Friday, June 3, 2011

Painful Solutions to our Debt Crisis

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

Last week’s contribution - "Inflation? I Spit in your Face!" drew an interesting question.

How does our national debt factor into the equation of my non systemic inflation argument? The answer is an easy one and somewhat of a copout. It depends on how the government intends to correct our addiction to the debt problem and looming crisis. Debt in itself is inherently deflationary if you agree with the premise that it must be serviced and eventually repaid. The whole process of deleveraging, reducing the amount of debt, is anything but inflationary for individuals and companies as we saw in 2008 on steroids!

Let’s walk through some scenarios on how Uncle Sam can attempt to fix the problem.
One way to eradicate ourselves of debt is print our way out. The Federal Reserve would monetize by essentially printing money and buying up all of the Treasury bonds, notes and bills. As you can imagine, that would flood the system with more money than it has ever seen and likely cause our currency to completely collapse, which would make all assets denominated in dollars (oil, grains and other commodities) skyrocket to crisis levels. It would also likely trigger more systemic inflation with money velocity soaring along with wages.

Think about the million, billion and trillion dollar Zimbabwe notes or the Weimar Republic post WWI with folks using wheelbarrows full of money to buy groceries from always bare store shelves. Dollars would be worth much more today than tomorrow so people would spend them as fast as they came in. Prices and interest rates would rise day after day, week after week and month after month until the crisis abated. The U.S. Treasury and government would also lose credibility and investment grade credit ratings around the world for a measurable period of time. Our economy would likely collapse.

The opposite end of the spectrum would be strict austerity to cure our debt problems. In that case, government spending would be cut, cut and cut some more, triggering rolling recessions with intermittent periods of stability rather than recoveries. In an extreme case, as we’ve seen abroad, strikes, protests and even riots could fill our city streets. It would “feel bad” for an extended period of time, perhaps a decade or more, but the U.S. would emerge with a very lean and competitive society at the end.

The best possible - and most unlikely - scenario to cure our debt problem would come from organic economic growth. By growing the economy, the percentage of debt to GDP would be reduced, not to mention all the added tax revenue that would come in to the Treasury. I don’t think anyone really thinks this can work now.

One proposal in Congress that I totally disagree with is to simply raise taxes on the wealthy to solve the countries addiction to debt. To begin with, I have seen study after study that shows decreased tax receipts from an increase in tax rates. Increasing tax rates generally hinders economic growth. Additionally, roughly 75% of all discretionary spending (cars, travel, non-staple retailers, leisure, etc.) is done by those making $250,000 or more. How do you think that group would react to having their tax rates rise dramatically? In fact, many of those folks are small business owners, which our economy is built on, and run their finances through their personal tax returns. How do you think a sharp rise in taxes would affect their hiring?

Before someone responds by telling me to look at how well the economy did with higher tax rates under Bill Clinton, those were different fiscal times. We did not have a debt crisis or a structural unemployment problem. The ground was very fertile for growth in the mid 1990s following the S&L Crisis and recession of the early 1990s.

Look, in the 1940s, the top tax rate was more than 70 percent! And the economy grew like a weed. I can’t imagine anyone arguing that our economy could survive rates even close to that today. It would be worse than the Great Depression. My belief is that trajectory is more important than the absolute rate. By cutting taxes from 70% to 60%, that is incredibly stimulative. By raising taxes from 30% to 40%, it is highly restrictive.

I have said for three years that we have run out of painless solutions. It’s going to hurt! Pick your poison. If I were in Congress and not beholden to special interests (HA!), I would cut $100B to $150B from the federal budget every year for the next 10 years. No area would be unscathed, including entitlements and defense. That would certainly curtail growth and make us look more like a European country than the U.S.
At the same time, I would completely revamp the tax system and broaden the tax base. Too many people have used gimmicks and loopholes to avoid paying taxes. We need to remove so many of the insane deductions and credits. The time has come. Sorry big oil, but you have made hundreds of billions of dollars over the past decade and your subsidies and tax credits are absurd. Sorry big corporate farms, but paying you not to grow crops is ridiculous when food prices are at all time highs. When we had a glut of crops and the farming industry was on the verge of extinction, I may not have agreed with the subsidy, but I understood. Now it’s an embarrassment.
At the same time, we need to incentivize R&D in cleaner and greener energy, but not superficially as we’ve seen. We really need to make it appealing for entrepreneurs. Look at how many of the great companies were born during a recession in someone’s garage. Anyone know of a company called Microsoft? The government needs to step up and allow that ground to be fertile again.

Finally, I would be naïve if I thought this could get through Congress without any compromise. While I do not believe in higher taxes, especially in the corporate world where companies just park themselves offshore, I understand that there has to be some give and take. On the social security front, I would accept raising the tax rate and the amount where it is capped in return for also raising the age to 70 over the coming decade or so with further increases if life expectancy increases.

So in the end, I believe there is only one scenario where our debt crisis leads to systemic inflation and I do not think that path is likely. We have become a country of instant gratification and whiners, me included. If America is truly going to solve our debt problems and reliance on foreign capital, we are all going to have to sacrifice over this decade.

FYI, I will be on CNBC’s Worldwide Exchange from 5:35 a.m. to 5:55 a.m. on June 7.

Feel free to email me with any questions or comments at

Until next time…

Paul Schatz
Heritage Capital LLC

Follow us on Facebook at and on Twitter @Paul_Schatz

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