The 15th stage of America‘s Financial Endgame™ will be a precipitous reduction in the amount of spending undertaken by the US government. This event will occur at the end of a long string of events that is brought about by perpetual deficits, eventually culminating in a bond market collapse, drastic government actions, and dramatic increases in taxes.
The natural follow-on to these undesirable scenarios is a series of deep cuts in government spending. The purpose of these cuts will be to bring the fiscal budget back into alignment. The reason why this will become necessary after so many decades of running continually deepening deficits will be a shortage of government and private entities that are willing to purchase US debt. As a result, the US government will need to act quickly and drastically to reverse this trend and re-establish a market for US treasuries.
This is not to say that the market for US treasuries will dry up completely … rather that the worldwide debt markets will not be able or willing to indefinitely absorb increasing amounts of US government debt. The unwinding of this deficit-debt sequence is what we expect to cause great amounts of financial calamity with multiple repercussions. One of those after-shocks will be a seismic adjustment in government spending. It is no sort of secret that the Government is living far beyond its means … the exact extent to which this is happening will not become apparent until the government loses its ability to continue increasing its debt burden.
As with increasing taxes, cuts in spending will most likely come from the areas of the government where the most spending occurs. In the case of the US government, the top three spending sources are Transfer Payments, Government Consumption, and Defense. Practically speaking, this means that there will be pressure on the growth rate of entitlement spending, cuts to discretionary spending, and reductions in Defense spending. The likely way that these will unfold is as follows:
- Pressure on Entitlements: While the probability of entitlement spending going away completely is zero, the probability of the entitlements decreasing in ‘real’ terms is nearly 100%. The reason for this is because entitlements are paid in nominal dollars that are adjusted based on a government controlled inflation index that backs-out the impacts of food and energy. Furthermore, with the continued socialization of medicine, the real costs of medical care can be hidden from the indexes with increased ease. What all of this means is that the price indexes will be used by the government to reduce the “real” amount of spending on Social Security, Medicare, Medicaid, Food Stamps, and other entitlement spending without reducing the “nominal” amount spent on these programs. To the extent that entitlement spending is reduced, the reductions are almost certain to be concentrated in the demographic segments that are too small to pose any form of electoral threat.
- What does this mean: Ultimately, this means that the under-class who is dependent on government assistance will continue to become more and more impoverished. This will further entrench their dependence and ensure that whichever politician promises the most will almost certainly be elected in the districts with the highest concentration of aid recipients. Expect geographic gentrification of high-producers away from areas with high concentrations of dependent people. Poverty and crime will become self-reinforcing cycles as the people of means vacate blighted communities, leaving a population of people with limited skills and increasingly limited means behind. The lack of mobility and marketable skills will leave large populations of people concentrated in highly dysfunctional communities.
- Cuts to Discretionary Spending: The government hides many of it’s special projects or “pork” in the discretionary spending lines. As a percentage of overall government spending, discretionary expenditures are relatively low. However, this means that the ability of individual politicians to “bring home the bacon” to their districts will be reduced when the supply of bacon available for delivery decreases. This is not to say that the best connected in Washington DC will fail to find ways to fund their projects … it is to say that the competition for government funding will become increasingly intense. This means that the grants are most likely to be awarded to the areas that are already the most affluent, further alienating the blighted communities.
- What does this mean: The reductions in discretionary spending will reduce the ability of politicians representing blighted areas to deliver stimulus. This will be exasperated by the generally high level of corruption exhibited by political representatives from these communities that will all but assure that any beneficial projects are awarded to political cronies with the profits skimmed off the top before much benefit is delivered to their constituents at large.
- Reductions in Defense Spending: As one of the single largest line-items of the government budget, defense will be high on the list for cuts and reductions … especially among the anti-military political class. While the probability of a complete dismantling of the military is zero, the likelihood of major restructuring is all but certain. The most likely first steps will be closures of smaller bases and overseas bases with increased reliance on major bases and sea-based transport such as aircraft carriers. This is another factor that is likely to create more blighted areas as the departure of Defense related bases and industries from rural areas will deplete the employment base, resulting in the departure of people with marketable skills. The ultimate result will be another blighted community vortex where the lack of employment leads to poverty, crime, and corruption.
- What does this mean: Reductions in defense spending will create more flight of educated people toward locations where their skills and abilities can produce a living for their families. The major defense industries are likely to see little if any net impact, since they possess sufficient political power to direct spending cuts toward other companies and contractors that are less well connected.
What we can see from all of this is that the reductions in government spending will create a multitude of localized poverty vortexes that drive out people with education and skills, leaving a blighted community of crime and corruption behind. As this phenomenon continues to unfold, more of these communities will develop as resources continue to consolidate in the hands of the wealthy, educated, skilled, and politically connected.
As investors, we should seek to ensure that our dependence on the Government-Entitlement Complex™ is minimized, and that our investment positions are liquid so that they can be re-assigned as conditions change. It is important to understand that times of chaos are also times of opportunity. When resources flee certain areas, they will move toward other areas. When markets crash, they will push high quality companies to unreasonably low prices. By being disciplined and astute, while making intelligent decisions, informed investors can not only survive the upcoming economic upheaval, but thrive and prosper.
Take-Away: As always, flexibility is key. The days of buying, holding, and forgetting are over. Astute investors must become educated investors. The art of reading the financial markets is no longer the province of Wall Street mavens. Individual investors who are looking to avoid being blindsided by the coming financial storm, must learn, read, study, and understand what is happening in all of the interconnected global markets so that can position their personal assets correctly to protect their families from financial ruin and benefit from the financial volatility that is brought about by drastic change.