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Change You Can Believe In

Last November, America wanted change. I say be careful what you ask for.  “The American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money.” — Alexis de Tocqueville, 1835

Just this past week, we learned that our current-year budget deficit will exceed $1 trillion dollars. One trillion dollars! And that’s just the over-expenditures for one year. In fact, since last fall when the Federal Reserve began flooding our financial system with (borrowed) money, our national debt has climbed to +/- $11 trillion.

That $11 trillion dollar figure does not include the Social Security and Medicare time bombs nor does it include the proposed government-run national health care changes that are coming. Include those fiscal obligations and our debt burden just explodes to an estimated +/- $50 trillion over the next few years. That’s roughly $180,000 owed for every man, woman and child in this country.

These numbers are big. While it may be hard to imagine just right now how that spending will directly affect us (not to mention our children and grandchildren), it will. Dramatically.

How? Well, for starters, we have to borrow that money from someone. At the moment, the strangers upon whose kindness we are depending happen to primarily be the Chinese. They alone have lent us more than a trillion dollars. And the Chinese government isn’t lending us this cash because it wants to help an old friend who is down on his luck.

It’s a business transaction, pure and simple. There’s a cost associated with the kindness. And it’s significant. We have to pay the interest on that debt. That interest burden currently makes up roughly 8 percent of the entire federal budget. That’s right. Nearly one out of every $10 you send to Washington goes simply to interest payments on our debt. No roads, no bridges, no schools.

And looking ahead it’s hard to see how things might change for the better. There seems to be absolutely no political will at this time to reign in this orgy of unrestrained spending.

Well, so what. Just slap on a few new taxes on the rich and we’ll be good as new, right? Nope. It is not possible to raise taxes high enough to cover the enormity of these bills. You see, given the financial commitments due over the next several years, there is quite simply not enough income to tax. Tocqueville’s prescient statement regarding the future of our Republic has more meaning now than at any point in our 233-year history.

As you might imagine, our creditors are worried about our growing debt burden. They should be. They are worried about possible short cuts that we might attempt to pull in order to get out of this hole: like simply printing money out of thin air in order to pay them back. This “printing of money” goes by the innocent sounding name of “monetizing the debt.” But know this — monetizing the debt is not a good thing, and it carries real risks if it is carried to extremes.

If the fed should attempt to monetize a large enough portion of our national debt, there are potentially serious inflationary implications. At some point an economic recovery of some sort will begin. Couple that recovery with enough debt monetization and things could really start to get interesting. For example, there could be a real problem with the value (that is, the exchange rate) of the U.S. dollar in the foreign currency markets — nothing like an extra trillion or so recently printed dollars floating around to kick the value right out from under them. You see, if too many U.S. dollars remain in the world’s financial system, it is quite possible that the currency markets will meaningfully devalue those dollars relative to other foreign currencies. Should that occur, then the cost of any goods coming into our country would necessarily skyrocket. Interest rates would likely climb significantly as well (who would continue buying our debt when our currency is dropping in value unless they were sufficiently well paid).

How can you protect yourself against the potential debt-related risks ahead?

One possible way would be to consider having a portion of your portfolio invested in debt securities not denominated in dollars. Countries that haven’t been printing money like it was wallpaper should see their currency valuations hold up better against the dollar. For example, it should be possible to capitalize on this situation by having a portion of your portfolio in a diversified selection of, say, global bonds which might benefit from a devalued-dollar scenario.

Regarding future potential inflation, commodity-based assets (oil, gold, timber, agriculture) would be an investment class that might merit consideration. The last time we went through a serious inflationary period — the 1970s under Jimmy Carter (plus ca change, plus c’est la meme chose) — these asset classes did well.

Last November, the American public voted for change you can believe in. If current fiscal policies remain on track, change is what they’re going to get. Be careful what you ask for.

Bo Billeaud has been president and chief investment officer of a Lafayette-based money management firm for the past 18 years. Contact him at [email protected] .