"Kee" Points with Jim Kee, Ph.D.

Last week, U.S. economic data (industrial production, retail sales, housing starts, jobless claims) came in stronger than expected (Wells Fargo Securities) as did Chinese growth (Financial Times). As for the debt-ceiling debate (the government will reach its authorized limit on borrowing sometime within the next 30-60 days), President Obama warned last week that  the markets could go “haywire” if there is another strong confrontation like 2011 (Financial Times). House Republicans are considering a three-month increase in order to provide more time for spending negotiations to ensure that a repeat of the 2011 debacle won’t occur. Again, my view is that the existence of the 2011 episode lowers the probability of a repeat, which seems to accurately reflect how lawmakers are acting at this point. In Europe, Germany’s GDP contracted slightly during the fourth quarter of last year (based upon last week’s preliminary data release), with 2012 growth in Germany being slightly below one percent. Most analyst expect this contraction to  be short-lived, and while 2013 growth estimates for Germany are expected to be positive, few expect growth above one percent (Financial Times).

 

During our San Antonio market update I was asked a very good question and I’d like to clarify and elaborate on my views. Kee Points readers know that I expect the pending “entitlement spending tsunami” to be handled with a combination of inflation adjustment tweaks, age and other eligibility requirement tweaks, and “means testing” in general (the more you have the less you get) rather than debt Armageddon or hyperinflation. The question was, “How are we going to deal with $16 trillion and growing in public debt?”Actual debt held by the public (including foreign entities like China and Japan) is about $11.6 trillion, while intra-governmental holdings, like the Social Security Trust Funds, hold about $4.9 trillion). These are agencies that run a surplus, and buy treasuries with it rather than just sticking it under a mattress (that’s a three hour topic!). I just want to make three points from an economic point of view that are missing from the coverage in the press:

 

1)     Looking at the debt-to-GDP ratio is comparing a cumulated stock of debt ($11.6 trillion or $16 trillion, depending upon which figure you use) with an annual flow of income, which is GDP (about $15.8 trillion). The relevant figure to compare to GDP is the annual service cost or interest payments relative to annual income or GDP. That number, according to the congressional budget office, is near 30-year lows because interest rates (i.e. borrowing costs) are so low. It is projected to rise as interest rates rise, but it was twice as high during the 1980s and 1990s. So it’s not a problem right now, but could be if interest rates rise quite a bit and other spending relative to income growth isn’t curtailed.

 

2)      The relevant number to compare the outstanding debt to is the value of the outstanding assets (that can service the debt),which is over $200 trillion in financial assets and plant, property and equipment alone. Of course, any economist trained over the last 30 years would name human capital as the largest asset. And here’s the point, the value of any asset, like a piece of land or an individual, depends upon the rules governing its use. A piece of property in the Eagle Ford is worth a lot if fracking is allowed, and worth very little if not. So again the value of an asset depends upon the rules governing its use, even if the physical asset is unchanged. That’s true of all assets, including people.

 

Right now fiscal (tax, regulatory) policy has been dominated by peaking uncertainty, which minimizes the income generating property of assets (in energy, healthcare, and financial institutions for example). As uncertainty comes down, markets know what the rules will be and assets will again start to flow towards their highest valued uses. In my opinion, at this point stability in the rules is more important to asset values than the incremental increases in taxes and regulations that are occurring. That’s a guestimate, but it is based upon my observation of the economic history of the U.S. over the past 100 years. So a move towards clarity and permanence is good, and away from clarity and permanence is bad. Markets can figure out how to navigate a myriad of tax and regulatory potholes once they know what the rules are. So policy clarity and permanence is how I’m judging the administration and Congress at this point.

 

3)      A related discussion, of course, is that the impact of debt depends upon whether or not the debt is used to create an asset that can be used to service the debt. If I borrow $10,000 for a pizza oven, I have used the money to acquire an asset that might generate income to service the debt. If, however, I borrow $10,000 and blow it gambling, I have the debt but no offsetting asset to service the debt (my net worth has declined). So government debt numbers don’t mean much without knowing how the money is spent. That, of course, explains the tendency for politicians to characterize every expenditure as an “investment.” That's not always completely accurate, but it's partially true.

 

Interestingly, some economists make the case that government spending should be mostly transfer payments (consumption), not investment, because the private sector should be doing the investing, not government.