Our Spendthrift Uncle, Sam

We have focused on debt and deficits quite a lot around here lately, and it's not hard to see why: the U.S. deficit is at a record level even as Europe struggles with the consequences of excess deficits in the Greek debt crisis.  Deficits are not intrinsically bad, pretty clearly some situations demand deficit spending: the choice between running a deficit and say, being conquered by Nazis and Imperial Japan, or a decade long economic collapse accompanied by death from famine and deprivation, isn't difficult to make.  However, the existence of persistent deficits, through good times and bad, indicates a political failure in this country.  To illustrate the problem, let's consider a thought experiment: imagine the U.S. government as a person- someone you know, your wacky, rich Uncle Sam.

Sam doesn't have a job, per se, he gets money by managing his trust fund, the U.S. economy.  When he invests wisely the trust fund grows and he can live off of a percentage of it- though if he takes out too much of the funds principal, and wastes it, then it hurts the fund's growth.  Over the past 50 years Sam's trust fund has grown steadily and now his principal is 27 times as large as it was then - 5.3 times as large when adjusted for inflation.  Yet, despite this massive increase in assets under management, Sam's personal debt has grown nearly 50 times as large over the same period.  As a result, while he already owed 50% of his trust fund in 1960 because he was still paying off debt accumulated during times of extreme crisis, he now expects liabilities to equal assets by the end of this year.  Even if he had never actually paid off any debt, but just lived within his means, Sam's debt would be a paltry 2% of his assets by now.  Instead, nearly 10% of what he takes out of the fund every year goes towards interest repayment on existing debt.

As a fund manager, Sam knows that sometimes taking on debt allows him to capitalize on investment opportunities.  If he pays 2% interest on a loan, but the fund grows 5% faster because of his spending then he makes a profit.  This line of thinking led him to make some strategic investments recently, because a weak economy presented him with an opportunities to buy low and reap long term profits.  However, most of his spending doesn't go towards investments, whether in education, infrastructure or research and development; instead, he mostly he uses his money on charitable contributions and security.  One set of Sam's advisors points out the immorality of someone so wealthy cutting his charitable contributions, while another set decries that cutting investments in security might mean losing the whole fund.  Recently, during a time of robust fund growth, Sam managed to cut charitable contributions and security spending (from 4.85% to 3.08% of the fund over 8 years), paying down his debts for four years in a row, something he hadn't done since 1930.  No one particularly appreciated this approach, however, and new fund management quickly turned things around by cutting the amount taken out of the fund, even while increasing spending on security and creating a new charitable program.

The big problem Sam has run into, is that while everyone at the bank loves when he takes less money out of the fund in a year, no one presents him with opportunities to break out of his long term spending commitments.  Some investment advisors give him contradictory advice: don't take money out of the fund since that will hurt its growth, but decreasing the size of the hole in his personal budget is essential.  Yet, aside from interest payments and contract obligations he made to long term investors, he now has a annual deficit larger than his income.  While maybe he could have cut spending in earlier times to close the deficit, now he's going to have to cut into the fund's principal just to keep the lights on.

When examining his portfolio, one immediately gets the impression that Sam lives in a state of crisis.  How else can you explain why he felt it was necessary to spend above income even when his funds were growing steadily?  For example, why does he spend so much more on security than other portfolio managers?  In absolute terms, he spends as much as everyone else put together, but even given that he manages the largest fund, he spends more proportionately than anyone else does.  Security is an investment, but usually only in a negative sense, like insurance; security prevents losses, rather than producing returns.  Is Sam purchasing the equivalent of expensive full coverage car insurance when perhaps only liability coverage is necessary?  Moreover, does having so much insurance lead Sam to be careless when driving?  After all, why get the insurance if you're just gonna follow the speed limit?  Just paying the deductible on all his crashes has become onerous to Sam, but he keeps finding someone new to drag race.  Not all of his advisors think security is a bad investment, they explain the one time he managed to pay off debt as a "peace dividend" that resulted from decisively and ruthlessly out-pacing his closest rival.  If his security investments in the Middle East pay off, a new era of prosperity will result.  So far, the results don't seem promising.

His portfolio is a bit of a mess right now, but my advice to Sam is to switch from the aggressive strategy that hopes to recoup all of his losses in one fell swoop in some sort of modified Martingale investment system to something more conservative and gradual.  In particular, investing directly rather than through complicated security derivatives might make returns more tangible.  Finally, if he can't live within his means, then maybe he should make more money, even if it hurts growth.  Otherwise, he's looking at a hell of a margin call in the future.