In fantasy novels, the intrepid heroes come across a sign saying “This Way Be Dragons.”  Of course, they venture on, facing calamity and death, but such is the nature of fantasy novels.  We live in a very real world, and if we do not turn around there will be some very nasty dragons in our future.  In this article, we will look at three possible paths we can lead the world down.  We will also review a number of charts and data on the housing market.

“I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis.  To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers.  The deficit in 2019 is expected by the CBO [Congressional Budget Office] to be $1,200bn (€859bn, £754bn).  Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget.  Clearly this will not and should not happen.  So how else can debt service payments be brought down as a share of GDP?”

“Inflation will do it.  But how much?  To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices.  That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent.  A 100 per cent increase in the price level means about 10 per cent inflation for 10 years.  But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.”
You can read the rest at (http://www.ft.com/cms/s/0/71520770-4a2c-11de-8e7e-00144feabdc0.html?nclick_check=1)

While Obama gives lip service to cutting the deficit in half, his actual budget increases it over the next 10 years.  As I have been writing for some time, this is a very dangerous path.  And, it is one that the bond market seems to be concerned about, as interest rates are rising, even on mortgages that the Federal Reserve is buying in massive quantities in its effort to hold down rates and stimulate the housing market.

“The good news,” Taylor concludes, “is that it is not too late.  There is time to wake up, to make a mid-course correction, to get back on track.  Many blame the rating agencies for not telling us about systemic risks in the private sector that lead to this crisis.  Let us not ignore them when they try to tell us about the risks in the government sector that will lead to the next one.”

Taylor is right that the massive tax increases necessary to fund these deficits and programs should not happen.  It is not clear to me that they will not.  A Democratic Congress is talking of adopting John McCain’s plan to tax health-care benefits.  While this would be a tax on the middle class (on everyone) that Obama said he would not do, he is clearly willing to sign a bill that has such a tax.

The administration is starting to float trial balloons about a new value-added tax (VAT).  Many of my non-U.S. readers will be familiar with value-added taxes, especially in Europe.  A combination of a VAT and taxing health-care benefits would raise enough to get us to a deficit of “only” a few hundred billion.  Take away the Iraq war and you get even closer.  You can make an economic case that a value-added tax would be preferable to an income tax.

However, the administration is not talking about a substitute but an additional tax.  There is momentum in the heavily Democrat-controlled Congress for large new health-care programs. While a few moderate Democrats are resistant to large deficits, there is a chance they could be brought on board with a tax or a series of new taxes that would offer the potential to pay for the new programs.  (Even though everyone knows that the cost overruns on new healthcare benefits will be much larger than estimated.)

As much as it grieves me to say it, a tax on health-care benefits or a value-added tax large enough to hold the proposed deficits to something under 3% of GDP would be preferable to running decade-long trillion-dollar deficits, which would destroy the U.S. economy and the dollar and do severe damage to the world economy.  (For the record, I am assuming the Bush tax cuts are history.)

But while a large tax increase would keep the economy from crisis and collapse, it is not without serious consequences.  It will put a serious crimp in economic growth.  It will lock in European-like growth rates and European-like unemployment rates.  We will be using the tax increases to fund new spending and will still not have solved the future problems of Social Security and Medicare, which are going to require massive increases in spending in another 5 to 7 years.  Which means that either a cut in benefits or another round of growth-crippling tax hikes is down the pike.

This is an excerpt from June 2009 issue of Trader's Journal.