U.S. Budget Battles Ahead

By: Axel_Merk

My most recent Merk commentary, published July 25, was motivated by the possibility of an impasse on the federal debt ceiling. Now that President Obama has signed a bill raising the ceiling, I am motivated to write once again. Standard and Poor’s has registered its concern by lowering its long-term sovereign credit rating on the United States from AAA to AA+.

Now that the early August debt-ceiling issue is out of the way, everyone should understand that the country is only temporarily saved from continuing bitter controversy over budget issues. We will likely see impasse after impasse in the future. Moreover, the controversy and economic uncertainty may well be affecting the economy, leading to market fears of renewed recession.

Why did we go to the budget brink? Democrats assert, correctly, that Tea Party Republicans held the country hostage over the debt ceiling. However, as I noted in my previous commentary, it might be equally argued that President Obama was holding the country hostage over his demand that taxes be increased as part of the deal. Republicans and Democrats have competing views and each party is willing to go to the brink if it believes that it can prevail by bringing popular support to bear.

We have also gone to the brink—over it, actually—on a funding bill for the Federal Aviation Administration. Congress went off on its usual August vacation without resolving the matter, and thousands of workers on FAA-funded construction projects were put out of work for nearly two weeks. Congress came back into session briefly to extend the FAA authorization until mid September, but the underlying controversy has not been resolved. Similar issues will continue for years to come.

What are we to make of the situation? I am reminded of one of Beryl Sprinkel’s favorite observations. Beryl, raised on a farm in Missouri, liked to say that on the farm everyone knew how to get the attention of an ornery mule. “You hit the beast with a two by four.” Sprinkel, who died two years ago, served for many years as chief economist of Harris Trust in Chicago and later as Chairman of President Reagan’s Council of Economic Advisers. On the debt ceiling debate, the tea partiers pulled out the only two by four they had available, and took the country to the brink of default.

Obviously, there has to be a better way to proceed. There is, but the basic problem from my perspective, and that of many others, is that President Obama refuses to present a plan to deal with the deficit. The Budget he submitted this past February ignored the issue. That is not just my judgment and that of the editorial page of the Wall Street Journal. Here is the opening paragraph of the Washington Post editorial (February 15, 2011) the day after Obama submitted the budget:

THE PRESIDENT PUNTED. Having been given the chance, the cover and the push by the fiscal commission he created to take bold steps to raise revenue and curb entitlement spending, President Obama, in his fiscal 2012 budget proposal, chose instead to duck. To duck, and to mask some of the ducking with the sort of budgetary gimmicks he once derided. "The fiscal realities we face require hard choices," the president said in his budget message. "A decade of deficits, compounded by the effects of the recession and the steps we had to take to break it, as well as the chronic failure to confront difficult decisions, has put us on an unsustainable course.” His budget would keep the country on that course.

The President’s unwillingness to offer specific proposals has much to do with the standoff and the poisoned atmosphere. In an op-ed in the WSJ on August 3, Congressman Paul Ryan focuses on the same issue. The op-ed headline is, “Where’s Your Budget, Mr. President?” For those interested in more detail on the budget issue, I strongly recommend the recent report by the Congressional Budget Office, “CBO’s 2011 Long-Term Budget Outlook.”

A major problem with the argument over taxes is that neither side is willing to be specific. Many observers—count me among them—believe that additional revenues will be needed to address the long-run budget problem. But I am not ready to sign off on President Obama’s plea for “balance” in the absence of comprehensive tax reform, which the country desperately needs. My expectation is that if the Republicans had accepted the President’s plea for more taxes in the interest of “balance,” then he would have been back in his budget early next year asking for more balance. Those who want more revenue need to be specific about how much more. And, most importantly, they need to accept the fact that the budget problem cannot be fixed through taxes alone. The major part of the work must be done on the spending side. Medicare, especially, must be reformed. It cannot survive in its current form.

Similarly, Republicans who want only to cut taxes need to be specific. There are essential functions of government that require revenues. Among these are certainly maintenance of an adequate military and domestic security. We need to finance a sound court system. It is not responsible to say “cut taxes” in response to every argument to increase taxes.

