spending reductions will have to reach deep into Republican constituencies as well. Investors in certain industries may be in for some rude shocks.

For investors, failure of the government to make genuine progress will mean increasing peril over time. If the United States cannot begin to address its long-run budget problems—above all reductions in scheduled spending—then the issue for investors will increasingly be when to bail out and what to bail into. Even with a budget stalemate, that macro issue will not arise in 2011.

The 2012 election will be fought over budget successes and failures this year and plans for the future. How those issues are framed will have much to do with how well the winner in 2012 will be able to govern.

We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com .

William Poole
Senior Economic Adviser
Merk Investments, Manager of the Merk Mutual Funds

© 2011 Merk Investments® LLC
The Merk Hard Currency Fund is managed by Merk Investments, an investment advisory firm that invests with discipline and long-term focus while adapting to changing environments.
Axel Merk, president of Merk Investments, makes all investment decisions for the Merk Hard Currency Fund. Mr. Merk founded Merk Investments AG in Switzerland in 1994; in 2001, he relocated the business to the US where all investment advisory activities are conducted by Merk Investments LLC, a SEC-registered investment adviser.

Mr. Merk holds a BA in Economics ( magna ***** laude ) and MSc in Computer Science from Brown University, Rhode Island. Mr. Merk has extensive experience and expertise in how the global financial imbalances, as evidenced by an enormous trade deficit, affect the markets. He has published many articles describing complex economic phenomena in understandable terms and he is a sought after expert presenter and moderator at conferences. Mr. Merk is a regular guest on CNBC, and frequently quoted in Barron's, the Wall Street Journal, Financial Times, and other financial publications.

In addition to 20 years of practical investment experience, Mr. Merk has a strong foundation in both economic analysis and computer modeling. His research in the early 1990s focused on the use of computer-aided models in financial decision making; he is a published author in “Adaptive Intelligent Systems” * and has been awarded a prize for excellence in economics. **

Mr. Merk focused on fundamental analysis of US technology firms in the early to mid 1990s, he diversified to other industries to manage volatility in his investments. In the second half of the 1990s, Mr. Merk received an early warning of the building bubble when he recognized that more and more companies were trading in tandem, causing the diversification offered through investing in other industries to diminish. As a result, he broadened his investments internationally. As the bubble burst and Greenspan and the Administration preserved US consumer spending through record low interest rates and tax cuts, imbalances in the global financial markets reached levels that Mr. Merk deemed unsustainable. Merk Investments has since pursued a macro-economic approach to investing, with substantial gold and hard currency exposure.

Merk Investments is making the Merk Hard Currency Fund available to retail investors to allow them to diversify their portfolios and, through the fund, invest in a basket of hard currencies.

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