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The Endgame Headwinds

The Endgame Headwinds


I have written repeatedly about the Endgame in the weekly letter, as well as in a New York Times best-seller on the same topic. By Endgame I mean the period of time in which many of the developed economies of the world will either willingly deleverage or be forced to do so. This age of deleveraging will produce a fundamentally different economic environment, which the McKinsey study referenced below suggests will last anywhere from 4-6 years. Now, whether this deleveraging is orderly, as now appears to be the case in Britain, or more resembles what I have long predicted will be a violent default in Greece, it will create a profoundly different economic world from the one we have lived in for 60 years. This makes sense, in that the prior world was defined by ever-increasing amounts of leverage. Outright reductions in leverage or even a significant slowing of the rate of growth is a whole new ballgame, economically speaking.

In all this I have explained the various options facing the developed world, but I have refrained from putting forth my own estimates as to what will actually happen and what the environment surrounding that outcome will be. That is about to change. I have been giving this a great deal of thought and research. While my conclusions will be somewhat controversial (I know, surprise, surprise), with enough to offend almost everyone on some point, I hope that I can muster enough clarity to help you think through your own personal views and how you will respond to what I think will be yet another crisis on the not-too-distant horizon. Whether that is Crisis Lite or Crisis Depression is up to us and the politicians we elect. I argue that we need to choose most wisely, because we are at a crossroads that is as critical as any since 1940.

As I start this letter, I am on a flight to San Diego, where I will co-host my 8th annual Strategic Investment Conference. As usual, I will be the last speaker on Saturday. This letter will be the beginning of that speech, and we will conclude (hopefully) next week. What I hope to do here is summarize the main points, add some new ones, and then move on to how I think the Endgame will play out. These next two e-letters will be among the more critical ones of the last few years. Feel free to forward, and if you are reading this letter you can join my one million closest friends and sign up for my free weekly letter at www.johnmauldin.com. (This letter may print longer than usual, as it will have a significant number of graphs.)

But before we jump in, many of you know that I am a serial entrepreneur. I look for business opportunities for inclusion in “the Mauldin companies.” My “hobby,” if you will, is looking at cutting-edge biotechnology. You have been asking for details and an update on one I mentioned last year. We partnered with a very serious biotech research firm, International Stem Cell Corporation, whose scientists discovered a patent-pending formula that rejuvenates skin. We continue to partner with them to help augment this breakthrough and, most importantly, to help fund their therapeutic research to find cures for very serious diseases. You can learn more at www.lifelineskincare.com/antiagingbreakthrough. Now, let’s get into the letter.

The Endgame Headwinds

Before we can get to how I think the Endgame of the debt supercycle plays out in the US, we need to quickly survey the current environment, and revisit (at least for long-time readers) a few basic economic themes that I will call the “headwinds” of economic growth. So many leaders in so many countries think that with the right policies they can grow (export) their way out of the problem. As I have written, not everyone can grow their way out of a crisis at the same time. Someone has to buy.

And while the right policies will in fact help, growth is, in my opinion, going to be severely constrained in the multi-year period of the Endgame. But, jumping right to the bottom line here, one way or another we will get through this very difficult period. Really. And my personal view is that in the period following the Endgame cycle we’re going to see a very real economic boom, for reasons we will visit briefly in this series and at length over the coming year. I am quite optimistic longer-term, but the flight to get there may be very bumpy if you are not prepared for it. I will try to do my part to help you.

Briefly, for new readers, let me define what I mean by the Endgame, as dealt with at length in Endgame: The End of the Debt Supercycle and How It Changes Everything (www.amazon.com/endgame). The US in particular and much of the developed world in general began a cycle of ever-increasing debt in the late ’40s, after World War II, both in the private and public sectors. Government began to grow as a percentage of overall GDP in the latter part of this cycle. In addition, politicians created large (well, huge) entitlement programs of pensions and health-care benefits that require significant taxes and, as we shall see, are unsustainable in the our present medium term.

