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MR. MICHAEL CEMBALEST: Good morning, everybody. This is the debt ceiling version of the Eye on the Market Outlook. So see if you can guess what the following people have in common, Erskine Bowles, who is the Democratic White House Chief of Staff, Kevin Warsh, who was on the Federal Reserve Board for a few years, Peter Orszag, an Obama appointee, ran both the OMB and the CBO, Michael Bennett, a Senator, a Democratic Senator from Colorado, Geoffrey Canada of the Harlem's Children's Zone, Mike Mullin, the 17th Chairman of the Joint Chief's of Staff, Richard Kogan of the very progressive Center of Budget and Policy Priorities, Mike O'Pake, who's an economist at the Federal Reserve, Bank of St. Louis. These aren't people you would necessarily associate with conservative points of views on fiscal policy.
That said, all of them have either written papers, given speeches, or worked on negotiated solutions on the issue of deficits, entitlements, and generational theft. They haven't had a lot of luck so far. The first chart in the Eye on the Market this week looks at the inflation adjusted federal debt since 1790. After the surge in spending in World War II, every American was responsible for about $30,000 in debt in today's dollars. That figures now almost 100,000. And when you look at the debt burden on the working age population, it looks even worse.
In addition to overall issues about the levels of debt, you've got a bigger issue, in my opinion, on the composition of spending, because what's happening is that discretionary spending, that contributes to productivity and growth, is shrinking relative to entitlement spending. And entitlements are important and critical, we all understand the purpose, why they were created in the late 1960s. But as a reminder, non-defense discretionary spending includes all sorts of things related to transportation; infrastructure, renewable energy, energy demonstration projects, inner-city rail, high-speed rail, air traffic control, education and training, job retraining, education subsidies for low-income students, vaccine development, border control, all sorts of things go in that category.
And in the late 1960s, once the entitlement system was created, the federal government spent a dollar on each. A dollar on the entitlements, and a dollar on all the other non-defense discretionary spending categories. By the 1990s, it was two to one in favor of entitlements. It's now around in favor of entitlements. And by 2032, in 10 years, it'll be four to one in favor of entitlements. And so, it's not just the level of the debt, it's the composition of government spending that's creating some issues.
Now, there's a lot of solutions one could—one could think about here. Both Senator Sanders and Senator Warren have proposed large increases in income and capital gains taxes on people earning over $250,000 or wealth taxes in excess of 20 million. You could raise taxes, spend that money entirely on non-defense discretionary spending and close that gap. You could do means testing of Medicare Part B and D. You could have higher Medicare copays and deductibles, higher eligibility retirement ages, increased rebates by Medicare Part D manufacturers. In other words, things to bring down the level of entitlement spending relative to non-defense discretionary spending.
You could also cut defense spending and use some of that money to boost non-defense discretionary spending. Right now, defense spending in the US is close to a 70 year low, believe it or not, as a share of GDP. Although, as you might suspect, on a per capita basis, we're the third highest in the world. And so, with this backdrop, the Visigoths, as I've chosen to call them in this piece called American Gothic, the Visigoths now say they're going to block the debt ceiling increase unless the White House agrees to spending cuts and a balanced budget agreement within 10 years.
So here are some questions I've been getting on this, and my answers to them. So most importantly, if there were a technical default of some kind, would it be followed shortly thereafter by some kind of negotiation to put things back on track, such as the Budget Control Act of 2011, there was the Graham-Rudman-Hollings Deficit Control Act in '85, and then a Balanced Budget Reaffirmation Act in '87. I think so. I don't know how long it would take to get there, but I certainly think the sequence of events would be, if there were technical default, you could have some kind of negotiations, things get back on track rather than any kind of restructuring of the federal debt in any emerging markets context.
Will the Visigoths be able to maintain their united partisan front to fight this debt ceiling increase? Unclear. It would only take five GOP defections to join the Democrats to go ahead and allow a debt ceiling increase. So it's unclear. According to CNN, there are some swing state Republicans from districts that were purple, that you'd consider most likely to break ranks with GOP leadership, who are—who are also saying, like the leadership in the caucus, that they don't want to back a clean debt ceiling increase unless there's some kind of fiscal agreement.
And look, nobody—it doesn't matter very much, but nobody knows whether the Visigoth concerns about government spending is genuine. And the fact that these same issues don't get raised quite as vividly when the GOB con—when the GOP controls the White House is politics. But again, that doesn't matter, because we are where we are. In 2011, you had a debt downgrade and stock market correction. And sometimes that causes politicians to change the things that they're doing.
But the bottom line from this week's piece is that reasonable people have had around 25 years to try to do something to fix both the debt levels and the spending composition issues in a sustainable way. And they haven't accomplished anything. So I'm not surprised that the Visigoths are going to try to do it for them, and with a lot more economic disruption and political turmoil. Now, I suspect the problem will go away this year in some way. But that doesn't mean that it's not going to come back again and again in the future, given the excessive levels of debt and also, some of the spending imbalances that we've—that we've mentioned here.
So there are some interesting charts that we've got here to look at for context; the net interest payments on the federal debt as a percentage of GDP, a history of US tax increases since 1950, and showing that the Sanders and Warren proposals would only get you part of the way of where you need to be if you really wanted to close that spending gap, some history on the estimated cost of healthcare entitlement systems and how the actual costs were generally much, much higher, some information on defense spending, et cetera, et cetera, and then a glossary of terms that you will need or may need over the next few months as you're trying to decipher the political jargon coming out of DC as these negotiations go ahead. So anyway, just a brief note for us on the debt ceiling issues. And look forward to talking to you again soon. Bye.
FEMALE VOICE: Michael Cembalest, Eye on the Market, offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market by contacting your J.P. Morgan representative.
If you'd like to hear more, please explore episodes on iTunes or on our website. This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information, which can be found at www.jpmorgan.com/disclaimer-eotm.
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