So We Have a Deal. Now What?

Image of Author John J. Hohn and dog Jessie

The news for the last several days, of course, has been all about the debt ceiling and the debate in Congress about raising it and cutting expenditures. So much has been written and broadcast about the subject that I don’t feel it serves much purpose for me to rehash things here.

Thanks to all of you who commented on several of my recent posts. Your responses have helped me find out in what subjects my readers may be most interested.

There one question, however, that is not being asked as often as it should, and that is how should the investor who is retired or close to retirement deal with the uncertainties that lie ahead with the economy, both national and international.

The pat answer, of course, is that during times of uncertainty, investors should stay the course. Staying the course, however, is largely a matter of what course a person is presently following. Traditional advice is that as an investor gets older, the allocation to stocks should be reduced and the allocation to bonds increased. But bonds don’t look that attractive given what the country will need to go through in order to establish some integrity to our fiscal policy.

Anyone over the age 60 can recall what happened after President Johnson’s “Guns and Butter” administration during the Vietnam War. The cost of funding an unpopular war and implement the many liberal domestic programs Congress was goaded into passing was enormous. Spending on the war and domestic programs, coupled with a wide-open demand for goods and services, finally culminated in one of the worst bouts of inflation in our history.

Those times—the final years of the Carter administration and the first years of Reagan’s tenure—hold a lesson for today. Our current situation has some superficial similarities. We are again fighting wars that are expensive and unpopular, although we finally learned to support our young people who are caught up in the conflicts. Consumers, however, have just come off a spending spree that depleted household reserves. It is unlikely that demand will be ignited again because budgets are burdened with debt and mortgage payments. High unemployment and high personal debt loads reduce the threat of inflation.

Low interest rates reduce income for bondholders, most of whom traditionally are seniors. The price of keeping inflation at bay, in other words, is already being born by retirees who get up every morning listening to politicians carp that the entitlement programs need to be cut back.

Some rhetoric ties reducing entitlements as the price to be paid in order to get through the current crisis. The recalcitrant position of some inexperienced congressmen to consider a compromise has already increased the possibility that U. S. Government Bonds may be downgraded. The cruel irony is that inflation can result from increased interest rates without the attendant surge in consumer spending and in spite of high unemployment. Thus we get a dose of inflation when households are least prepared to cope with it.

If U. S. Government bonds are downgraded by the rating agencies, the interest rates will go up. That will create at least three negative outcomes. First, it will cost the government more to borrow money. The government will need to pay higher interest on the new bonds that it makes available as existing bonds mature and to fund current spending. Second, it will make the bonds held by investors lose value. Newer bonds issued to pay a higher rate of interest will be more attractive than currently issued bonds available on the secondary market. Finally, increased interest rates will make it more difficult for companies to borrow money to fund projects that would lead to more employment.

In their own myopic view of the world, tax-cut people refuse to evaluate the downstream consequences of their own manifesto. No increase in taxes, of and by itself, holds out no merit to anyone in the long run.

It remains to be seen how all of these trends will play out to a conclusion. Any responsible planning needs at least to address three goals. First, the national debt needs to be reduced. New sources of revenue must be found that do not exacerbate the employment problems nor create a strain on the budgets of families who are struggling now to make ends meet.

New revenues mean new taxes, or a revision in the existing tax code, that  asks those who are benefiting the most from our capitalistic system to recognize their patriotic duty—the same sense of commitment with which our young men and women go into mortal conflict—and pitch in, do their share, and get the job done. This is an economic war and the country cannot afford to have those blessed with the most sitting on the sidelines. They need to put their money behind all the patriotic posturing and make a contribution.

Second, Congress needs to enact revenue neutral programs to stimulate employment. A company barely hanging on now with a skeleton crew and  fearing government restrictions is not paying much by way of taxes. Finding an incentive for businesses to hire additional employees would at least increase take home pay for the new hires. The long-range goal of increasing revenues could be realized by postponing reinstatement to a equitable tax level over a prolonged recovery period so the employer’s effort isn’t crippled right out of the gate.

Finally, government spending needs to be restrained. The priority should be given to cutting those programs that have the least impact on the performance of the economy. The United States cannot continue to lend support around the globe economically and militarily at the levels we have grown to accept since World War II. These programs have minimal positive impact on our own employment and represent a revenue drain from which we realize little benefit. Subsidies of foreign-based corporations need to be eliminated. We are under no obligation to assist any company or country that cannot find the resources to deal with the problems of their own economies and cultures. Earmarks in legislation that limit benefit to a given geographic or economic area need to be eliminated.

Of course, it is not likely that any organized approach to the problems of our economy will come out of Congress. Most argument in the political realm is controlled first by beliefs rather than reality

So, for your retirement nest egg, lighten up on bonds. If you insist on holding them, keep short maturities that will get hurt less if U. S. Government Bonds are downgraded. Compare the yields on short-term bonds to money market funds that usually hold their unit value no matter what. Look for income in other areas. U. S. companies with good dividend paying histories can easily match the best payout with bonds and will benefit from being tax qualified if chosen carefully and you could benefit from a market gain with the recovery.  Rather than pick individual stocks, ask your advisor to look for mutual funds that seek income from dividends. Don’t be afraid of exchange-traded funds that hold alternative investments and generate dividend interest from trading or writing options. Good luck.