We Can't Grow Our Debt Away (SPY, ITE, TBT)

Let's be frank. There's not a whole lot of honest discussion out there about the U.S. debt. On the right, hard-line conservatives and Tea Party activists often claim that our debt is over $60 trillion and that fiscal catastrophe, hyperinflation and the end of America as we know it is unavoidable (unless, of course, we elect someone who is ideologically opposed to tax increases). On the left, we have only lip service to the debt, for-show spending freezes and a general game of la-la-la-la-I-can't hear-you.

Both sides are driven more by ideology and electoral pandering than honesty and logic. The $60 trillion number is an accounting gimmick designed to scare you (usually followed be thirty exclamation points), and many conservatives would have you believe that we can fix the debt problem by cutting things like foreign aid and earmarks, which are meaningless compared to the size of the debt.

But we also can't stay on this unsustainable path. Liberals tend to downplay the issue because it means less money to programs they fought hard to get into the budget. It also requires them to put the unpopular idea of tax increases on the table when talking about ambitious new programs.

Chairman of the Federal Reserve Ben Bernanke summed up the problem best: “A variety of projections that extrapolate current policies and make plausible assumptions about the future evolution of the economy show a structural budget gap that is both large relative to the size of the economy and increasing over time.”

Read: We have a big deficit now, but we're not Greece just yet. We do need to act before our fiscal situation deteriorates, which will happen not too far down the road if we don't. The main threat is not the run up in spending due to stimulus or economy-saving measures; it's the fact that in normal economic times, with normal tax returns and normal spending, we will likely still have a large deficit.

If you think this is an example of Keynesian economics at its worst, you're dead wrong. This isn't Keynesian economics at all. Yes, in Keynesian economics, government spends more to make up for the fall in private spending, thus running up a deficit. But the whole idea of countercyclical policy is to smooth out the business cycle. Therefore, when times are excessively good, you pull back on government spending and/or raise taxes so that the economy doesn't overheat and set the stage for asset bubbles, excessive debt accumulation and a larger crash. This is supposed to lead to surpluses. In true Keynesian economics, over the long run, you run surpluses in the good times by enacting contractionary policy and deficits in the bad times by enacting expansionary policy. In the long-run, when you take out the variations based on "cyclical" swings, you should have a long-term, "structural" budget that is more or less balanced.

That's where the problem comes in. Bernanke's comments reveal a budget gap that is not cyclical. It's a budget deficit that exists regardless of economic condition due to one fact that can be boiled down into this: Spending > Taxes.

I don't care what side of the political spectrum you lie on, that's a problem in the long-run. It means debt is piled on to debt year after year, interest payments become larger and eventually our solvency is called into question by people that matter (a.k.a not bloggers). As long as the short-run, annual budget deficits are not the size of our current debt, they don't really matter in so far as economic stability goes. But when they occur every year, the burden gets heavier and the ability to service that debt becomes more difficult.

As of June 8, the total debt is 13,056,957,049,453.42 according to the U.S. Treasury. That's around 90% of our GDP. That's a scary idea: our debt is almost the amount of the value of every good and service sold in the American economy. No wonder people are riled up.

But that doesn't give the whole picture. When government revenues for certain programs that don't draw from general revenues, such as Social Security, exceed the amount they pay out, the surplus is invested in Treasury notes, i.e. U.S. debt. Because a Treasury note was sold and a liability was created, the government counts that in the total $13 trillion figure, even though it's essentially money the government owes to itself. When you take out that type of debt, you get a figure known as the "debt held by the public." As of June 8, this number is at $8,577,518,574,552.20, according to the U.S. Treasury. That's the real amount the government owes, and that rests at a much more manageable roughly 60% of GDP.

This does represent a real challenge, but it doesn't herald catastrophe right now. In 2009, the United States' public debt was ranked 42nd highest in the world out of 129 recorded figures, according to the Central Intelligence Agency. We rank ahead of many developed nations like France, Canada, Norway and the United Kingdom, as well as the world average of 56%. But we are behind countries like Australia, China, Luxembourg and others, whose debt held by the public are all estimated to be less than 20% as of 2009.

In sum, we do have a debt problem. But it's not because of Keynesian economics, Obama's bailouts, health care reform (which is fully financed, unlike Bush's wholly unfunded Medicare drug plan) and the typical culprits painted by conservative commentators. It's because we have a structural deficit: in normal economic times, Spending > Taxes. The time to act is now, when we can act carefully, thoughtfully and rationally without the threat of impending doom that has stricken many European economies. We can phase in tax increases and/or spending cuts over time instead of all at once, which is what catalyzed Europe's social unrest. We have time to act, but we won't forever.

Any such measure to shore up our fiscal house and set it on a more sustainable path would be an enormous boon for the financial markets. If we even so much as raised the retirement age, the least painful (yet enormously cost-saving) major step we could take, you could see the SPDR S&P 500 (NYSE: SPY) take off for a huge run. Investors don't like large debts, because it shows there's a big risk that they won't be paid what's owed to them. Obama's meager spending freeze and efficiency plans won't engender that sense of security. But a bold, proactive step to tackle the nation's increasingly unsustainable debt by the U.S. government will set off a wave of investment in the American economy — one that is driven by America's strength, as opposed to the rest of the world's weakness.

If we don't eliminate the structural deficit Bernanke spoke of, the alternative is this: typical partisan bickering, a steady rise in the debt, growing difficulty in servicing interest payments and finally a panicked package of painful austerity measures forced on us by our lenders.

This puts into play several exchange-traded funds related to the interests rates on Treasury notes. If we can find a way to make our debt more sustainable, rates will fall, and ETF's that go long on Treasury yields like SPDR Lehman Intermediate Term Treasury ETF (ITE) would strongly benefit. But if we fail to act until crisis compels us, rates will rise quickly and ETF's that take a short position on Treasury yields like ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT) will be the real winners.

One way or another, eventually, Spending = Taxes. It's just a matter of when.

By Alex Schiff

For other ways to play the Treasury yield, check out How to Play the Long Bond by Michael Zerinskas.

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