The Fog at the End of the Tunnel

It was the French social philosopher Alexis DeToqueville who noted around 1835 that Americans are especially optimistic.

Today, as calls are becoming louder that the recession is over and the recovery is underway, we can ask whether this optimism is premature.

We can also question whether the optimists are wrong when they infer that the post-recession economy will resemble ones we had in years past.

What seems to be missing is whether the optimists have addressed the root causes of the sub-prime credit bubble, which led to the current deep, consumer-led recession.

These root causes are part of the systemic excesses which existed in the banking system, the failure of financial self-regulation, and shortcomings in the active management and derivatives use among mutual fund managers.

It is these managers who have been entrusted to increase the retirement wealth of millions of Americans, yet the portfolio declines clearly indicate that something failed to operate properly.

The New List of Problems
In an interview with Nobel Prize economist Joseph Stiglitz of Columbia University, Stiglitz noted that the Federal government’s financial stimulus package ends in 2011. Without a new program with spending in the range of $175 billion to $200 billion, Stiglitz said there is a “serious risk” of another “downward blip” in the economy.

He also said that state revenues should decline further, accompanied by continued softness in commercial real estate. The job market should continue to remain weak, which affects consumer spending. The combined effect is that prospects for a jobless recovery, diminished consumer optimism and volatile markets should make for a very uncertain future.

Then, there is the illusion of prosperity which is a goal of the Fed. But this illusion is being projected to American consumers just as the U.S. dollar continues to slide, and as China, India and emerging nation continue to recover faster than the U.S.

The Sunny Side
The financial industry, however, prefers black-and-white pronouncements, such as the “light at the end of the tunnel,” and “the inevitable turnaround.” These are all shorthand for encouraging investors to re-enter the market for the proverbial buy-and-hold, stay-long, retail strategy.

But the new, post-recession economy will not look like the past. There is a new list of possible forces which can delay any solid recovery:

Among these are:
• Prospects for increasing taxes;
• Shifts in major industries;
• Slow job growth;
• Demographic changes as unemployed people move to new locations nationwide;
• More market volatility due to sovereign debt funds and weaker central banks;
• Excessive reliance on China to hold U.S. Treasuries.

All of these can have an excessive impact on the domestic U.S. economy and portfolio returns.

Looking ahead, investors can expect lower rates of returns on their portfolios. We have already seen a new formula for calculating retirement wealth which includes lower property values (due to tighter mortgage standards and a huge backlog of unsold homes), lower wage growth, higher health care costs, and a lower savings rate.

More bad news comes from workers who have suffered reductions to their 401(k) plans in the form of delayed, eliminated or reduced employer contributions. This should be considered a decline in real take home pay which for most Americans is the only source of retirement savings they will enjoy.

Cutting Social Security and Medicare Benefits
As a result of the increased Federal debt, the elephant in the political room is cutting Medicare and Social Security benefits. In terms of paper debt, $11 trillion in total paper debt, plus Medicare and Social Security debts, the U.S. has never faced this size of financial deficit in US history, according to economist Kent Smetters, a Wharton professor and a former deputy assistant Treasury secretary and economist for the Congressional Budget Office.

The problem with delaying reform in Social adds about $2 trillion to the present value shortfalls in each program, so any delay in repairing these problems can double the existing deficit, Smetters said.

While some have talked about increases taxes on the wealth, raising Social Security cap limits, and taxing fringe benefits, the fact is that the benefits are increasing faster than inflation which makes the system unsustainable.

The biggest problem is Medicare which has 67 times the size of a shortfall than in Social Security. Medicare is a crisis”, he said, and creates a shortfall which is twice as large as all the non-perishable assets in the U.S. And 80% of this shortfall is attributable to Medicare.

Another problem is that Medicare is paid in-kind, which means that medical services are paid for as they are provided. As a result, Medicare is not geared towards paying for half an appendectomy, for instance. This raises the touchy issue of medical rationing, and it has nothing to do with the current debate about the Obama administration’s medical costs proposals.

Hard Choices
Medical rationing is probably the most inflammatory issue in politics. Rationing takes place when people have to decide whether the costs of providing an extraordinary treatment, such as a triple-by-pass to an 85-year-old person is worth the price versus the benefits it can deliver. This is a social-political and ethical problem, which also has a consumer education component where people have to be taught about the lower-cost alternatives versus the costs of receiving extraordinarily expensive medical services.

This bleak scenario should take place in about 20 years, which is beyond the timeframe of most politicians who are most concerned about winning the next election. This will force the educational effort to citizens groups.

The change also will result in a benefit reduction, most likely to high-income individuals who will receive smaller Medicare benefits. This could mean that Medicare and Social Security become flatter in terms of the benefits received versus the amount of money paid into the system, Smetters said.


So what’s the bottom line?
Taxes should increase, accompanied by an increase in government debt, and a corresponding reaction by foreign government debt holders who may re-thing their decision to hold Treasuries as we realize the implications of this debt increase.

This realization will produce a decline in 30-year Treasury yields, an increase in inflation, and a decline in Treasury prices. This decline will affect the Chinese, Japanese and UK investors, as well as future American retirees.