The Now Generation Government Has Failed the Marshmallow Test: Making Sense of the Fiscal Cliff Outcome

Over the past five years, the government has applied the usual demand-side remedies in the epic battle against The Great Recession. The graph shows the time profile of past recessions and recoveries as compared to the Great one that we are still in. Though stimulus fiscalcliff1has been applied in heroic proportions, the employment high ground of five years ago has not been revisited.  This graph clearly reveals this recovery lags all others in the post WWII era in which stimulus spending was considerably lower.

At this moment in history, the realization that continuing to run deficits to win the recessionary battle is compromising the ability to win the war of fiscal sustainability — and without that goes future entitlements, at least in real terms. Thus a trade-off of now vs. the future needed to be confronted.

As former Wells Fargo CEO Richard Kovacevich puts it, at the end of the day, the fiscal cliff deliberations continued to put the stimulus on the overstretched Federal Credit Card.  In his words our federal budget is equivalent to a family earning $22,000 per year, but spending $38,000 per year with an existing credit card debt of $143,000.  The next leg of the saga is to raise the debt ceiling so we can continue to max out a higher credit card limit.

What all this did was to reveal in plain sight that our leaders, who are likely a reflection of our population at large, are members of the Now Generation.

Overcoming our current inability to deal with the bigger problem of fiscal sustainability is key to economic growth as well as maximizing future fiscal proceeds and government benefits. To do so requires an inter-temporal trade-off.

This is a classic test of immediate vs. deferred gratification.

This trade-off was memorably tested in the “Marshmallow Experiment”fiscalcliff2 of children aged  4 to 6 by Stanford psychologist Walter Mischel  who found in a follow-up study that children who were capable of deferring gratification eventually went on to earn higher scores on their SATs and achieved other life accomplishments that require some front-end investment.

Now it is important to note that the Stanford Marshmallow Experiment offered higher returns as compared to present returns. That is, the promise of two marshmallows later vs. one today was made by Professor Mischel, not the U.S. fiscal system.

In our case with projected growing entitlements, we just can’t vote them in and expect them to happen.  We need an environment that would be conducive to fiscal discipline so as not to allow unaffordable debt overhead, lest Reinhart and Rogoff effects of slower growth and government default set in. While this might seem Utopian it has happened, even in the U.S.

The Gramm-Rudman-Hollings Balanced Budget Act nearly 30 years ago addressed the issue of defining a framework to self-control government deficits. Basically, the Act created the requirement that adding a dollar of spending would require identifying a specific spending reduction. This caused each dollar of additional spending to be traded against some existing obligation as a yardstick of value.

Well you can image how popular that was, even then, when leaders could pass the marshmallow test!  Regrettably, the automatic self-constraint mechanism was found to be unconstitutional and was replaced by a succession of legislation that watered down the spending and deficit constraints and brought us to our current state of allowing debt to compromise the economic growth engine along with fiscal sustainability.

In today’s societal trade-off, Congress likely has already put us in an environment in which one marshmallow today will only perhaps generate a fraction of a marshmallow tomorrow. That is, growing marshmallows for the future requires deferred gratification today so that today’s debt is not a deterrent to economic growth and future government revenues and marshmallows.

One factor that reinforces the lack of will to bring about deficit and debt control that could lead to additional future marshmallows is the unwritten American ethic to not willingly fork over to the federal government more than 20 percent of annual GDP in all forms of collected taxes.  If individual income tax rates would generate Treasury Revenue that exceed that proportion of total GDP, deductions and exemptions have been added to the tax code to keep the checks written within society’s actual shadow ceiling.

Even during the height of WWII, with an economic boom and confiscatory individual and corporate income tax rates, the government was only able to raise an income share of 20.9 percent of GDP from all tax sources —  even though the federal spending shares of GDP was 43.6 percent in that wartime period.

Since then, only capital gains of the tech era generated a Treasury revenue share of GDP barely in excess of 20 percent of total income. The state of the economy is the primary determinant of the Treasury taxes paid, so a slow-growth economy spells big trouble for the deficit almost irrespective of tax rates being agonized over in Washington.

