We find ourselves living in historic times along many fronts.

At a recent campaign event, presidential hopeful Mitt Romney took a hard look at the reality of government debt, noting that the thorny crisis caused by perpetual can kicking will likely be faced by our kids in the near future.

While Mr. Romney is right to address the seriousness of the government debt issue, he may be slightly off on the timing of this trade. While he anticipates the debt crisis to require attention “by our kids,” mathematical logic might indicate the problem could fester in the very near future – potentially in three to five years in the United States, according to some projections. The mathematical logic indicates that the over expansive monetary policy that lead governments to embrace expenditures significantly higher than their revenues is coming to an end. Greece is example A of a society that received a natural margin call. With debt to GDP breaking into triple digits, investors might take note that all governments will likely receive their “margin call” at some point. The question is, when?

Republican Congressman Paul Ryan (Wisconsin) may have corrected Romney’s timing. Speaking on Meet the Press on Sunday, May 20, Representative Ryan called for a potential US debt crisis in two to four years. This coincides with other credible projections. “We could have a debt crisis in (the US in) 2-3 years absent action,” observed David Walker, former US Controller General and head of the Government Accountability Office (GAO). “There is a lot of irony and hypocrisy in Washington’s desire to make sure that JP Morgan has proper risk management practices,” Mr. Walker added, noting a general lack of appropriate risk management in government regarding deficit spending and leverage usage. Mr. Walker has been the early leader in speaking to the mathematical logic of a coming debt crisis, a message that few care to hear.

Making the required difficult and unpopular political decisions required to fix the debt problem will require significant political will. David Gregory of NBC’s Meet The Press noted this in his May 20, 2012 grilling of Republican Congressman Paul Ryan and Democratic Senator Dick Durbin. This is because over-leveraged governments have really two choices, neither of which are positive. In other words, there are no easy answers to the debt problem, only “worse and worser,” as author John Mauldin is so fond to point out the harsh reality.

What is the mathematical and practical logic behind a two to three year debt crisis projection?

Here is the reality, the wakeup call: In the United States, a demographic shift in three to five years is about to strain budgets as the government continues to spend nearly double its revenue. This is well documented in a Bloomberg BusinessWeek article written July 27, 2011. This demographic shift occurs when baby booming seniors retire in historic numbers, straining government benefits. This strain may occur the same time interest rates have risen, as a once infallible fiat currency discovers its fallibility. This strains a budget just when expenditures are running nearly double revenues. That’s the mathematical logic, one potential outcome. But the undeniable truth is that deficit spending such as being exhibited by government would be alarming on any balance sheet, but the fact that it isn’t even being addressed in a serious fashion is troubling, the root cause of the debt crisis.

Consider Greece from the basic perspective of their out of control leverage usage, with government spending well beyond revenues for years. When asked to face the economic problem and address the core structural issues through austerity – the widely unpopular `political choice – politicians prefer to kick the can down the road. The problem Greek political leaders face is they have just discovered the limits of how far the can kicking can last.

Is Greece a “One Off?”

When investors take a pure mathematical look at the structural problems, similar core issues appear in other over-leveraged western societies. Portugal, Spain, Italy, France, to name a few, all have the same structural spending problem, which could come to a head shortly. And from a mathematical perspective similar problems exist with the government who currently holds the reserve currency of choice status. At a basic level an understanding needs to take place that the root of the difficult problem is spending must be cut and revenues need to be increased. This will become a political football, a tug of war of epic proportion.

Will False “Growth” Through Easy Monetary Policy Solve the Problem?

In the past, the easy solution for government has been to stimulate growth through quantitative easing. Such tactics of “adding liquidity” typically work well early in a debt cycle but have less impact the more they are used. An example of this in the US can be found by examining the significant impact of an easy monetary policy during the 1980s and contrasting this to the relatively diminishing return on “growth” that today’s quantitative easing has on the economy. If one were a trader looking at the debt crisis they might conclude the significant risk of adding leverage to the government debt trade might not be worth the diminishing reward.

The key for investors is to recognize that the market environment to which western economies are headed may require difficult political solutions, which will not be easily solved without volatility. This could lead to a very different economic environment to which investors should be prepared to defend against. Economic environments that perhaps could be punctuated with bouts of volatility with strong market price trends emerging both positive and negative.

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Mark Melin will be speaking on a panel at HedgeWorld June 6 @ 1:30 regarding MF Global. Click here for the agenda.

About the Author: Mark Melin is host of the internet video show Uncorrelated Investing and editor of Opalesque Futures Intelligence, a newsletter written for professional investors that covers investments in the futures and options industry. A futures industry practitioner and consultant, Mark has taught managed futures as an adjunct instructor at Northwestern University / Chicago and has written or edited three books, including High Performance Managed Futures (Wiley 2010) and The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill 2008). Mark has worked as a consultant to the Chicago Board of Trade and OneChicago, the single stock futures exchange. He was director of the managed futures division at Alaron Trading until they were acquired by Peregrine Financial Group in 2009. Mark worked with Peregrine Financial Group until 2011.

All contents copyright 2011 © Mark H. Melin all rights reserved.

Risk Disclosure: This article is intended for educational and informational purposes. Past performance is not always indicative of future results. There is risk of loss when investing in futures and options. Managed futures investing can involve volatility and may not be appropriate for all investors. The opinions expressed are solely those of the author, they are not appropriate for all investors and may not have considered all risk factors.

This entry was posted on Monday, June 4th, 2012 at 10:33 am and is filed under Commodities, Economics, Hedge Fund Research, Hedge fund strategies, Managed Futures, Risk Management, The Debt Crisis, hedge fund performance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.