There is a limit to how much money an individual or country can borrow. We all intuitively know this. If you grow your debt faster than your income and your ability to service the debt over a long period of time, people will eventually stop loaning you money. This is true for individuals, businesses, and nations. The end result is a restructuring of the debt (default by one of several means, including serious inflation) or a very reduced standard of living (by previous standards) for a period of time in order to service the debt. For individuals, that may mean cutting off the cable, no eating out, no vacations, etc. For countries it means reduced government programs and benefits, and higher taxes.

And make no mistake. I believe that the situation in the US is becoming urgent all too quickly. We are risking the health of the economic body of the US. While the republic will survive the crisis, the shocks and burdens it will place on all of us will be very great. For those not prepared it will seem like the end of the world, as jobs and safety nets might evaporate without proper restructuring. As I argue, the goal of fiscal sanity is to get the growth of the debt below that of the growth rate in nominal GDP. Failure to do so will result in the US suffering much as Greece or Ireland are today. Ugly.

The 2008 banking crisis showed us the limits of how much individuals can borrow, at least against their home equity. Since then, private debt (except recently for student loans in the US) has begun to shrink. But governments everywhere stepped into the breach by massively borrowing. But even governments, including the US, have a limit. We see that in Greece and Ireland, and are watching the debt crisis unfold in Portugal and Spain as well. It will soon become all too painfully clear in Japan. As I have often noted, Japan is a bug in search of a windshield. Japan is big enough that when it hits its own version of the Endgame, it will shake the world. It will not be pretty. (But there are opportunities for the nimble.)

As we will quickly cover here, the economic environment in which individuals and governments either willingly or are forced by the markets to reduce their borrowing and debt is significantly different from the period where they could create ever-increasing amounts of leverage. I call this period the Endgame. What we think of as normal gets turned upside down. Volatility increases, at a minimum. For many people this will qualify as a true crisis. But if you can see it coming and prepare, you can at least insulate yourself (somewhat) from many of the negative aspects of the Endgame. And volatility and crisis also mean that there will be opportunities for those prepared for them.

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Now, let’s look at three graphs. The first is familiar to long-time readers. It shows the rise of debt in the US. And even with the recent pullback in consumer debt, because of the enormous government deficits, the rise is still there if we update this chart to last year.

The next two charts come from the Bank of International Settlements. They outline for 12 countries what happens, in terms of the debt-to-GDP ratio, if current spending and tax rates remain unchanged (the top dotted line), what happens if there are efforts to rein in spending with small gradual spending cuts and tax increases (middle line), and what would happen with serious spending cuts and significant tax increases (the lowest line). Some countries, even with measures that could be considered draconian, simply do not recover. While the chart shows what would happen if age-related spending were held constant, most seniors would think that getting ever-smaller pensions and health care would be drastic measures indeed. These countries are in an unsustainable spiral, which means drastic (the word used by the BIS) measures will be needed.

Note that there is only one example of a country that ever saw its debt-to-GDP rise over 150% and did not default, and that is Britain at the height of its empire and power, with long-term rates at a very low level and a completely different investment and bond climate. But notice how many of the countries are now on a path to twice that level in the very near future.

If Something Can’t Happen…

There is rule in economics: If something can’t happen, it won’t happen. That may seem obvious, but so many people think the current linear trend can go on forever. This time is different, we tell ourselves. And I (and some others, like David Walker, Stockman, etc.) are telling you that so many things are on unsustainable paths that changes in present trends, as much as we might not like to think about them, are inevitable. So what we must think about now is what will happen when change is either forced on a country or entered into willingly. Some times you have to think the unthinkable.

Look at the projected debt for the US, compiled last year by the Heritage Foundation, based on realistic assumptions, not with rose-colored glasses. This is a chart of something that will not happen. Long before we get ten years of multi-trillion-dollar debt, the bond market will being to require much higher rates than we currently experience, driving up the interest-rate cost as a percentage of tax revenues to very painful levels, forcing cuts in all sorts of things we currently think of as absolutely necessary, like military, education, and Medicare spending. Later on I will put a timeline on this prediction.

One way or another, the budget deficits are going to come down. As we will see later, we can choose to proactively deal with the deficit problem or we can wait until there is a crisis and be forced to react. These choices result in entirely different outcomes.

