At last week’s Morningstar Investor Conference in Chicago Jeff Gundlach, bond guru and founder of DoubleLine Capital said the USA is confronted with a terrible deflationary battle that will ultimately end in default (see the full presentation here). I was shocked to read this from Gundlach who is truly a master of the debt markets. He appears to connect all of the dots with near perfection only to come to what I believe is a maniacal conclusion (that we will default).
At the presentation Gundlach focused primarily on the government debt level without focusing heavily on the difference between private sector and public sector debt levels (which is absolutely crucial in my opinion). He said:
“The problem for the near term is that the load of all of this debt is deflationary. We need to work through these deflationary outcomes. Debt growth creates a headwind where we need more and more and more debt.”
Of course, deficits are as American as apple pie. As you can see below, the USA has essentially always run deficits. Throughout many of our most prosperous periods we have run large deficits and been deep in the red. Government has spent more than its brought in for almost the entirety of the existence of the USA yet we have never had trouble paying for our children’s futures or “financing” anything. This confounds the inflationistas and those arguing that we will default. How can a nation never be in surplus and still be, arguably, the greatest economic engine ever known to man?
The answer is a matter of accounting. Private sector net savings is public sector deficit. TO THE PENNY. This is simply an accounting identity. The government cannot be in surplus at the same time the private sector is in surplus.
The Gundlach commentary got decidedly more negative from there. He essentially blames government spending for our current woes:
“Government workers are being paid with taxes on borrowed money. If you are going to create government jobs, you are just borrowing more money. Those aren’t real jobs.”
This is a blanket falsehood. First of all, the USA doesn’t “borrow” money. We are no different than an alchemist who funds his spending internally. As the monopoly supplier of currency in a floating exchange rate system we are our own banker. Not China, not Japan. Just like the alchemist, we simply press a button and wahlah! Money appears. The bogey for the alchemist is not “funding” himself. The bogey for the alchemist is ensuring that there continues to be demand for his currency – that he does not inflate away its value. But as Gundlach earlier pronounced there is no risk of inflation….Only deflation as the private sector continues to destroy money via debt reduction.
The other flaw in his thinking is with regards to jobs. I don’t know where this idea comes from that government spends no money on productive labour. Most of us know our local police officers, fire fighters, perhaps someone in the military? Government employees are VERY real. These are not fake jobs at all. These are productive jobs that put real dollars into Main Street’s pockets. We can argue over the effectiveness of a large portion of these jobs or whether they are all necessary, but saying they are fake is simply erroneous. Would you rather we put those dollars into the pocket’s of bankers because that is what Ben has done for the last 18 months. How is that working out for us? I am the last person on earth to advocate a fully run government economy (I wouldn’t refer to the site as Pragmatic CAPITALISM if that were the case), but this idea that government is always and everywhere a bad thing is simply false. They are blanket falsehoods based on nothing more than political beliefs that cloud rational thought.
Where Gundlach nails the argument is in his deflation/stimulus argument. He clearly recognises that the environment we are in has been and remains a deflationary threat. As I have argued for several quarters, Gundlach says that the removal of government aid will reveal a private sector that is still deeply in debt and unable to “run with the baton” (as I have previously described):
“Take the stimulus away, and you’re going to have a double-dip recession or a significant contraction or slowdown of economic growth.”
The flaw in Gundlach’s larger argument is the same one that David Einhorn and Alan Greenspan have recently made. It is this inability to differentiate between private sector debt and public sector debt (of which there is really none – a sovereign nation which has monopoly supply of currency in a non-convertible floating exchange rate system never really has any “debt”) which leads them to believe that the US government is no different than a household. This of course is what is leading us all to believe we are the next Greece. It’s sheer lunacy. And it is why we are implementing austerity measures almost universally. Because of this, Gundlach says tax increases are on the way:
“You have a tax increase coming and a radical policy shock that will affect investments in the economy.”
Ultimately, however, Gundlach says the USA will be forced to default as we truly are the next Greece:
“some type of polite default, at a minimum, will happen.”
And I would like to politely say, that Mr. Gundlach is wrong. The United States will not default unless we choose to default due to some mental lapse by the US Congress. On the other hand, we could effectively default by creating hyperinflation, but that is in direct contradiction to the rest of Mr. Gundlach’s argument. The US consumer might be on the verge of default, but there is no solvency risk in the United States at the government level, unlike the single currency nations in Europe.
Unfortunately, no one cares to listen to these vitally important facts (and simple accounting identities) so bring on the tax hikes. Bring on the austerity. Bring on the pain. We’ve become a world of masochists. Let’s see how well we handle it. My guess is not so well. Fortunately for Mr. Gundlach his bond portfolios will likely benefit enormously.