“To contract new debts is not the way to pay old ones.” –George Washington
My first introduction to the concept of borrowed money occurred when I was four or five years old. I was at a restaurant with my grandparents and playing trucks with an older boy and girl whose parents were farmers. Rather than the typical racing and demolition games I was accustomed to, the oldest playmate said that he was driving his toy truck into town to pay off their debts. The term “debt” was unknown to me at the time, but I did recognize that the task of paying off debts likely commanded such attention from the boy’s parents that it also became a central theme to the boy’s playtime. While my aversion to financial leverage likely cannot be attributable to this childhood experience, the memory has served as a reminder of the financial burden that debt can place on families, companies, and governments and the freedom that comes with being debt-free.
For most of our country’s history, fiscal deficits were primarily utilized as a means to finance wars with every effort made to repay the debt in times of peace. Times have changed, and the United States has increasingly turned to deficit spending as a driver to stimulate and grow our economy. Easy monetary policies have helped ensure that existing debt can be refinanced and new debt can be issued at low interest rates. Today, our country has nearly $20 trillion of debt outstanding and our government and citizens likely have neither the capacity nor the willingness to repay our borrowings. The “get out of debt free” mentality in today’s society is evidenced through the daily barrage of advertisements highlighting either the benefits of bankruptcy or providing the opportunity to repay mortgages, student loans, and credit card debts at a fraction of the balance due. As our country is unlikely to have the means to repay our massive borrowings by generating fiscal surpluses, the two remaining options are either to eventually default on at least a portion of the debt or to print money that will be used to repay the debt (quantitative easing).
While both alternatives produce a similar result (reducing a debt balance by delivering nothing of value) quantitative easing allows the full faith and credit of the United States to be maintained and also allows the deficit spending to continue for a longer period of time. As Gate City Capital Management, we prefer to avoid this situation entirely by investing in companies with no debt outstanding. If a portfolio company does have debt outstanding, the urgency to repay that obligation should occupy management’s every attention, both while at work and at play.
The Federal Reserve kept interest rates unchanged again at its September meeting, with the four rate hikes anticipated by the Fed heading into 2016 now a distant memory. The Fed decided to delay tightening until core inflation moved closer to their 2.0% target, in an attempt to fulfill their dual-mandate of fostering maximum employment and price stability. I remain uncertain as to why 2% inflation is a good representation of stable prices, but that arbitrary number will likely continue to dictate our nation’s monetary policy for at least the near future. Less well-known to most market participants is that the dual-mandate often cited by both the Fed and the financial press is actually a triple mandate.
The Federal Reserve Act of 1977 mandates the Fed to pursue maximum employment, stable prices, and moderate long-term interest rates. Policy makers have ignored the third part of their mandate with nearly all Fed officials now succumbing to the view that interest rates will stay low for an extended period of time. By overlooking the third portion of the mandate and maintaining an interest rate policy near zero percent, the Fed has subjected the economy to significant risks including asset price bubbles and excessive leverage. In addition to the economic hardships that can come from popping bubbles and deleveraging rapidly, the combination of super low interest rates and quantitative easing has done surprisingly little to return economic growth to historical norms. In response to the limited impact of exceedingly easy monetary policy, Fed officials have actually encouraged additional fiscal stimulus or government spending to fuel economic growth. As is the case with all spending, someone eventually has to pay for it.
Ultimately, our government cannot spend a dollar without first taking that dollar from someone who worked to earn it, or in the case of deficit spending, taking it from someone who will work to earn it in the future. The virtues of capitalism ensure that the best allocators of capital will always be someone motivated to earn a return on their investment rather than government officials whose primary motivation is generally to be re-elected. Thus, the Fed has effectively expanded its role to serve as both the enabler of deficit spending and one of its chief proponents.
[us_separator] The above post has been excerpted from a recent letter of Gate City Capital Management.
Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2015 has undergone an Audit by Spicer Jeffries LLP. Performance for 2016 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014. The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.