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In the US, the real question we must ask ourselves as a nation is, “How much health care do we want and how do we want to pay for it?” Everything else can be dealt with if we get that basic question answered. We can radically cut health care along with other discretionary budget items or we can raise taxes, or some combination. Both have consequences. The polls say a large, bipartisan majority of people want to maintain Medicare and other health programs (perhaps reformed, but still existent), and yet a large bipartisan majority does not want a tax increase. We can’t have it both ways, which means there is a major job of education to be done.

The point of the exercise (reducing the fiscal deficit to sustainable levels) is to reduce the deficit over 5-6 years below the growth rate of nominal GDP (which includes inflation, about which more below). A country can run a deficit below that rate forever, without endangering its economic survival. While it may be wiser to run some surpluses and pay down debt, if you keep your fiscal deficits lower than income growth, over time the debt becomes less of an issue.

GDP = C + I + G + Net Exports

But either raising taxes or cutting spending has side effects that cannot be ignored. Either one or both will make it more difficult for the economy to grow. Let’s quickly look at a few basic economic equations. The first is GDP = C + I + G + net exports, or GDP is equal to Consumption (Consumer and Business) + Investment + Government Spending + Net Exports (Exports – Imports). This is true for all times and countries.

Now, what typically happens in a business-cycle recession, as businesses produce too many goods and start to cut back, is that consumption falls; and the Keynesian response is to increase government spending in order to assist the economy to start buying and spending, and the theory is that when the economy recovers you can reduce government spending as a percentage of the economy – except that has not happened for a long time. Government spending just kept going up. In response to the Great Recession, government (both parties) increased spending massively. And it did have an effect. But it wasn’t just the stimulus, it was the absolute size of government that increased as well.

And now massive deficits are projected for a very long time, unless we make changes. The problem is that taking away that deficit spending is going to be the reverse of the stimulus – a negative stimulus if you will. Why? Because the economy is not growing fast enough to overcome the loss of that stimulus. We will notice it. This is a short-term effect, which most economists agree will last 4-5 quarters, and then the economy may be better, with lower deficits and smaller government.

However, in order to get the deficit under control, we are talking on the order of reducing the deficit by 1% of GDP every year for 5-6 years. That is a very large headwind on growth, if you reduce potential nominal GDP by 1% a year in a world of a 2% Muddle Through economy. (And GDP for the US came in at an anemic 1.75% yesterday, with very weak final demand.)

Further, tax increases reduce GDP by anywhere from 1 to 3 times the size of the increase, depending on which academic study you choose. Large tax increases will reduce GDP and potential GDP. That may be the price we want to pay as a country, but we need to recognize that there is a cost to growth and employment. Those who argue that taking away the Bush tax cuts will have no effect on the economy are simply not dealing with either the facts or the well-established research. Now, that is different from the argument that says we should allow them to expire anyway

Increasing Productivity

There are only two ways to grow an economy. Just two. You can increase the working-age population or you can increase productivity. That’s it. No secret sauce. The key is for us to figure out how to increase productivity. Let’s refer to the last equation.

The I in the equation is investments. That is what produces the tools and businesses that make “stuff” and buy and sell services. Increasing the government spending, “G”, does not increase productivity. It transfers taxes taken from one sector of the economy and gives them to another, with a cost of transfer, of course. While the people who get the transfer payments and services certainly feel better off, those who pay taxes have less to invest in private businesses that actually increase productivity. As I have shown elsewhere, over the last two decades, net new jobs in the US have come from business start-ups. Not large businesses (they are a net drag) and not even small businesses. Understand, some of those start-ups become Google and Microsoft, etc. But many just become small businesses, hiring 5-10-50-100 people, but the cumulative effect is growth in the economy and productivity.

Now, if you mess with our equation, what you find is that

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Savings = Investments.

If the government “dis-saves” or runs deficits, it takes away potential savings from private investments. That money has to come from somewhere. Of late, it has come from QE2, but that is going away soon. And again, let’s be very clear. It is private investment that increases productivity, which allows for growth which produces jobs. Yes, if the government takes money from one group and employs another, those are real jobs, but that is money that could have been put to use in private business. It is the government saying we know how to create jobs better than the taxpayers and businesses we take the taxes from.

