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The Frog in the Boiling Water


Many of our clients are upset or at least disappointed about the situation with the U.S. government debt and deficits. For context, federal debt as a % of GDP is about 120%(1) given total federal debt of about $32.5 trillion and U.S. GDP of about $27 trillion. The annual budget situation is not good and is almost certain not to get better any time soon: the deficit for fiscal year 2023 (ending 9/30/23) will be about $1.6 trillion (or 6% of GDP). It's concerning that less than 18 months ago the Congressional Budget Office (CBO) forecast this figure would be about $1 trillion (or less than 4% of GDP). The gap is partly explained by rising interest expense, as a high proportion of treasury debt is being rolled over at higher interest rates. The latest CBO forecast (2) pegs annual deficits at around 6% of GDP over the next 5 years, increasing to 7% within next 10 years. Entitlement programs and interest expense will inevitably drive spending higher. And the forecast ignores recessions - which will also drive spending higher.

Unfortunately, government spending today is just not as productive as it once was - you can see this in a statistic called "marginal revenue product of debt" (essentially how much GDP can be generated per $ of additional government debt). This statistic measured around 1 in the 1950s and 1960s when the US was investing in highways and infrastructure but is much lower today (more like 0.4) given higher government debt levels and more spending in support of consumption rather than investment(3).

Debt always means borrowing from the future. As our business builder clients know, borrowing that supports investment to enable higher future cash flows is productive. Borrowing that only supports current consumption is a direct transfer from future generations (who must service the additional debt) to the current generation.

This is not to say that the Boomer generation should not be supported. It is to say that we did a very poor job of preparing for the next 20 years. We simply have not saved enough to meet Boomer retirement consumption needs. Today the problem is big, obvious, and growing - and we continue to do nothing. Except borrow.

We’ve come to view fiscal deterioration as somewhat inevitable. Our conclusion is that it likely leads to accelerated loss of purchasing power over time because the path of least resistance for dealing with debt and obligations is to make a series of decisions that monetize the growing debt load. As other (smarter) investors have noted, there isn’t a master plan per se, it's just how things are most likely to evolve.

In a recent blog post, Ray Dalio talks about the "Proverbial Frog in the Boiling Water" problem:

"Supposedly, if you throw a frog into a pot of boiling water it will jump out of the pot. But if you put the frog into a pot of cold water and gradually raise the water temperature to a boil, the frog will remain there and boil to death. The point is that if things gradually get worse those experiencing these changes might not notice them until they are terribly threatening or lethal and not make the needed changes in time to save themselves."

Dalio is describing our ongoing social breakdown in trust and loss of confidence in rule of law, but he could just as easily be describing why we seem unable to properly address the fiscal problems. We just don't seem to be very good at solving slow moving, intractable problems until crisis is imminent.

Ultimately, it's going to be very hard for policy makers to resist the temptation to address that future crisis (or series of crises) without meaningfully expanding the money supply in some way. Slowly but surely, purchasing power will erode…barely perceptible - just like the frog in the boiling water.

 

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