So I posed the question earlier: How can the U.S. not be considered the first destination of global capital in search of safe (although historically low) returns? Easy answer : It will not be if we continue down the current road and don't address our “fiscal gap.” IF we continue to close our eyes to existing 8% of GDP deficits, which when including Social Security, Medicaid and Medicare liabilities compose an average estimated 11% annual “fiscal gap,” then we will begin to resemble Greece before the turn of the next decade. Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow and the dollar would inevitably decline. Bonds would be burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive within the “Ring of Fire.”
If that be the case, the U.S. would no longer be in the catbird's seat of global finance and there would be damage aplenty, not just to the U.S. but to the global financial system itself, a system which for 40 years has depended on the U.S. economy as the world's consummate consumer and the dollar as the global medium of exchange. If the fiscal gap isn't closed even ever so gradually over the next few years, then rating services, dollar reserve holding nations and bond managers embarrassed into being reborn as vigilantes may together force a resolution that ends in tears. It would be a scenario for the storybooks, that's for sure, but one which in this instance, investors would want to forget. The damage would likely be beyond repair.
Eoin Treacy's view The most widely held view I came across while in the USA last week was that the fiscal cliff represents the greatest threat to a continued economic recovery. This is despite the very real advantages of greater competitiveness as a result of the recession, the weakness of the Dollar, a bottom for the housing market, consumer deleveraging and the prospect of lower energy prices over the next decade. In an election year, these concerns tend to get aggravated, as some very different views of the country's future are aired. Nevertheless, the issue will have to be addressed by the next administration.
The USA, as well as a number of other “developed” countries, have suffered from deteriorating governance for more than a decade. Ineffectual financial regulation, fiscal irresponsibility, the triumph of political correctness over common sense, declining education standards, the fettering of private enterprise through increased regulation, the increase in the size of government with no commensurate growth in tax receipts, volatile financial markets and expensive wars have all contributed to a declining sense of confidence that the cycle can be broken.
The reality is that Medicare, as it is currently structured, will be impossible to fund. There are three possible solutions. Either income, state, federal or consumption taxes will be raised, spending is curtailed through efficiencies and cancelation of services or a mix of both. Muddle through appears most likely. The shape and size of the necessary reform is likely to shape investor perceptions for the medium-term.
While it may seem Pollyannaish to expect the trend of governance to reverse, it is not impossible, just unlikely at present. For whatever reason if developed countries were to return to a trend of improving governance over the next couple of decades, it would represent a very positive outcome for stock markets.