The rates that Congress does apply are more for political showmanship and a statement of the collective values, wants and needs of its members rather than a reflection of actual revenues received — though I doubt most of them realize it.

In 2011, the Treasury collected only 15.4 percent of total GDP against spending of 24.1 percent, accumulating debt equal to 8.7 percent of the current GDP pie. This will continue for as long as the eye can see or until the deficit can no longer be financed or pawned off on the central bank.

On top of those implicit American inhibitions, the issue of shared sacrifice in the face of imminent danger is also a passé American ethic, as discussed here by Lacy Hunt.  In 2011, the bottom half of the income spectrum contributed but 2.4 percent of individual income taxes receipts, and the recent taxing the “wealthy” adjustment only reduces that proportion.

We can only guess what tomorrow’s marshmallow allotment will be. But with no deferred gratification constraining debt blow-up, no shared sacrifice, and no willingness to give up more than 20 percent of GDP, future gratification will fall on the back of the central bank until inflation inescapably reduces tomorrow’s marshmallows in real terms.

If there is any rationality to it, what Congress and the President seem to be saying is that they realize there is no Professor Mischel to supply two future marshmallows and that the government’s ability to do so is already lost, except via money illusion of the printing press. So, their logic has become, deferred gratification on our watch is senseless.

Investors thus far have been concerned that would be the unintended consequence, but it now appears to be the unspoken plan.  Investors would be wise to protect themselves.


If you enjoy this blog, please forward it to others who may be interested. Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

The Bond Market Rocket and Fiscal Unsustainability Are On a Collision Path

Recently, the bond market has been in rocket mode. It has achieved liftoff and slipped the surly bonds of earth. And some believe it will keep going.  The price of the U.S. Treasury 10-year bond recently reached an all-time high, generating yields at all-time lows. Moreover, the market yield on the British perpetual bond is reportedly at a 300-year low.  Bond mania has even spread to the sovereign debt of Denmark and Singapore and others where negative yields exist.  More astonishing is the ability of France to issue short-term sovereigns with negative yields!

The U.S. has eclipsed the record interest rates that prevailed when the 1930s Depression era came to an end with the onset of World War II, as shown in the chart to the right.

To get to the previous low yields of early December 1941, the U.S. economy had experienced a decade of depression with cumulative deflation of 30 percent.  With that decade-long trend influencing expectations, the future seemed to call for more of the same.  In that environment, investors favor long-term fixed income that appreciates in real terms as a result of deflation if the long bond is successfully paid and retired despite depression circumstances.  Hence the asset category of choice in a deflationary depression is survivable high quality debt.  In the ’30s, this also included surviving corporate debt that appreciated along with Treasuries, and the AAA-Treasury spread narrowed over the depression years.

Since we presently are in an era of Federal Reserve QEs, you might suspect that the Fed was possibly behind the rising Treasury prices and lowest yields of that era.  However logical it might seem in today’s context, the Fed was nowhere to be found on the buy side of the Treasury market during the depression (something Bernanke seeks to not repeat). Indeed, the money supply declined by 30 percent over the course of the depression, so the bond market did it all on its own, without Fed support. Indeed, being in a pre-Keynesian world, the rationale or desire for manipulating the interest rate or credit conditions was not part of the Fed’s understanding of how to run a central bank.

Then as now, the private market participants price the expected risks and costs of holding a debt instrument over its life, and they require additional yield for each risk and cost they anticipate will materialize.  They generally make this assessment of risk by extrapolating previous trends or by finding a similar historical episode to benchmark the likely gains or losses in value that might take place. Today we find many forecasts (even on this blog) citing the withering force of deleveraging due to over–indebtedness, which takes down an economy and softens demand and prices for goods.  Hence, today’s natural historical model for bond pricing would seem to be the 1930s.

