The First Law of Holes

The first law of holes is “When you are in one, stop digging”. This is precisely what Congress has been unable to do for many years, no matter which party has been in power. The first step to an eventual solution is acceptance that the Federal debt level is a very real problem. Putting aside the nonsense that the debt limit debates produce, the fundamental problem is our level of debt, not the debt limit. Much like a consumer unable to pay their bills and unable to get more credit, at some point the market will place its own limit on the Federal debt unless we find a way to stop digging.

Viewing the problem in a slightly different way, the problem is that our debt is growing faster than our economy (GDP). There are only two fundamental ways to reduce our relative level of debt: increase revenue (grow the economy faster and/or raise taxes) and reduce spending. The crux of the current problem is that economic growth has been relatively meager since the Housing Crisis in 2008; tax rates are down and spending is up. It is not an ideal situation. With the trajectory of debt now going parabolic, it is very clear that any solution will require contributions from all sides. The devil is in the details and those details do not mix well with politics.

We certainly hope the idea that we can print unlimited amounts of money has been put to rest by the inflation that followed the massive money printing during COVID. Our experience was a very far cry from the Weimar Republic, but the message was the same; too much money can destroy a currency. If we are to maintain our position in the world, we need to begin to get a better handle on our growing deficits.

The Biden Budget

The Biden Administration unveiled their budget proposal this week, which centered on higher taxes on the wealthy and reducing government waste and projects to cut deficits by nearly $3 trillion over the next 10 years. The GOP predictably countered that this is just more ‘tax and spend’ policy. Both sides promise not to cut Medicare and Social Security, but the GOP doesn’t want tax increases, they just want to cut spending. Here is the problem, as quoted from the Wall Street Journal this week: “If lawmakers take raising taxes and cutting Medicare, Social Security, defense and veterans programs off the table, Congress would need to cut 85% of spending in all other categories to balance the budget in 10 years, according to the Committee for a Responsible Federal Budget.” We all know that can’t be done.

Biden’s proposals have been released and the plan includes an increase in the Medicare tax from 3.9% to 5.0% for those with income in excess of $400,000. In addition, it would dedicate these funds to Medicare exclusively. (Currently Medicare taxes go to the general fund and can be used for any purpose.) Another part of the plan would depend on the Government’s ability to negotiate drug prices as a way to lower the cost of Medicare. According to the Biden Administration these measures would extend the solvency of the program by 20+ years. But the Biden agenda also includes increased spending, including an expansion of child care and pre-K programs, as well as a 5.2% raise for federal workers.

As of this writing, the Biden plan for Social Security is not known, but this is the other gorilla in the room. Current projections have the Social Security Trust hitting a wall in 2029, where Social Security would be unable to pay full benefits. (See chart below.)

Productivity Gains are Critical

What’s missing from both sides of the aisle are proposals to realize the potential gains from growth, i.e., productivity gains. In their report titled “Rekindling US productivity for a new era”, McKinsey & Co. states: “Labor productivity growth has been the engine of US economic power and prosperity since World War II, adding 2.2 percent annually to economic growth and contributing mightily to a 1.7 percent annual gain in real incomes.” The problem is that from 1948 to 1970, productivity growth was 2.8% but more recently, it has been only 1.4%. Productivity does not garner headlines, but given the limitations to cutting expenses or raising taxes, it needs to play a major role in correcting our debt problem.

Much like the JFK’s goal of reaching the moon, we need programs that enhance our technological skills. The technological carryover effects of the space program are massive and have been a huge addition to productivity. Programs that promote technological advances are critical. The chart below, also from McKinsey, shows the strong correlation of productivity growth and digital adoption. Debate about revenue and expenses is necessary, but ultimately, we must spend more wisely if productivity is to advance at a more rapid rate.

The Biden Plan has plenty of holes, but we need to start somewhere and his plan is a reasonable starting point for debate. There is a solution out there, but the grandstanding on the left and right needs to be put aside. Addressing the debt problem will require some long-term resolve and our window of opportunity is closing fast. Congress needs to stop digging and start investing.

An Old-Fashioned Bank Run

On Wednesday, SVB Financial (Silicon Valley Bank) closed at $267.83. On Thursday SVB closed at $106.  The stock never opened for trading on Friday and after the close was the bank shuttered by FDIC as depositors were scrambling to get their money out of SVB. With the threat of yet another banking crisis cropping up, we expect the FED to have a busy weekend attempting to get someone to ‘buy’ SVB and make depositors whole. Many depositors, mostly tech start-ups, stand to lose a lot if the Fed is unsuccessful. After the close on Friday, Roku announced that they had almost $500 million of uninsured deposits at SVB and they have no idea how much, if any, will be recoverable. They are not alone.

We don’t believe there is direct carryover from SVB to the banking sector. SVB specialized in the venture capital world, while other regional banks have little, if any, participation there and the funding is very different than SVB. Nonetheless, it does make markets painfully aware that these things can still happen. Suddenly the market’s antenna is up and it would appear that regional banks are in the crosshairs. The largest regional bank ETF was down about 18% this week.

The concern among the regional banks appears to be about more about commercial real estate lending, particularly office buildings. Interest rates are much higher than they have been in many years and as loans mature and need to be re-financed, we are seeing some of the largest owners simply giving the properties back to the banks. Blackstone and PIMCO have both recently defaulted on hundreds of millions of loans and handed commercial buildings back to the banks. Post COVID, many office buildings remain empty with little prospect of finding tenants and the regional banks could be left holding the bag.

Regional banks have less stringent reserve requirements than the large, systemically important banks, so the action in SVB is raising the specter that regional banks might well be in trouble too. It goes without saying that there is nothing that can push the FED to pivot to lower rates more quickly than a banking crisis. Rates were down massively of Friday, but a Fed pivot could probably not come at a worse time with inflation still running hot. Stay tuned to this developing story.


What We’re Reading

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Fed’s Powell sets the table for higher and possibly faster rate hikes

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China’s New Way to Control Its Biggest Companies: Golden Shares

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By: Adam