Economic history is replete with examples of countries which have managed to bring seemingly intractable budget deficits under control. However, when we consider the traditional ways this has been achieved, it is very difficult to see how the US is going to extricate itself from this fiscal morass:

1. Strong economic growth ? unlikely at this stage

   The best solution would be strong US economic growth, which would boost fiscal revenues and reduce the level of debt relative to the size of the economy. Unfortunately, the huge debt burden is likely to constrain growth for many years to come. The recent history of Japan, which built up an excess of debt in the 1980s, is not encouraging. Japan?s economy has stagnated for two decades. America is a more dynamic and flexible society and will probably emerge from its present problems more quickly, but it will take some years to do this.

2. Increase tax collections ? difficult to achieve

   Another way of eliminating a deficit is to increase tax collections. This will be very difficult to achieve because the US tax base has been severely eroded by declining profits and dividends, low interest rates, capital losses, unemployment and a contraction in remuneration packages. Because the deficit is so large, it will require a very substantial increase in tax rates to have a significant impact. The US government has become very dependent on a small group of rich taxpayers. In 2005 the top one percent of taxpayers paid 38 percent of income taxes. Meanwhile, history has demonstrated that increasing tax rates tends to decrease collections. A big increase in tax rates on the wealthy will aggravate an already large deficit. The fiscal problem cannot be solved by increasing personal taxes and a broad-based consumption tax, such as value added tax (VAT), is unlikely to get political support.

3. Reduce spending ? equally unlikely

   Bringing the deficit under control by reducing spending is equally unlikely. This is always the last resort politically and can be achieved only when the electorate supports such harsh remedies, as for instance in the political revolutions at the end of the 1970s when Ronald Reagan and Margaret Thatcher came to power. However, it took a decade of increasing misery to bring voters to accept that radical changes were necessary. We are only at the start of this process.

Given that the deficit is unlikely to be brought under control by growth, tax increases or by reduced expenditure, one way out may be inflation. Inflation is a stealth tax. Generally, people do not realise that it is a regressive levy on their earnings. It erodes the value of liabilities such as the national debt, while boosting asset prices. US monetary policy now clearly has an inflationary bias with the Fed printing money to buy government bonds. Given the large surplus of capacity and high levels of unemployment, inflation seems improbable in the near term ? but once world economic growth resumes, it could return with a vengeance.

There are two classes of inflation ? asset prices and the prices of goods and services. We are already seeing a rise in asset prices as surplus money creation works its way through the economy. Recently, there have been significant rallies in the prices of equities and commodities and in the dollar prices of currencies such as the euro and the rand. Many investors are choosing gold because they fear the latter type of inflation, where the prices of goods and services spiral upwards. As yet there is little evidence of this happening, but the concerns are there. Hence the rise in the gold price.

Taken from Allan Gray's second quarterly commentary of 2009