This is not to argue against government and taxes. There are true roles for government. The discussion we must now have is how much government we want, and recognize there are costs to large government involvement in the economy. How large a drag can government be? Let’s look at a few charts. The first two are from my friend Louis Gave, who will be speaking at my conference this weekend. This first one is the correlation between the growth of GDP in France and the size of government. This chart shows the rate of growth in GDP and the ratio of the size of the public sector to the private sector. The larger the percentage of government in the ratio, the lower the growth.

I know, you think that is just the French. We all know their government is too involved in everything, don’t we. But it works in the US as well. The chart below shows the combined federal, state and local expenditures as a percentage of GDP (left-hand scale, which rises as the line falls) versus the 7-year structural growth rate, shown on the right-hand side. And you see a very clear correlation between the size of total government and structural growth. This chart and others like it can be done for countries all over the world.

Sidebar: Now, I would not argue, as some libertarians do, that we need almost no government. I do not. But we must recognize the cost-benefit. I think the benefits of police are clear. Schools. A professional military (its use can be up for debate). Financial regulation. Courts. Etc. Certainly, society functions better with these and other services, and in a broad sense you can say that increases productivity. We “buy” services collectively with tax dollars that are seen as essential public goods. Those services could be offered by private companies. But there is a limit in the minds of most people. Do you want your government to own the steel mills and airlines? Energy production? In many countries and at times in history, the answer was yes. But government-run businesses are rarely as efficient as private ones. And that efficiency is a direct component of productivity.

Next, (and finally for this week), let’s look at a chart from my good friend Rob Arnott. This is part of what will one day be an Outside the Box. (For new readers, this is a publication that goes out Monday night, which features the writing and thinking of someone other than your humble analyst, and which I don’t always agree with, but that does make us think. You can get it at www.johnmauldin.com just by putting in your email address and becoming one of my 1 million closest friends.)

The chart needs a little set-up. It shows the contribution of the private sector and the public sector to GDP. Remember, the C in the equation was private and business consumption. The G is government. And G makes up a rather large portion of overall GDP.

The top line (in dark blue) is real GDP per capita. The next line (yellow) shows what GDP would have been without borrowing. So a very real portion of GDP the last few years has come from government debt. Now, the green line below that is private-sector GDP. This is sad, because it shows that the private sector, per capita, is roughly where it was in 1998. The growth of the “economy” has been government.

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Is it any wonder that we have no net new jobs over the last decade? I get that there have been two recessions, but in an effort to appear to be “doing something,” to “feel your pain,” government is slowly sucking the air out of the room. Not all at once. Just a bit at a time.

And it shows up in worker pay. The average worker has not seen their pay rise in real terms in almost 15 years. If they have a job. In fact, for the last decade, they LOST 5%.

Do you want more tax revenues so we can have more government services like health care? We have to grow the private economy. If we tax the private economy as it is now, that will just reduce the growth in the private economy and slow or reduce the growth of jobs. There is simply no way to get around that fact.

I will close here and start with part two next week. But the short take-away? The fiscal deficit and the national debt are a cancer on our economic body. They threaten to destroy the economic body of the republic. As a conservative, simply writing the words “tax” and “increase” in the same sentence makes me nervous. But I am even more afraid of what will happen if we do not get the deficit under control over time (next week we’ll explore why we cannot do it all at once). Sometimes, when they have cancer, people take drugs they would not normally want to be in the same zip code with, in order to increase their chances of surviving. But those drugs have side effects, some of them quite severe and long-term.

How we solve this crisis will determine the nature of the Endgame. But that is for next week.

Toronto, Cleveland, LA, Philadelphia, Boston, and Italy

I am in La Jolla with about 450 attendees at my annual Strategic Investment Conference, co-hosted with Altegris Investments. It is a fabulous, sold-out event. It is truly one of the highlights of my year, joining so many old and new friends for a few days. And the intellectual conversation? Wow. We are recording the panels and hope to make them available at some point.

I fly to Toronto on Sunday for a quick speech, then back to Dallas, on to Cleveland for a night, then right off to Rob Arnott’s annual conference in LA. Another very impressive line-up and one that I am privileged to be allowed to participate in. Then home for a weeks to catch my breath.

