Last week, while clearing out old office files, I came across a brilliant 2004 presentation by Northern Trust's Paul Kasriel, one of my favorite economists. He spelled out exactly why the housing bubble would inevitably burst, and he predicted the financial train wreck that would certainly ensue. His devastatingly accurate appraisal was based on the simple observation that house prices could not forever outpace household incomes. And sure enough, they didn't! But it took over three years for the mortgage frenzy to finally collapse, during which time the NASDAQ index soared 55%, proving once more the importance of timing.

When we realize that certain economic or financial conditions cannot go on forever, we must examine how long they might persist, what is likely to finally bring them to an end and how that end could affect investment risks and opportunities. With effort, we can learn how to use this awareness to strategic advantage. Soaring government spending provides a real-world example we can practice on.

Double-Digit Deficits
In August, the stock market shrugged off as unimportant the news that the federal deficit for the next ten years was estimated to be $9 trillion, up from a $7 trillion estimate just a couple months before. This anticipated funding challenge takes into account no additional costs for the proposed health-care reform, and it assumes healthy economic growth despite rising tax rates. Nor was investor optimism diminished by the estimated current year deficit of $1.6 trillion, which is more than 11% of GDP; this figure is about four times deficit levels in recent years, levels considered by some pundits back then to be an immoral imposition on future generations.

Total federal debt is now expected to approach 100% of GDP in about four years. That's almost a five-year double. Can we keep doing this without serious consequences?

What attitude, what expectation allows investors to be so nonchalant about deficits on a previously unthinkable scale? The prevailing explanation is that this huge spending has been necessary to sidestep a credit meltdown, and that it is only temporary. The Fed and Treasury will remove the stimulus in a timely fashion, navigating between the Scylla and Charybdis of deflation and inflation. Enlightened regulation will prevent a return of the avarice that precipitated the problem in the first place. And resumed economic growth will make the debt quite manageable, thank you.

Nice concept; neatly covers the issues. Yet I am so not convinced. I personally think that most investors have not intellectually embraced this rosy scenario; they are just swept up in the short-term trading mentality that has dominated market activity during the huge rally from the March lows. I think a fear of missing the upswing (especially on the part of fund managers desperate to show they haven't lost their mojo) has overwhelmed nagging concerns about longer-term fundamentals. As if to showcase this idea, journalist Floyd Norris penned a recent article in The New York Times about the new deficit forecast. His headline read, "It's hard to worry about a deficit 10 years out."

In a recent investment meeting at Financial Advantage Inc., as we tossed around this question of whether government deficits were more ominous than markets seemed to indicate, our staff observed that we Americans "don't do future very well." Perhaps our risk perception has been numbed by the long post-World War II credit cycle that allowed us to indulge today on a promise to pay tomorrow. We live in the now, and somehow the ability to think critically about possible future problems has been deleted from our societal DNA. In this year's stock market surge, I see similarities with the run-up between 2004 and 2007 that ignored Kasriel's and many others' chilling forecasts for housing and credit.

A rally supported solely by investor insouciance is ephemeral. Perhaps, like the stock market recovery during the last stages of the mortgage bubble, our current rally offers us a golden opportunity for serious reflection on the realistic outlook for the economy and for securities. To that end, I can't think of a more poignant inquiry than this: "How long can a country live beyond its means without serious negative consequences?"

Reality Check Time
Optimism is bred into us as Americans. It is in many ways our unique strength, giving rise as it has to an indomitable, can-do spirit. But if our tendency to anticipate only favorable outcomes were to morph into a childlike naiveté, our virtue will have become our Achilles' heel. (In case you forget how that poor fellow ended, check Wikipedia. Sobering!)

During four and a half decades of jousting with Mr. Market, I've developed my professional investor's definition of "optimism": "The conviction that one can make money in any kind of market." This is profoundly different from a naive optimism which supposes that the private economy will almost always grow and prosper, governments will act in the public's best interest and citizens will behave prudently. I have learned that realism, peppered with skepticism, is the healthiest attitude if you want to prosper in spite of the market's capricious behavior.
So what are the consequences of a nation living beyond its means? I propose a series of four basic questions (realizing that each is prone to generate a flurry of subsidiary questions, insights and possibilities).

If the situation in question (in this case, high government deficits) should continue indefinitely, what are some likely consequences? Newton's first law of motion says: "Every body persists in its state of being at rest or of moving uniformly straight forward, except insofar as it is compelled to change its state by force impressed."
What forces might reasonably be expected to precipitate a change in the current situation (i.e., to cause the deficit to shrink, to disappear or even to accelerate)?
If the situation does change, what are some of the likely consequences of change? Describe the real-world fallout. Who or what benefits? Whose ox is gored?
What data series or other information should we watch to decide whether the change is actually occurring and when. At what point does it allow us to adapt our portfolios to a "new normal"?

