The Republican landslide victory has got me thinking more about policy, stocks and the economy. I realized that there's a scenario that could play out sometime next year, which could very well spell the end to the stock market's rise and the economy's expansion.
I don't want to worry you too much because it wouldn't happen until next March at the earliest, but I think it's important to understand what could potentially happen.
If you've been reading my columns for the past two years you know that I've been pretty much bullish on stocks and the economy the entire time. The main thing I look at is government spending because that drives all the other components of GDP (personal consumption, business investment and net exports). When the government spends, dollars flow to the non-government sector as income to people and firms, both domestically and to the rest of the world.
While the deficit (total spending minus total taxation) was shrinking (government spending less and taxing more), it's the "top line" (i.e., spending) that is the key number. Annual government spending has been comfortably above $4 trillion since 2009, and the market and economy have been expanding since 2009. No one can refute this. You can characterize the growth anyway you like, but the total output of goods and services has been steadily increasing since then, both nominally and in real terms. And companies in the S&P 500 have had no problem capturing their trillion or trillion and a half in earnings from that $4 trillion of government spending.
However, in order to make that happen we have had to go through some bruising political battles centered on raising the debt ceiling. Republicans were pretty much universally against raising the debt ceiling. But they didn't have control of the Senate and, therefore, had to acquiesce each time. That was a good thing because raising of the debt ceiling allowed for a net addition of income and savings to the private sector by virtue of the government spending more than it removed in taxes.
The Republicans see the national debt not for what it is (national savings of the non-government), but instead, as some parasitic wealth-sucking monstrosity that will doom our kids and grandkids. In their recent op-ed piece for the Wall Street Journal, Senator Mitch McConnell and House Speaker John Boehner said that one of the goals of the new Congress would be to bring down the debt. I take them at their word.
This is where the recently concluded elections really matter. The last time Congress addressed the debt ceiling was at the beginning of this year and they suspended it until March 2015. That means, until March, the government can keep on spending freely (adding income and savings to the non-government) without problem. It's "green lights" until then.
But then what?
Currently, the government is running about a $480 billion deficit. Let's just call it $500 billion. By next March, the deficit could be more or it could be less, I don't know, but let me just use that figure. A half a trillion dollar deficit means there is a half a trillion more in spending than taxes, so that half a trillion adds to the private sector's income and savings by that amount. It's a big part of what's fueling spending and growth.
When we get to March 2015, however, and if the debt ceiling is not increased -- which it won't be, in my view -- then it instantly puts the government in "balanced budget mode." Why do I believe the debt limit won't be raised? Because Mitch McConnell already said it won't be increased. He said that Congress will address the debt ceiling fiscally, via spending. In other words with spending cuts.
So next March the government will basically be forced into a balanced budget spending mode, which means it will only be able to spend what it takes in, in taxes. Some people might be asking, "What's wrong with that?"
Here's what's wrong with that. In an instant you remove that half a trillion dollars from the economy. In an instant. That means, in the best-case scenario, we start off with annual spending next year in the $3.7 trillion range, which is well below the $4 trillion-plus we've seen since 2009; and again, since 2009, the economy has been expanding and stocks have been going up.
That's just for starters.
When you remove that much income from the economy what happens? The economy slows, business sales fall, and jobs are cut. A slowing economy means falling tax revenues, and since the government is now operating in balanced budget mode (you can only spend what you take in, in taxes), the government is forced to spend even less. The more spending is cut, the more the economy slows, the more jobs are lost, etc. A vicious circle is created.
In the meantime, people who have suddenly lost their jobs file for unemployment insurance. Under the constraint of a hard debt ceiling and balanced budget operating mode, the government cannot expand unemployment insurance. You have switched off the "automatic stabilizers." These are things like unemployment insurance, Social Security, Medicare, Medicaid, veterans benefits, disability insurance, etc., which normally expand when times get tough.
In order to meet those payments the government will have to make cuts elsewhere. But where? Most of the big outlays are in the areas of the budget I just mentioned and those are all non-discretionary: they must get paid.
Pretty soon the vicious cycle down gets really brutal. Government spending reductions forced by a "hard" debt cause the economy to crater, tax revenues to plummet, forcing more spending cuts, more job losses, etc. Meanwhile, the automatic stabilizers have been shut down and there is no safety net. Very quickly the whole system goes into default. It's game over.
I will make this prediction and remember, you heard it here: There will be no more debt ceiling increases under this new Republican Congress. Next year, by March or maybe shortly thereafter, the government will go into a balanced budget mode of operating. The automatic stabilizers will get shut down. From there you go "Full Europe," which means the system goes into default. At that point, the banks get saved by the Federal Reserve, but that's about it.
But don't worry, you're good until next March.