The Sword of Damocles

The Roman politician/philosopher Cicero tells a famous parable of the tyrant Dionysius and his servant Damocles in which Damocles desires the wealth and power of his master. Seeing this desire, Dionysius instructs his men to bring to Damocles the best wines and foods; then they were to present him with gold and treasure beyond imagination. As Damocles expresses thanks, the tyrant Dionysius then orders his men to hang a sword by a single horse hair from the ceiling directly above Damocles’ head. Much like the sword above Damocles’ head, we believe the debt that hovers over Uncle Sam’s head is perilous.

As we watch the interplay between the capital markets and US politics we believe the current fiscal problem could be disastrous if not handled quickly. Former Federal Reserve Chairman Greenspan recently said as much when he told a subcommittee of the Senate Finance panel “if we presume that we have a year or two before starting serious long-term restraint, and we turn out to be wrong in that optimism, the impact on financial markets could be devastating.” Not only have pundits and politicians glossed over the long term implications of not resolving the current problem, they seemingly have little understanding of the importance of making those decisions in 2011.

Why 2011?  The US budget deficit is expected to be approximately $1.4 Trillion in 2011. The White House’s Budget estimates the deficit at $900 Billion by the end of 2012 and decidedly smaller in subsequent year ends. But the devil is in the details, so the question is where is the money coming from to reduce the deficit? The Administration’s Budget shows that the decrease is primarily based on an increase in (tax) revenues from individuals and corporations equaling $580+ Billion of additional money coming into governmental coffers over the next two years. Problem: achieving that magnitude of revenue increase requires real GDP growth well above the anemic .4% and 1% growth seen in the 1st and 2nd quarters of 2011 respectively and there also has to be significant reduction in the (current 9.1%) unemployment rate. In a recessionary environment having substantial GDP growth with a considerable decrease in unemployment without some catalyst is unrealistic. While the prospect of an increasing or unchanged deficit should be more than enough get politicians' attention, they should be further incented because in 2012 the U.S. will need to make decisions regarding approximately $4 Trillion in short term debt that is coming due. Both parties would agree that the current situation is untenable and corrective action is necessary. However, it is clear that both parties are unwilling to repair Washington's largely broken system because of the deeper spending cuts and more substantial tax hikes that are required.

But won’t the Federal Reserve help revive the economy- that would be the catalyst for economic growth, right? Chairman Bernanke has indicated that the Fed will act to help revive the US economy. Problem: the two methods proposed thus far i.e., a third round of Quantitative Easing or a “TWIST” - a process whereby the Fed sells short term treasury securities and buys longer term treasuries - does not address the underlying problem. We submit that in order to revive this economy individuals and companies need to SPEND/INVEST money AND banks need to LEND/INVEST money. The ideas put forth will keep rates artificially low and keep money available in the system but neither idea encourages spending, investment or lending.

So the question - where is the money going to come from to reduce the deficit - remains unanswered. Historically we would look to the international community to finance any shortfall but given the still developing situation in Eurozone because of Greece, Italy et al, no one country has the financial wherewithal to provide assistance.

From our vantage point the logical solution is to embrace the difficult decision to cut spending AND raise taxes. We agree with many that state cutting entitlements would be the "easier” solution. Problem: while this is true mathematically, politically we think it inconceivable that entitlement programs like Social Security, Medicaid and Medicare will receive the substantial cuts that are needed. After all the name “entitlements” describes how people receiving these governmental benefits feel - entitled to receive them. Add in the fact that 2012 is an election year and we would be hard pressed to believe that decreasing benefits in any great measure to senior citizens would happen. According to the U.S. Census Bureau during the last presidential election more then 79% of people 65 and older voted. This is meaningful when compared to an overall voter turnout of 52%.

Clearly there is a confluence of events globally which make previous actions and other ideas in a recessionary environment either ineffective or near impossible to implement. The uniqueness of the current situation notwithstanding, the time is NOW for politicians to address the United States fiscal problems. Observers need only to look at the meteoric rise in gold prices which proxies investor fear to see that many believe the global economic situation is precarious and the US economy is very much part of that. We believe this was certainly validated when S&P downgraded the U.S. credit rating. There are a growing number of economic indicators that clearly tell us the canary in the fiscal coal mine may quickly lose consciousness.

Much like the sword dangling precariously above Damocles, we can see the dangers of our debt and deficit perilously hanging there. In the end Damocles chose to remove himself from the deadly situation before the horse hair suspending the sword breaks. U.S. politicians need to remove America from the perilous economic situation we find ourselves in; one can only hope that they do so before the hair breaks—in this case timing is everything.