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.