Significant Austerity Without A Crisis--Unlikely

Avoidance of the "fiscal cliff" brought clarification of  several important tax rate issues.   This should boost  business and consumer confidence over the near term.  However, these changes are only  the "low hanging fruit" in the herculean  effort to bring the nation's debt burden to manageable levels.  (This tax increase on the richest Americans is acceptable to most of the voting public.)  Over the next ten years, these changes only amount to 15% of what will have to be done merely to keep federal debt as a percentage of GDP constant. The tough austerity lies ahead.

What needs to be done involves spending cuts, tax reform, and entitlement reform.  The problem is that most everyone will have to give up something.

On CNBC recently,  Larry Summers interviewed  the chairman of Caterpillar, one of this nation's premier capital goods companies. The Caterpillar executive agreed that all tax preference items should be eliminated and the discussion as to which ones, if any, should be reinstated should then begin.  Examples of some tax preference items are the deductibility of mortgage interest, charitable contributions, state and local taxes, and accelerated depreciation of capital equipment.  When Summers then pressed the executive whether he would approve elimination of the accelerated depreciation provision, he answered that that provision stimulates capital spending and improves the country's  productivity and should therefore be kept intact.

The real estate industry  feels the same way about mortgage interest.  And the charities about contributions.  It reminds me of a town's needing to build a new garbage dump and each citizen says
"Yes, we do need one, but NOT in my backyard!"

And consider entitlement reform.  Extending the social security eligibility age from 65 to 67 enrages those heading into retirement.  AARP has an ad campaign warning Congress that its members are  a huge voting block, so don't mess with us!

And unfortunately we have interim elections in less than two years.  While the voting public has a vague understanding that we have a debt problem, there is no catalyst to force strong action. At some point, holders of  the U.S. government's debt will demand much higher interest rates in anticipation of rapidly increasing inflation.  But that hasn't occurred yet.  In fact, investors still buy Treasuries as  a hedge against uncertainty when fear of a European country's default resurfaces.  In my opinion. the financial markets will ultimately have to be in disarray to force meaningful change.  We experienced such disarray in late 2008 when a bear market forced Congress to enact TARP.  (At that time,
I wrote about this in a post entitled "Scared Straight!")  When this will occur is difficult to predict.  It could be years from now.

Meanwhile, the thirty year fixed income bull market has probably ended.  The ten year U.S. government note reached a low yield of 1.33% and is now trading at 1.87%.  At these low interest rates,  it doesn't take much of an increase in rates to cause a loss on these investments.  In aggregate, investors have been withdrawing money from equity mutual funds and putting funds into fixed income mutual funds since  the brutal bear market of 2007-2009.  Also, as the baby boomers reach retirement age, they are more inclined to move money out of equities and  into fixed income to "reduce risk."  On the other hand, if a period of losses on bonds were to occur, there should be some movement out of fixed income back into equities.  This would result in an increase in price to earnings multiples, thus rendering an overpriced equity market even more overpriced.

I remain with my core equity position.