I will be in Philadelphia Tuesday May 24 to moderate a panel and listen to a serious gathering of speakers at the 29th annual Monetary and Trade Conference, where the topics are “Is Housing Ready for a Rebound?” and “QE2, Housing and Foreclosures: Are they Related?” Philly Fed president Tom Hoenig, Chris Whalen, Michael Lewitt, Paul McCulley, William Poole, and Gretchen Morgensen, among others. To find out more you can go to http://www.interdependence.org/Event-05-24-11.php. Then it’s on to Boston with some friends for fun (and a board meeting), then straight to Italy and a train to the little village of Trequanda in Tuscany, where vacation for me is staying in the same place for a few weeks, writing and thinking, and having friends show up. The kids will be there for the beginning, and Tiffani and I will make it a working vacation after that. And then I’m off to Kiev, Geneva, and London with my youngest son in tow; but more on that later.

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It is time to hit the send button. I have 450 guests wondering where I am, so I bid you adieu for today, and we will finish up next week. Have a great week.

Your just a very happy and contented analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

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Discussion

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0 comments

Mike Krechevsky
May 10, 2011, 3:15 p.m.

Objective source like the Heritage Foundation. Now that is laugh out loud funny.

Keith Covington
May 3, 2011, 5:29 a.m.

enjoy the comments even though I don’t agree with all pov..some of you who need to question the motives of John should simply unsubscribe or at least provide the data when you are in disagreement rather than take cheap potshots.

my only question is a possible conflict of the graphs: total US debt as % of GDP is shown as 369% in 2009 in the large graph and looks like 100% in the graph when shown in the 2nd set of graphs, the lower right graph in the set of 6? am I missing something?

Fred Swartz
May 1, 2011, 5:53 p.m.

Thought provoking as always.  Thanks.  Two additional issues that might be addressed:

(1) Some countries with high standards of living (eg, Nordic) have high level of taxation.  How have they been able to do this so successfully?

(2) Maximizing GDP has always seemed like looking for keys where the light is, instead of trying to optimize the well-being of the citizenry.  For example, reducing income disparity may not increase GDP, but could increase overall happiness, decrease crime etc.  Throwing a rock through a store window may increase GDP, but ...

Russ Abbott
May 1, 2011, 4:56 p.m.

Two quick comments.

1. You lose credibility when you cite work from the Heritage Foundation (2% unemployment?) as believable.

2. You confuse government with non-productive work. I’d much rather have the government spend taxes on public infrastructure than have the private sector spend its money on non-productive activities like sports, other big-money entertainment, or junk food like sugar-based soft drinks. The former will make the economy more efficient and productive. The latter won’t. In fact, the free-market’s success at selling soft drinks is putting tremendous pressure on the economy in the form of unnecessary medical expenses. This is not to say that I would have the government limit the ability of the market to manufacture, advertise, and sell soft drinks. I wouldn’t; and please don’t accuse me of wanting a big-brother government.  My point is that it’s far too simplistic to adopt the attitude that it’s bad for government to provide services and good for the market to do so. It’s much more complex than that.

NR Peterson
April 30, 2011, 5:54 p.m.

The Debt to GDP chart is one factor. How about incorporating interest rates and the maturity schedule? The only reason the US economy hasn’t blown up sooner is because interest rates have dropped to zero and the maturity schedule is being dramatically shorten. The US Government balance sheet is more similar to Bear Stearns than we might like to think: look at the mismatch or assets and liabilities and the increasing significance of off-balance sheet items. Clearly, there are no adults in the room and this ends badly!

Clayton Buerkle
April 30, 2011, 3:37 p.m.

I was thinking the same thing as Robert Gilroy. I keep reading these polar opposite viewpoints that both make sense and seem backed up with reliable data and analysis. How can that be? Yet, the two sides are unwilling to have a “point-by-point discussion” because, why? In the meantime vacuum of anything close to agreement, partisan politics decides the nation’s fate.

Phil Printz
April 30, 2011, 3:28 p.m.

As a liberal, I agree with most of what John writes concerning our serious problems with a rising deficit. My question concerns his failure to specifically address the effect of tax increases on just the wealthy as a potential solution and the effect of companies outsourcing jobs overseas to achieve greater productivity. 

