Perennial Asset Management

The Tinderbox of Debt and Deficits

Looking Beyond the Headlines

Every day we are overwhelmed by hundreds of media headlines. We tend to scan these headlines, moving quickly to the next until something catches our attention. Some headlines are clearly pressing, but we only read further if the time spent can be justified in our time-deprived world. Other headlines are barely acknowledged; we have read something similar and the news no longer seems pressing. But it’s time to look beyond the following headlines to better understand the underlying facts:

  • On September 10, 2013, Global News noted “Ontario deficit drops to $9.2 billion in 2012-13.”
  • On August 27, 2013, Reuters reported “Japan’s debt-funding costs to hit $257 billion next year.”
  • On September 12, 2013, the Wall Street Journal noted “Budget deficit on track for smallest shortfall since 2008.”
While these headlines are not unusual, the problem is that we often read about debt and deficits without understanding both their magnitude and their potential consequences. For example, the annual U.S. deficit was greater than $1 trillion1 for four out of the last five years. How can the U.S. continue to run an annual deficit of this size? According to the U.S. Debt Clock2, the U.S. federal government’s debt outstanding today is around $17 trillion, and increasing by almost $2 billion a day. Each U.S. taxpayer owes $148,200.3  It’s not just the U.S. that’s living on borrowed money; Ontario is currently running a $9.2 billion deficit and has $252 billion in net government debt. Similarly, Japan’s total government debt now stands at ¥1 quadrillion – that’s right, a quadrillion4 with 15 zeros. When managing our own debts and expenses, it would be unacceptable to continually spend more than we earn. Yet, somehow we don’t think governments require similar constraints.

light bulb 11 linesNeil deGrasse Tyson, an astrophysicist and director of the Hayden Planetarium (American Museum of Natural History), tells us how to think about a quadrillion. “It would take you 31 million years to count to a quadrillion — one number per second, never sleeping,” or “a quadrillion Yen, stacked in 1,000-Yen notes, would ascend 70,000 miles high.”

Given the enormity of these debt numbers, consider the following questions:

  • Is it normal for a government to run a deficit year in and year out?
  • Is it not a red flag when annual deficits grow more quickly than gross domestic product (GDP)?
  • What are the real costs and benefits of ongoing deficits and growing government debt?
  • How does this growing debt burden affect us as citizens and taxpayers?
  • How could this growing government debt burden affect equity markets?
In this paper we answer the questions above. We address how and why the developed economies reached the point of ongoing annual deficits and steadily rising debt loads. Starting close to home, we review Ontario’s recent deficits and growing debt, and then delve into the history of both Japan’s and the U.S.’s ongoing deficits and ever-increasing debt. We highlight some striking parallels between where Japan is today and where the U.S. is headed. Our thesis is that developed economies are now in a slow-growth environment that will persist until they get their fiscal houses in order and balance their budgets. But we fear the unintended consequences of governments’ current fiscal policies and central banks’ monetary policies, and we question whether their solutions will cause worse problems in the future.

rule topOur thesis is that developed economies are now in a slow-growth environment that will persist until they get their fiscal houses in order…rule bottom

A Grand Experiment with Unintended Consequences?

Economies have always been cyclical, with periods of strong growth and periods of contraction. Today, governments and their central banks are trying to control the economic cycle. They believe that their interventionist policies can smooth out the cycle troughs and ensure the economy continues to grow. However, periods of economic contraction, while painful, serve a useful purpose; they eliminate both the excesses built up during growth times and the weak and poorly-managed companies. The stronger, surviving companies then have a better operating environment in which to grow during the next up cycle. This self-cleansing process is an integral part of the economy’s evolutionary process, and governments’ well-intended intervention is hampering the transition to the next growth phase.

Over the past 40 years, the developed economies have experienced a fiscal policy era characterized by exponential growth in government debt, especially since the 2008 financial crisis. Central banks are maintaining low interest rates to help governments, businesses and consumers service their debt, and to keep the economy growing. However, going forward, it will become more challenging for governments to service and manage their significant debt loads, as debt service costs will constrain spending; these costs are already having a negative effect on economic growth.

light bulb 4 linesIn 1930 the U.S. government’s spending amounted to just over 3% of GDP. In 2012 it represented 22% of GDP.27

Before we examine the debt challenges in Japan and the U.S., we first assess Ontario’s finances as it’s close to home.

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