Why $16.4 trillion debt isn't enough

Despite what Wall Street thought, the last-minute, middle-of-the-night fiscal cliff deal was a dud. Not only did it raise taxes on nearly 80% of Americans and ignore the spending that's the root cause of the deficit and long-term debt problem, but the animosity it engendered also dropped more poison into the dry well of bipartisanship in Washington.

Count the victories: Lower- and middle-income Americans avoided a $120 billion income tax hike this year but will be hit with a $120 billion payroll tax hike instead. The rich face a $70 billion income tax hike. The $100 billion or so in spending cuts, the "sequester," was delayed by a measly 60 days.

But now America faces an even larger precipice: a combination of the debt ceiling, the sequester and the end of the continuing resolution funding the government in lieu of an actual budget. The fun is set to start as soon as Feb. 15, which is the earliest the Bipartisan Policy Center believes the U.S. Treasury could exhaust its cash reserves -- forcing us to raise the debt ceiling, default on the national debt or sharply cut discretionary spending.

We're on a collision course with fiscal reality. There is no more pretending it isn't there -- the Pentagon says the problem is so big that it jeopardizes our national security. For too long, rhetoric has alternated between Democrats promising goodies and Republicans promising to not make us pay for them. There are no easy solutions left; the bills have come due.

Dreadful trajectory

The least-disruptive option, of course, is to raise the $16.4 trillion debt limit. America will, at least in the short term, need to borrow more. Part of this is because the economy is deficient and in need of critical investments from the government. And part of it is because Washington is a long way from addressing the root cause of the problem.

And as a result, the country's debt -- which totals more than $52,000 for every man, woman and child in this country -- just isn't enough. It's not even close.

But we also need to wake up to the fact that the time to fix this is short. The credit agencies and our foreign creditors grow increasingly impatient with our budget petulance.

Washington just doesn't get it.

President Barack Obama and the Republicans in Congress are preoccupied with pointing the finger at the other party -- not fixing the structural problems of a weak, debt-hobbled economy and out-of-control health-care costs, both of which have been decades in the making. Slivers of hope during the fiscal cliff negotiations, including discussions of changing how Social Security benefits are calculated (by changing how inflation is measured) and raising the Medicare eligibility age (to match the Social Security full retirement age), were quickly abandoned to focus on the old tropes of the rich versus the middle class, paying "fair shares" and punishing job creators.

The result was a deal that merely delayed the pain without changing the long-term debt trajectory. The chart above shows our course quite clearly.

The Congressional Budget Office estimates that, compared with the full force of the fiscal cliff (had we gone over it), the deal adds $4.6 trillion to budget deficits over the next 10 years -- a deficit the CBO believes will total nearly $10 trillion, enough to take the national debt to an incomprehensible $27 trillion by 2022.

By then, according to Credit Suisse estimates, almost all of America's tax revenue will be going to entitlement programs and interest payments on the debt. Spending on everything else -- including bullets and jet fuel -- will add to the debt load. A weaker-than-expected economy or higher-than-expected interest rates will bring the day of reckoning closer.

No progress

Troublingly, the bickering has already started anew.

Before he even signed the fiscal cliff deal into law, Obama said he wouldn't negotiate over the Treasury's borrowing limit and that any new spending cuts would need to be offset by additional tax hikes. Over the weekend, Senate Minority Leader Mitch McConnell, R-Ky., delivered a riposte, saying that Republicans are "done raising taxes" and that any increase in the debt ceiling would need to be accompanied by significant entitlement cuts. House Speaker John Boehner, R-Ohio, echoed these sentiments.

In other words, both sides have returned to their corners to pout and fold their arms. Meanwhile, most Americans are starry-eyed from the stock market's rise, focused on the jump in small caps represented by the iSharesRussell 2000 Index (IWM), and blissfully unaware of what's coming.

The farce will end soon. The deadlines we now face cannot be delayed as easily as the earlier ones. And even if they were, the credit-rating agencies have threatened that, without action to at least stabilize the trajectory of the national debt, they will downgrade us -- setting the stage for a repeat of the August 2011 market meltdown caused by the loss of America's AAA rating from Standard & Poor's.

No easy answers

Why is the task of balancing this budget so hard?

For one, part of the deficit is "cyclical" and caused by the weak, credit-addled economy, bombed-out home prices and a subpar jobs recovery. Tax revenues are low, not only because we've been enjoying the Bush tax cuts and Obama's payroll tax cuts, but also because the employment-to-population ratio has fallen to levels last seen in 1981. Moreover, growth is weak because business owners and executives aren't investing enough in new equipment and employees -- in large part because of fears of higher taxes.