However, while there are similarities, there are also big differences. Today it is the government that is over–leveraged, whereas in the l930s it was the corporate debt sector which makes today’s long Treasury yields suspect.   Though the economy is weak today, we are not in a decade-long depression, and while inflation is low, it is not in a cumulative deflation.  And while the Fed held back this week, they still have a commitment to positive inflation.

The greatest difference is today’s checkmated body politic, which is unable to resolve an ultimately un-financeable Federal deficit. This week we had another episode of kicking the can down the road, with the agreement to run the debt meter another six months before facing the music. This is all in sharp contrast to a much lower government debt load and an obsession to run a balanced fiscal budget despite the depression that prevailed in the 30s.

While the growth/inflation profile is different in the two eras, it is more important to note the difference in long-term fiscal sustainability.  Somewhere during the unfolding drama there will be an unspoken need (not mentioned in legislation or treaties) for the Fed to pull a “Super Mario” Draghi — who, last week, signed up to “do whatever it takes,” which apparently meant ignoring the ECB mandate and directly supporting Spain’s bank and government debt because the market no longer will.

Indeed, in the U. S. at the outset of WWII, the Fed presented the patriotic idea of wartime bond support to the Treasury, not the other way around. Central banks are not shy in the ultimate moment of money needs.

In what should be considered a “white paper,” the Fed’s role in these dire circumstances is recently discussed by Renee Haltom and John A. Weinberg in the Richmond Fed Annual Report, 2011, titled Unsustainable Fiscal Policy: Implications for Monetary Policy. In a rare Fed admission they indicate that “a central bank can reduce the government’s debt burden by creating inflation that was not anticipated by financial markets.  Inflation allows all borrowers, the government included, to repay loans issued in nominal terms with cheaper dollars than the ones they borrowed.”

Indeed, if the Fed were to create inflation, it would not be totally unanticipated.  This is the outcome seen by many observers, including Bill Gross of PIMCO.

And Bill Gross is not alone, as the bond-buying public seems to believe little of the fiscal sustainability story.  Indeed, the flow of funds data, at least for 2011, indicates that the private sector purchased a minority of net new government debt issuance.  Hence, private investors are not the leading purchasers of U.S. Treasuries, causing the all-time depressed bond yields. The graph indicates that the Federal Reserve is buying the lion’s share of net new Federal debt, and foreign investors are in second place. That market thrust no doubt represents a flight from European sovereign exposure, which is in a more advanced state of fiscal decay at the moment.

No doubt some have bought the1930s deflationary depression story as a model outcome to justify buying and holding sovereigns, but this time around it doesn’t lead to the necessary conclusion that sovereigns will appreciate from here.  At today’s entry point of taxable low nominal yields and negative real yields, betting on both a deflationary depression with fiscal sustainability is not only a long shot but is mutually inconsistent.

A deflationary depression doesn’t generate government tax revenues to reach fiscal sustainability unless the voting public is willing to accept a substantial entitlement haircut. Moreover, if the low bond yields were to be maintained it would systemically cause defined-benefit pension plans to underperform.  They would become forced sellers of sovereign bond holding to meet payouts — as is now finally occurring with Japan’s Government Pension Investment Fund.

The bond market rocket can glide for a time, perhaps years, until it collides with fiscal unsustainability. At that time it will be revealed plain enough for all to see when the private demand evaporates, much as it did with Spain this week. At that time, the U.S. Treasury is no longer a riskless debt instrument, nor is it immune from inflation.

(That being said, it leaves open the question of whether intentional inflation is bravado in the absence of bank lending, which will be addressed in a subsequent blog.)

When the market comes to understand that sovereign bond strength from a central bank is a mixed blessing — as it both purchases government bonds but also intentionally seeks to create “unanticipated” inflation —the bond market rocket is susceptible to the gravitational pull of Earth.

When that happens, there will be a large debris field for those who entered this untenable crowded trade (or stuck with it) so late in the game, supported not by the bond-buying public but only by a central bank wishing to do its patriotic duty — which includes inflation generation.

This indeed is not the 1930s.


If you enjoy this blog, please forward it to others who may be interested. Links to forward and sign up to receive are in the right hand column.