Blog Department
Written and published quarterly by Caves & Associates.

August 5, 2004
  There is an old adage in investing and financing which says: “You can eat well, or you can sleep well, but you can’t do both.” In the world of investing, this trade-off is described as “no risk-no return,” or “there is no free lunch.” In other words, high returns require high risk, so one eats well (from the high returns) but simultaneously one doesn’t sleep well (due to the high risks). Conversely, the investor can sleep well by taking less risk but must cut out expensive foods (eat less well) because of lower returns. In the world of corporate and real estate finance, high leverage (meaning lots of borrowing) can translate to very high returns on equity when a successful venture earns in excess of the cost of using other people’s money. However, it can also translate into significant losses when a venture underperforms by even fairly small amounts, not adequately covering the interest cost. If a leveraged venture’s underperformance is even greater, it can produce complete losses when there is an inability to service both interest and principal (i.e., bankruptcy).
 

It should be clear that higher risk approaches have much less margin for error. For example, in selecting from a set of very risky investments, the wrong selection can be devastating. Likewise, because heavy use of debt magnifies results, a fairly small shortfall can also produce disaster.
  The above is prologue for expression of concern about U.S. policies and behaviors. The U.S. has been “eating well,” so to speak, by the simple mechanism of borrowing. At all levels, corporate, consumer, and government, we have been spending beyond our means:
 
  • Can’t afford it: put it on a credit card.
 
  • Need more business capital: issue bonds.
 
  • Need more money for social programs and wars: “print more money” and borrow from the Social Security Trust.
  To be clear, we have no problem with the prudent use of debt. After all, few can imagine buying their first car or house with all cash. But borrowing means interest payments and eventually the debt has to be repaid or refinanced. Thus, the key questions are:
  1. Can we afford to service and repay the debt?

2. If we can’t afford to repay principal, will we be adequately creditworthy to rollover the debt?

3. How much have we decreased our margin for error and sacrificed our future flexibility?

4. Do we have any potential problems with who our creditors are? How much are they
concerned about our needs versus theirs?

5. Are we using borrowed funds productively? Are we improving our public capital (roads and other infrastructure), our social capital (a well-educated, well-fed, healthy workforce), and our business capital (investments in technology and research and development)? And finally, are we benefiting adequately from the massive war spending in Iraq and Afghanistan?
 
  We’re becoming increasingly uncomfortable with the answers to these questions. At a minimum we can criticize the consumption excesses of our country (and much of the developed western world). We need policies to increase our national savings rate. Clearly, as well, we need to examine our priorities.
  We also need to address the impact of the Internet and inevitable growth of outsourcing (we say inevitable with the hope that free enterprise and global trade are retained – let’s not throw out the baby with the bathwater). Are many “average” Americans (in addition to corporate CEO’s) overpaid for what they do viewed on a worldwide perspective? What can we do to protect our standard of living and especially that of our future generations?
  While the global economy appears relatively stable, we are concerned that the current U.S. recovery, driven by the massive monetary and fiscal stimuli of historically low interest rates and huge tax cuts, is unsustainable because it is not founded on a solid economic foundation domestically and globally. There are many elements of fragility: a highly valued equity market and U.S. dollar, a household debt and real estate bubble, largely structural rather than cyclical Federal budget deficits, and a lackluster level of aggregate demand in the rest of the world. Accordingly, we face a world of higher risk and U.S. vulnerability. We are walking a tightrope which can more easily than ever be shaken by a host of factors such as policy mistakes by the Fed, Congress, and the White House, external shocks like 9/11 or an oil embargo, and any change in the willingness of foreigners, especially Asian central bankers, to provide much of the financing for the U.S. fiscal and trade deficits.
  American’s resources are increasingly being spread thinner and thinner. We may soon see the U.S. economy overburdened if the costs of Iraq and the war on terrorism are not shared more equally by other nations. We also need to face sooner rather than later a purely domestic challenge, the huge cost of shoring up the Social Security and Medicare systems. Lamenting, the Los Angeles Times recently observed on a front-page headline that these major fiscal worries are not on anyone’s agenda (referring to vagueness and even silence in Republican and Democratic Party platforms).
  In conclusion, these are tough questions, and the analysis is indeed complex. Venturing an estimate for 2050, what do you foresee as the U.S. position economically and politically in the world order?
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