And the government has been running huge deficits, not just because of Bush's stimulus checks and Obama's $787 billion stimulus spending, but because it's been facilitating the deleveraging of the rest of the economy. Overly indebted households passed losses to the banks via mortgage defaults, which passed the losses to the government via the $700 billion bank bailout and FDIC-funded bank closures.

While households and the financial sector have made progress in rebuilding their balance sheets, they are far from healthy. Households are still battling stagnant wages and the rising cost of living. Banks are facing the loss of unlimited FDIC deposit coverage, pitiful loan demand, unattractive credit risks, falling net-interest margins, market volatility and growing calls for mortgage-principal forgiveness and other measures.

The government has stepped into the breach with cheap mortgage loans and unemployment benefits, among other efforts. If it pulls up stakes now, and starts a harsh, European-style austerity program, nearly the entire economy will be deleveraging at once. Debt reduction, not profit maximization, will become the maxim. Such is the stuff of economic nightmares and the Great Depression.

The other part of the deficit problem is "structural" and deals with the fact that areas of the economy funded by the government -- Medicare, public education and civil-service jobs -- have been insulated from the deflationary forces that have pinched the rest of the economy, especially construction (the housing bust) and manufacturing (globalization). The free market hasn't been able to control costs and demand higher quality.

The results include health care cost inflation that's been running at 154% of the overall inflation rate since 1995; mediocre health care results compared with those of other developed countries; subpar global education rankings; and state and local governments struggling to balance budgets burdened with pension and pay schemes that are far more generous than those in the private sector.

At the federal level, it's all about health care costs and the underfunded entitlement programs tasked with paying those bills. And all the while, we're neglecting to invest in infrastructure and technology that could reaccelerate the economy's growth and lessen the future burden of today's debts.

How to break the cycle

There are only a few ways out of this:

One involves a long, painful European-style repayment plan based on austerity and mixed with higher inflation from the Federal Reserve that will continue to pinch the middle class and will likely result in increased social and political turmoil -- the subject of one of my recent columns.

Or there's the "Chicago Plan" that would return the power to expand the money supply to the government (currently granted to the banks by the Fed), using the proceeds to pay down the debt. This was also the subject of a recent column.

Or there's the one-time wealth tax idea floated by Boston Consulting Group, which would tap the rich to reduce the economy's indebtedness. I discussed that plan in a column here.

And of course, the country could simply default as Greece, the birthplace of democracy, has done, succumbing to the dangers Plato warned of thousands of years ago: A government ruled by the people will, eventually, overspend and undertax to the point that its very existence and sovereign freedoms are threatened.

Right now, Athens has become a ward of its creditors, mainly the Germans. For us, will it be the Chinese?

Last year, after our credit downgrade, China's state-run media demanded that the U.S. end its "addiction to debts" and realize the "painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone" before questioning the strength of the dollar. China's Dagong credit rating agency also downgraded its U.S credit rating to A from A+, below the likes of the Czech Republic, Qatar and France. (It rates China AAA, by the way.)

Last week, Dagong put the U.S. rating on its negative watch list in response to Washington's internal strife, the risk of recession this year and a poor long-term outlook, which jeopardizes our ability to repay what we owe. There is a real risk the rating will slide to BBB+, the same as Peru, Morocco and Colombia, as the debt keeps climbing.

This dark outlook justifies my expectation of a new recession and a new bear market in 2013. The task required, a delicate balancing act between medium-term structural reforms and short-term stimulus, seems too difficult and politically challenging for our current government. We probably won't see meaningful progress until the financial market turmoil and economic spasms that lie ahead end the political gridlock in Washington after the 2014 midterm elections.

For now, I continue to recommend that investors play it defensively with exposure to the dollar, U.S. Treasury bonds and targeted short positions. Options include the iShares Barclays 20+ Year Treasury (TLT) and PowerShares DBUS Dollar Bullish (UUP) exchange-traded funds.

Risk-takers might consider adding long volatility exposure since the CBOE Market Volatility Index ($VIX) posted a historic collapse in the wake of the fiscal cliff deal. The "fear gauge" is poised for a rebound and can be played via the iPath S&P 500 VIX Short-Term Futures (VXX) exchange-traded note or the leveragedVelocityShares Daily 2x VIX Short-Term (TVIX) ETN.

At the time of publication, Anthony Mirhaydari did not own or control shares of any fund mentioned in the column. Anthony has recommended iShares Barclays 20+ Year Treasury ETF, PowerShares DB US Dollar Bullish ETF, iPath S&P 500 VIX Short-Term FuturesETN andVelocityShares Daily 2x VIX Short-Term ETN to his money-management clients, and VelocityShares Daily 2x VIX Short-Term ETN is a member of his Edge Letter Sample Portfolio.

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