Government Revenue Creep

I concluded my November 25th post (”Who Doesn’t Enjoy A Good Spending Spree?“) with the following comment: “This has been the enduring failure of Keynesian economics. Everyone loves a good spending spree. No one ever wants to take away the punch bowl.”

The following graph (courtesy of Greg Mankiw) does a wonderful job of illustrating this. The rapid increase in government revenue relative to GDP in the early 1940’s was due to World War II. The more interesting observation, though, is that this temporary increase in the size and scope of government was never reined in following the war. Instead, the government’s share of economic activity has continued to grow over the past 60 years.

It would be naive to think that our government will ever proactively address the growing deficit and debt (on and off balance sheet) problem that we face. As has typically been the case, our leaders won’t act until forced to, at which time we may be faced with a serious decline in the value of the dollar and/or the arrival of hyperinflation. Some combination of less government expenditure, higher taxes, lower entitlement spending, higher inflation, reduced entitlement benefits, and a weaker dollar are what ultimately await us. What we don’t know are the exact contents of this poisonous cocktail or the timing of its arrival.

As for the investment ramifications of this, I would expect dollar weakness and gold strength. Assuming reasonable global growth, I would expect many commodities to perform well, and select international equity markets with better growth prospects and better fiscal restraint should handily outperform the U.S. (assuming reasonable valuation). Much of the U.S. fixed income market would be destroyed, although TIPS would certainly benefit.

Not coincidentally, many of our core long-term positions would benefit from such a scenario. Also consistent with this thesis, I recently added a long Canadian dollar and short U.S. Treasury (20+years) position. I’ll spend a little more time on each of these later this week.

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