Debt Got Us Into Mess, Will Keep Us There

The economic recovery is fragile, and excessive borrowing by the government will add a heavy burden.
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) -- Consumer credit caused the recession. And government debt threatens the rebound.

Excessive borrowing by corporations and consumers made a bad situation worse. Massive government spending, projected to double in 2014 from last year, will fuel inflation, pushing up interest rates, and lead to higher taxes.

As the stock-market rally approaches its ninth month, investors must take into account the burdensome effect of debt, the factor most likely to sink the economy. That's why


(GOOG) - Get Report



(MSFT) - Get Report

may be better choices than

General Electric

(GE) - Get Report



(IBM) - Get Report

. And gold and tax-exempt securities may prove to be the ultimate havens.

The U.S. has been in this situation before. As the following graph shows, debt dwarfed gross domestic product in fiscal 1945. The peak wouldn't be reached again until 1984, when America first began its sharp climb to the current heady debt level that tops $12 trillion and is projected to soar to more than $18 trillion in five years.

Those gigantic numbers are scary for several reasons. The first is the threat of rampant inflation.

To pay for the assorted bailouts and stimulus packages, the government needed to issue debt, but the Federal Reserve felt pressured to keep interest rates low and leave money in the system to ensure there are affordable loans for businesses and consumers. To accomplish that, the Fed purchased securities from banks in the open market. As a result, the government forced down interest rates in the short term and increases inflation in the long term as newly created money sloshes around in the system.

Faster inflation leads to higher interest rates, which means every form of borrowing gets more expensive. Businesses looking to expand may shelve plans, and people wanting to buy a new home may drastically reduce their budget because of exorbitant mortgage rates. High interest rates are an excellent way to slow economic growth during boom times, but during a turnaround, interest rates need to be low to nurture growth.

Inflation would also send the wrong message to creditors around the world. China owns about $800 billion of U.S. debt, which isn't indexed to inflation. That means if the U.S. allows inflation to reach elevated levels, China's investment becomes increasingly worthless. In such a case, major foreign investors could sell their current holdings or, worse yet, refuse to buy more government issues. That would push down the price of government securities, requiring the U.S. to pay a much higher interest rate on borrowed funds, making it more difficult for the U.S. to meet debt obligations and driving up other interest rates in the country, resulting in even more pain.

Gold is a natural hedge against inflation. While it's never a bad time to own gold because it tends to retain its value, owning it out of fear of inflation doesn't seem like the right move. Still, bullion could be a smart bet as investors drive up its price more than actual inflation warrants. The most recent consumer price index showed no real sign of trouble brewing.

A more sensible play could be to stick to equities. Stocks, like gold, can be a hedge against inflation since cash flowing from shares aren't set in stone, as they are with debt securities. But heavy debt erodes companies' profits, so the best bets are those with low debt-to-equity ratios and a lot of cash.

It's also important to consider stocks that can quickly adjust prices to reflect the new value of the dollar. General Electric and IBM could suffer if inflation accelerates since long-term projects may have prices negotiated at fixed levels, effectively reducing revenue as the dollar declines.

Microsoft and Google would be better protected. Microsoft holds almost 11% of its assets in cash and only a small amount of long-term debt. Google has 32% of its assets in cash and no long-term debt.

To whittle away debt, the government will need to curb expenses. Currently, the Department of Defense gobbles up more than 48% of discretionary spending, with a total of $663 billion in the proposed 2010 budget. Easing back on defense spending would go a long way to help balance the budget, but not in the near term. Waste needs to be controlled across the system.

Because controlling waste has never been a strong suit of the government, an easy answer is to raise taxes. On the surface, it seems like a logical plan: increase taxes and slash budgets, and the deficit could be nearly wiped out. Unfortunately, it doesn't quite work like that.

Raising taxes often results in lower revenue, as production is discouraged at home or encouraged to move out of the country. Massachusetts recently offered various tax benefits aimed at lowering the cost of producing a movie in the Bay State. A few months later, Tom Cruise runs through Boston Common and Justin Timberlake hangs out in Harvard Square. Businesses move their operations where the government takes the smallest chunk of taxes.

To complicate matters, there's the Laffer Curve to consider. This little kernel of economic theory is boring enough to have been immortalized in the scene in "Ferris Bueller's Day Off," in which the economics teacher, played by Ben Stein, drones on about it and explains that this bell-shaped graph actually argues that tax revenue can be increased by reducing the tax rate if the current rate is above the optimum level.

Unfortunately, the Bush tax cuts resulted in reduced tax revenue between 2000 and 2007 versus GDP despite economic growth. That would seem to suggest that the U.S. is actually below the optimum tax level, and the country could collect more taxes by increasing tax rates.

This creates a confusing situation in which the sensible thing to do is to raise taxes, but increasing taxes could trample economic growth and cause a longer recovery period than may be possible otherwise.

The effects, of course, can't be predicted with any degree of confidence due to the massive amount of other factors that could play with the results of a tax increase. Given the Obama administration's platform during the election, however, it seems to be a fairly safe bet that taxes will rise.

In light of that, investors should consider tax-exempt securities, like municipal bonds, to make up their fixed-income portfolio as well as stocks that don't throw off much in the way of dividends. Dividends could be an attractive route for the government to raise tax revenue because it could affect the rich more so than the poor.

That, again, brings Google into the discussion of solid investments, given the current economic outlook. Stocks that retain earnings, instead of pay them out as dividends, could be better-suited to succeed in this environment since they wouldn't suffer the stigma of a dividend cut.

The government is projecting interest costs on debt to reach nearly $500 billion by 2014, an increase of almost 2.5 times from today. The massive amounts of government debt and its servicing requirements will quickly become a vicious cycle as the U.S. will have to borrow more just to pay the interest. The government has used debt as its main weapon against the recession, lending crisis and market meltdown. As such, Americans ought to invest accordingly.

-- Reported by David MacDougall in Boston.

Prior to joining Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.