Sunday Musings: No Free Lunch

Economist Irwin Kellner had some interesting thoughts in “No such thing as a free lunch:”

The budget that is now being put together for the coming fiscal year calls for the federal government to spend far more than it expects to take in. Last year’s budget deficit was the biggest in history in nominal terms and this year’s figures to be even larger.

As you might expect, the administration is trying to determine how best to finance this humongous shortfall. It goes without saying that the manner in which Washington pays for this deficit will affect the outlook for 2010 and beyond.

When you or I spend more than we make, our first thought is to tap our savings account to make up the difference. Unfortunately, the government has no savings from which it can draw upon to pay its bills.

It did ten years ago, when the federal budget was in surplus, but having run deficits in each of the years following, that well has run dry. As a consequence, Washington will have to raise the funds needed to close its budget gap.

In case you did not realize it, there are only two ways in which the federal government can obtain money to spend. One is through taxing, the other is by borrowing.

There is no other way. There is no such thing as a free lunch.

Together, taxing and borrowing make up the true burden that Washington imposes on our economy, for they add up to total government spending. One way or another, you and I have to give up something to the politicians in Washington so they can satisfy their needs du jour.

Raising funds by hiking taxes is out of the question in this economy. It drains buying power just when the private sector needs it to cope with depressed incomes, depleted wealth and difficulty in borrowing.

Even in good times, raising taxes is not popular. This is because it is a highly visible means of confiscating from the haves and giving it to the have-nots.

That said, borrowing is the only option left.

If Washington borrows from the private sector, it will cause interest rates to rise as the supply of loanable funds declines. This will make it tougher for people to buy homes, cars and other big-ticket items, and for business to invest in new plants and equipment, especially the technology needed to compete in today’s global marketplace.

Borrowing also saddles both current and future generations with a legacy of debt.

Of course, Washington could borrow from abroad. However this, too, will produce higher interest rates in order to attract foreign funds. This approach also raises the value of the dollar, thus hurting those companies that export and/or compete with goods that come from other countries.

It also lowers earnings from abroad, produces fewer jobs — and leads to lectures from foreign governments on fiscal profligacy.

And should the government choose to borrow from the Federal Reserve, it would have the effect of adding to the money supply thus setting the stage for a new round of inflation. Besides debasing our currency, this hurts retirees and others on fixed incomes.

If Washington can’t live within its means, it must either raise taxes or borrow.

There is no other way. There is no such thing as a free lunch.

Sad but true. What the story does not address is the fact that surplus money made during good times is never set aside to cover shortfalls during bad times. Kind of like any normal person would/should do within his own personal budget.

As a consequence, this lack of financial prudence will now play itself out in various serious scenarios ranging from municipalities to cities, states and the federal government along with problems in sovereign entities.

In regards to the markets, we will continue to see a wide range as sudden optimism pushes the major indexes to higher levels only to be followed by sharp pullbacks as economic reality sets in.

The result will be slipping into and out of recessions for years to come with the markets essentially moving in a broad sideways pattern as discussed in “Going Sideways for 5 years.”

Be alert and prepared to use my recommended exit strategy and don’t even think for a moment that there is any investment that you can simply buy and hold without principal losses. If you try, chances are that Wall Street will teach you a very expensive lesson.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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