An Acid Test

Most arguments favoring federal spending seem implicitly to assume that someone else is or should foot the bill. For Democrats, “someone else” is the upper-income taxpayer. I propose the Social Security test instead.

I’ll illustrate my proposed test with the FAA bill mentioned earlier. One of the issues there is subsidies to airports in rural areas. Would you favor financing these subsidies by cutting Social Security payments to those currently on Social Security? Ask any member of Congress—even one living near an airport receiving the subsidies—and I am quite positive what the answer would be, if you could cut though the likely evasions.

I would apply the same test to subsidies for ethanol, for wind and solar power, for high-speed rail, for farm subsidies and a host of other programs. Indeed, I would apply this test to all federal spending. Speaking for myself, I would be willing to accept a cut in Social Security—my own Social Security—to pay wages for military personnel fighting abroad, for salaries for judges and FBI officers, and for other essential functions of the federal government.

Why do I make this argument to Merk investors? The reason is that clarity in our public debates will affect many outcomes as the country deals with the budget deficit. I hope that Republicans repeat at every opportunity, “What is your plan?” We must understand, as the CBO makes clear, that our budget problem cannot be solved by a tax increase confined to the top brackets. For tax increases to make a material contribution to solving the budget problem, the increases will have to apply to most brackets.

I would be delighted if my proposed Social Security test provokes some clear thinking. After all, if you would rather have a tax increase on all brackets, keep in mind that the increase will fall in part on those currently receiving Social Security benefits and the rest of the tax increase will fall on future Social Security beneficiaries. Roughly speaking, broad tax increase, reduction in Social Security benefits—same difference.

So, here is the acid test: would you advocate a reduction in Social Security benefits to pay for subsidies for windmills? If not, ax windmill subsidies.

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We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com .

William Poole
Senior Economic Adviser
Merk Investments, Manager of the Merk Mutual Funds

© 2011 Merk Investments® LLC
The Merk Hard Currency Fund is managed by Merk Investments, an investment advisory firm that invests with discipline and long-term focus while adapting to changing environments.
Axel Merk, president of Merk Investments, makes all investment decisions for the Merk Hard Currency Fund. Mr. Merk founded Merk Investments AG in Switzerland in 1994; in 2001, he relocated the business to the US where all investment advisory activities are conducted by Merk Investments LLC, a SEC-registered investment adviser.

Mr. Merk holds a BA in Economics ( magna ***** laude ) and MSc in Computer Science from Brown University, Rhode Island. Mr. Merk has extensive experience and expertise in how the global financial imbalances, as evidenced by an enormous trade deficit, affect the markets. He has published many articles describing complex economic phenomena in understandable terms and he is a sought after expert presenter and moderator at conferences. Mr. Merk is a regular guest on CNBC, and frequently quoted in Barron's, the Wall Street Journal, Financial Times, and other financial publications.

In addition to 20 years of practical investment experience, Mr. Merk has a strong foundation in both economic analysis and computer modeling. His research in the early 1990s focused on the use of computer-aided models in financial decision making; he is a published author in “Adaptive Intelligent Systems” * and has been awarded a prize for excellence in economics. **

Mr. Merk focused on fundamental analysis of US technology firms in the early to mid 1990s, he diversified to other industries to manage volatility in his investments. In the second half of the 1990s, Mr. Merk received an early warning of the building bubble when he recognized that more and more companies were trading in tandem, causing the diversification offered through investing in other industries to diminish. As a result, he broadened his investments internationally. As the bubble burst and Greenspan and the Administration preserved US consumer spending through record low interest rates and tax cuts, imbalances in the global financial markets reached levels that Mr. Merk deemed unsustainable. Merk Investments has since pursued a macro-economic approach to investing, with substantial gold and hard currency exposure.

Merk Investments is making the Merk Hard Currency Fund available to retail investors to allow them to diversify their portfolios and, through the fund, invest in a basket of hard currencies.

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