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Farr: This Could Get Uglier

Europe's travails can and should be teaching us something: Do not wait until it is too late to get your fiscal house in order.

The United States is currently in the enviable position of benefiting from everyone else's problems.

As borrowing costs rise in the PIIGS countries (Portugal, Italy, Ireland, Greece & Spain) in response to their surging budget deficits, the US Treasury's borrowing costs are decreasing (despite our surging budget deficits).

Why?

Because the US dollar is still the reserve currency and, therefore, we still benefit from the "flight to safety" that occurs when investors get scared.

Investors simply know of no safer place to hide.

So despite the trillions of dollars that the government has borrowed and printed to bail out troubled financial institutions and help stimulate economic growth, demand for Treasury bonds only grows.

And as demand for Treasuries grows, the US economy benefits in numerous ways: 1) prospective homebuyers get cheaper mortgages, supporting housing prices; 2) existing homeowners can refinance into lower-rate mortgages, freeing up disposable income for other purposes; 3) businesses pay less on their outstanding loans and credit lines, freeing up resources for new capital equipment or new employees; and 4) the federal government pays less to service its massive debt load, lowering budget shortfalls and providing cover to continue its reckless spending.

So while the crisis in Europe has also led to some negative side effects in the US (stocks are down 12%, bond spreads are widening, consumers are more cautious), the resulting decline in interest rates is coming at a very fortuitous time in our economic recovery.

But lower interest rates also have a down side.

Falling interest rates will undoubtedly encourage borrowing and spending over saving and investing. This incentive structure is what caused the financial crisis in the first place.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

At the start of the financial crisis, financial institutions and consumers were carrying unprecedented amounts of debt by any measure.

Why?

Because interest rates were very low and bank regulators did nothing to discourage excessive leverage at our financial institutions. In response to the crisis, the governments of the world effectively assumed much of this debt through various stimulus measures to support the economy and rescue the financial system.

While many of these programs can be deemed successful, they also caused massive budget deficits and surging debt levels at the government level. At the same time, consumer debt levels have barely budged off their historical highs. So while higher spending is exactly what the economy needs in the short term, low interest rates and the assumption of even more debt will come at a risk. Moreover, the flight-to-safety bid for Treasury bonds and resulting lower borrowing costs are likely to breed complacency among policymakers.

Do we have to wait for a crisis the likes of the Greek one to wise up and live within our means? I hope not, because by then it could be too late. Policymakers must address the long-term budget deficits now if we are to avoid the fate of Europe.

We have mentioned in previous market commentaries that we don’t believe a sudden surge in inflation is forthcoming in the near term.

Unemployment remains at near 10% and capacity utilization is historically low. However, we have also said that we are keeping our bond durations relatively short because we also believe that the money created by the government will eventually lead to inflationary pressures within the next 3-5 years. Moreover, we cannot rule out a Greek-like scenario whereby investors flee US debt as a result of continued deficit spending.

Debtor Nations
Debtor Nations

This is why tough decisions are critical now before investors lose confidence in our ability to contain our spending.

The government must set a road map to fiscal stability, and it must do so before investors get nervous.

Unfortunately, the outlook is not too promising given our government's track record of avoiding difficult decisions. But indeed there may never be a better time to address our long-term budget deficits.

The crisis in Europe has showcased what can and will happen if we don't act. And the electorate is beginning to understand.

As we continue to navigate choppy waters, we continue to agree with Bill Gross when he said "bonds have seen their best days" and that stocks appear more attractive than bonds for the years ahead. While we are seeing no signs of inflation and bonds continue to benefit from a "flight to safety" in the US, we believe these days may be limited. In other words, we cannot rely on the misfortune of others to bail us out indefinitely.

Europe will get its act together eventually, and then it might be our turn.

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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.