You can, of course, ponder these questions by yourself, collecting your ideas under the four headings for later reference and further deliberation. A more dynamic way is to gather your investment team or, lacking that luxury, a peer group of good thinkers; plan with them a meeting divided into 15- or 20-minute segments to brainstorm each of the four topics. You'll want one person responsible to collect succinct notes while everyone chimes in. Brace yourself for an animated session.

It may take a second meeting or even a third, but eventually you'll want this exercise to produce three lists:
A) A list of potential economic scenarios and the relative likelihood of their occurrence.
B) A list of data series and other sources of information that you'll want to monitor.
C) A list of portfolio emphases that you believe would be appropriate for each scenario.

Economic Scenarios
To give you some idea of where these explorations may lead you, take for example the list "A" that recently emerged from an investment meeting we held at Financial Advantage. (Perhaps we can get into lists "B" and "C" in a later column.)

To come up with the list, we began with the notion that rising debt (private and public) would boost economic growth until it took $5 of new debt to squeeze out $1 of GDP growth. Finally, we assumed, the credit system would collapse under the weight of debt service and defaults. To prevent the very deleveraging process that we need to restore financial health, Washington would begin issuing bonds as Band-Aids, shoring up the system with public debt to first replace the failing obligations of financial intermediaries and then those of private companies and citizens. Their rationale: If debt shrinks, the economy shrinks, which is considered political suicide. Our takeaway: The political class, whose influence is enhanced by the crisis (there's that skepticism), will stay on this course until forced to relent.

Given that background, we came up with our "list A" of economic scenarios:
Stagflation (a 45% probability). Except for the period following World War II, there is little evidence of government's willingness to voluntarily reduce spending (in other words, to relinquish power). If the deficit must be reduced under the pressure of, for example, rapidly rising interest rates or a voter mandate in 2010, it would be more politically expedient to reduce the deficit by raising income taxes, which also depresses consumption. We think consumers, who dominate GDP, are in transition to a more responsible financial style that respects saving and eschews debt. We also believe that businesses would cope with slow consumer demand by keeping a lid on employment costs and paying down debt. Meanwhile, less competitive vendors would lose market share and unnecessary productive capacity would be eliminated.

In short, a stagnant economy. This is the "morning after" for business and consumers, but the political class parties on! Inflation benefits debtors and the government is the thousand-pound gorilla in that department. So expect inflation.
Debt-deflation spiral (a 35% probability). The main competitor to our stagflation scenario is one in which the government fails in its reflation efforts. We think it is less likely but clearly possible (c.f., Japan) that default weeds may choke off the green shoots of economic recovery and overwhelm the monetary stimulus. Inflation is a monetary phenomenon, but if the destruction of debt assets (loans are a lender's assets) outpaces monetary creation, the money supply could actually shrink. Deflation, which manifests itself in generally falling prices for goods and services, is the true boogeyman in a highly indebted economy such as ours. And it is self-reinforcing. Deflation is tough on wage earners, tough on businesses, terrible for stocks and brutal on both borrowers and lenders. Frightened capital would flee to the safest bonds, driving their prices up and interest rates down to, well, depression levels.
Normal real growth (a 20% probability). Of course, miracles do happen. Our least likely scenario for upcoming years would be a home run for current deficit spending policy. In this outcome, cheap federal money lures consumers back to their profligate ways, and rising consumption improves the job outlook. Lenders, their assets buttressed by all sorts of federal guarantees, get a little less fussy about their customers. Regulators, under political pressure to "be reasonable," would practically encourage securitization and increased leverage by intermediaries. The consequence would be inflation, of course, with a serious risk of hyperinflation.
You can make a similar exercise out of other "can't go on forever" observations.
Can money market funds yield 0% forever?
Will France and Germany forever subsidize Spain and Italy to protect the euro?
Can government keep raising taxes on the top 5% of earners without consequence?
Can the U.S. dollar remain the reserve currency as other economies grow 100% faster?
How long can a barrel of oil sell for 27 times an MCF (a thousand cubic feet) of natural gas?
Can housing starts stay at 400,000 with growth and replacement needs at 1.5 million?
As you become more comfortable thinking about these sorts of big-picture observations, they may well help you anticipate significant economic and financial developments in a way that will sharpen your investment judgment and bolster your conviction for taking a contrarian position.

At least it will keep you from being completely swept up in the Extraordinary Popular Delusions and the Madness of Crowds-who never ask
if a tulip bulb can forever cost more than a house.