Also what many analysis fail to include in the deficit reduction calculation is the cost of rising crime as the poor lose the social entitlements that they have received for generations. We are a country after all of gun owners, unlike europe, and when people feel they have been unjustly treated and watch family members go hungry and not receive needed medical care it is not hard to imagine they will act out in unpleasant ways. Does anybody really think the poor will just quietly sit by and watch their humble lives destroyed? How much spending will we need to control the angry poor of the inner city. What is the cost of people being afraid to shop at malls and grocery stores because of potential violence. To avoid this violent scenario we must all tighten our belts and share of the pain with the wealth carrying more than the middle class and the poor if we hope to solve this very challenging problem. We must use wisdom to make very gradual spending cuts in social entitlements, while sharply raising taxes on the rich and changing our defense spending programs.

CArolyn Lilly
April 30, 2011, 3:26 p.m.

I find it disappointing that you choose healthcare to lessen government - what about cutting back on military spending (certainly Vietnam and Iraq were huge costly mistakes)-it’s foolhardy to believe we can control the world. Let Europe and Asia fend for themselves. Also delete other worthless government spending as incarcerating drug addicts (instead provide rehab!).  QE has only benefited the already rich bankers, and worsened the situation for the middle-class.  “The richest 1 percent of Americans now take home almost 24 percent of income, up from almost 9 percent in 1976.”- Read about the new US Banana Republic at: <http://www.nytimes.com/2010/11/07/opinion/07kristof.html?_r=1>
Why wasn’t QE used to create jobs (improve infrastructure, renewable energy, mass transit, etc.)? That would increase productivity and lessen the need for “social welfare”. People need JOBS!
Yes, taxes need to increase- capital gains and dividends should pay the regular earning rate, Bush tax cuts dropped, etc.  Current government policy is for the rich (catering to rich political contributions). The middle class are the workers who made this country great… too bad our country has significantly moved towards a two-class system (rich and poor),  which, if continued, will result in real class warfare=revolution.

Gerard Longpre
April 30, 2011, 1:44 p.m.

John:  pretty hard to accept your proposition that Government spending sucks the money out of the economy so the entrepreneurs cannot bring their start up businesses to fruition.  Start ups pay no tax. 

Between 1960 and taking into account the large decreases in 1982 and 1986, when tax rates in 1986 came down from top of 50% to 38% approx for top earners and 2010 Federal tax receipts have all averaged between 16% and 18% of GDP.  GDP between 1986 and 2011 has averaged between 4% to 5%.  Total Federal Spending between 1986 and 2010 has averaged between 18% and 20% of GDP.

US Government Public Debt under Reagon and Bush 1 went from 36% of GDP to 66% of GDP under Clinton, then 57% to 81% under Bush and under Bush with brainless Greenspan who created the Great recession’ to about 88% under Obama.  So the Republican geniuses increased the Debt by 54% in the last 30 years.

Between 1980 and 2008 the Private Savings Rate has dropped from 10% to -2% (at least).  Interestingly Corporate profits have gone from 8% of GDP in 1985 to 10.6% of GDP in 2005.  However from 2005 have gone from 10% of GDP to 12% today.

So even though the Reagan and Bushes increased the public debt 54% and Reagan and Clinton dropped the tax rates where is this dynamic growth that you state will take place if the Government stops spending and decreases taxes, going to come from?  Because neither tax receipts have really increased or decreased or Government spending increased or decreased over the last 15 years and other than Federal Government borrowings increasing dramatically, GDP up until 2008 was pretty much in the same range of 4 to 5%.  Corporate Profits only went up about 2.5% in the bull market (18 years) while since 2008 Corporate profits have gone up 2% in 3 years.

Sorry I cannot see based on the facts of the economy where decreasing taxes without government spending will give the magic growth.  With all of the government and Fed largess in 2008 to 2011, with tax receipts staying pretty much the same we have seen quite dramatic Corporate profit growth but GDP is now 1.8%

Abel Rossenblat
April 30, 2011, 10:45 a.m.

I basically agree with yr comments regarding government size all around the world.The main problem I see is that will be very difficult to reduce spending due to al the created interests and the lack of understanding for the majority of the people.
We realy need great leaders and excellente managers to rationally reduce government spending and we have not them today.

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