Why the Sequester Is Your Friend

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For those investors focused on the big picture I thought I would share a few thoughts on the current situation. I previously discussed some of the worrying structural trends in the US economy in an article linked here, and in this article I want to discuss why so many commentators are getting it completely wrong.

What Went Wrong With the Free Market?

The problem with free market thinking is that it is most visibly and vehemently promulgated by those who are the biggest absolute winners in it: the expensively suited Wall Street professional, the corporate ‘fat cat’ and the propertied wealthy who have done so much better than the rest of the US over the last 20-30 years. Of course such caricatures of America were tolerated and even admired by the rest of the country as long as the economy prospered and blue collar America could participate in the dream of having a better standard of living than its parents.

The rest listened to the wealthy and their exhortations over how the modern democratic capitalist state was a new meritocratic utopia where everyone had opportunity. And although they never fully believed the wealthy, they accepted it was better than living under communism and they were grateful for their chance.

I emphasize meritocracy because it has the wonderful byproduct of obviating the necessity for any form of collective responsibility: a convenient state of affairs for the uber wealthy and a large part of the reason why the wealthy genuinely don’t want to pay more taxes.

Of course the principle of meritocracy went completely out of the window in 2008 and along with it went the free market ideology so beloved by Wall St. The idiotic, reckless and in some cases corrupt bankers were rewarded with a collectivist scheme of redistribution. They were bailed out and saved by racking up public debts in the name of saving the system. If the meritocratic free market really had its way than the senior bankers would be senior burger flippers by now. As John N. Gray put it to me when discussing the issue ‘unfairness is the price you pay.’ Indeed.

What We Learnt and What We Should Learn

Of course what we learnt from all of this is that, as George Soros always said, there is nothing inherently stable or self rectifying about free markets. And if he is right then there is no pure meritocracy or free market in the real world. I suspect the Occupy Wall Street and Tea Party movements share the same disaffection with how the recession was dealt with. I suspect they both want to get back to the American dream of opportunity through self effort.

Putting all these things together it is easy for a free market enthusiast to retreat into his shell. It is easy to give up. It is easy to forget that social mobility occurs better in freer economies. And it is also easy to forget, in my opinion, that the corporate sector has far more checks and balances in it than the public sector does. My argument is not to defend free markets just because it is a doctrine argued by the very same people who made a mockery of it with the bailouts, but rather to point out why and where it does work.

What Corporations Do and Government Don’t Seem Able To

Allow me to flesh out this point by comparing how the corporate sector functions (when it is not interfered with by bailouts) as opposed to the Government.

Let’s go back to 2001 and recall that the recession then was largely caused by over investment or rather misallocated capital. Corporations spent too much and generated over capacity, particularly in the technology sector. Now look at how the corporate sector has adjusted to this ever since.

<img src="/media/images/user_12882/free1_large.png" />

From 2001 onwards they diligently built up assets over liabilities and they didn’t rack up debt in order to do it. Even now the net worth of corporations is surely at an all time high while the debt/net worth ratio was lower than in the 90’s for the last ten years save for recession-affected 2009.

The non-financial corporate sector is good at adjusting to market discipline. In fact the problem now may be that corporations are too reluctant to spend. All of which means that Johnson & Johnson (NYSE: JNJ), Microsoft (NASDAQ: MSFT), ADP (NASDAQ: ADP), and Exxon Mobil (NYSE: XOM) have a higher credit rating than the US Government. I suspect Apple (NASDAQ: AAPL) would do too if it had the need to issue credit!

I’ve included GE and McDonald’s by way of comparison. Apple isn't included because it has no debt.

 

<img src="http://media.ycharts.com/charts/5afb231ac71e6b4a6aaf647073f37954.png" />

ADP Debt to Total Assets data by YCharts

What the Government Can Learn From These Companies

While I appreciate that these companies are AAA rated partly because they have little debt in relation to assets, I also think there are some key lessons to be learned here. Starting with JNJ, it has had production issues over the last few years and has stagnated to GDP type growth in that period. No matter, because it has sound finances it is able to manage these disruptions without being forced to make sudden cutbacks and forced sales in the way that, say, Dell or HP will likely have to do. JNJ will not be undergoing a sequester!

Turning to Apple, this is an example of an innovative company that needs to take product risk on board. So being fiscally conservative isn't just about consolidating to mediocrity, on the contrary it lays the groundwork for risk and innovation--another thing for the politicians to consider. Sound finances lay the groundwork for growth and risk taking. Similarly it is fair to say that MSFT is in a mature industry which is somewhat challenged by new devices utilizing different operating systems (think Android etc), but it is in position to invest in new growth areas because it has a strong balance sheet.

The next two examples ADP and XOM are cyclical companies whose balance sheet provides them with insulation from tough times. XOM has substantive oil reserves whose evaluation will fluctuate with long term projections of the oil price. It is subject to uncertainty, and if oil prices fall it will need the flexibility to invest in finding more reserves. As for ADP its prospects are tied to the employment/payroll market. Now contrast these two companies with governments that have to expand spending in a recession. You simply cannot do this unless you have sound finances.

What Is the US Government Doing?

So while corporations are adjusting to realities, here is what the US Government (and it is not alone) is doing.

<img src="http://media.ycharts.com/charts/30be0faad61a0fc355661758a8c028dd.png" />

US Federal Government Revenue as % of GDP data by YCharts

These are the hard numbers. This is the truth. And with every recession the situation is getting worse, and so is the debt.

It is not enough for Wall St to drone on about a meritocracy while they merrily save themselves from market forces and despise higher taxes and, it is not enough for Main St to carry on pretending that the fiscal trend is sustainable.

Something has to give here, and public spending as a share of GDP must be reduced in order that the US never gets itself in this situation again. Simply put, the Government is not good at managing finances because its members are not subject enough to an efficient form of accountability. And so, I repeat the same question. If a recession comes in the next few years--and I do not have a black swan warning system--then how will the US pay for it?

It strikes me that the Sequester is not the enemy of the US, it's part of the hope. Racking up debt for future generations is surely not an option anymore.


SaintGermain has a position in Johnson & Johnson. The Motley Fool recommends Apple, Automatic Data Processing, and Johnson & Johnson. The Motley Fool owns shares of Apple, Johnson & Johnson, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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