will inexorably lead to a breakdown of the Democratic-welfare regime which has lasted from 1932 until the present. The reasoning is very simple and direct. We already have huge debt. Rapidly increasing entitlement spending on our rapidly increasing number of retirees will keep driving our debt higher and higher. We won’t be able to grow our way out from under this debt because we have run out of industrial revolutions to spur new growth. A new study co-written by Doug Elmendorf, CBO Director from 2009-2015, makes the case that our fiscal crisis, although real, is less urgent than often believed for the following reasons:
Lower than expected health-care inflation
The persistence of low interest rates
The above chart shows, for example, that the public debt may not reach 100% of GDP until 2032 instead of the earlier CBO prediction of 2030. I believe that this Elmendorf projection should be viewed as false comfort.
Both health-care inflation and low interest rates are a direct result of very low overall inflation in the U.S. and this will not last forever. Low interest rates mean that interest payments on the debt are also very low. This is a very poor reason to increase current borrowing. When interest rates do go up, whether it is sooner or later, interest payments on the debt will increase by hundreds of billions of dollars a year over a likely relatively short time period.
This is the severe crisis, or Fourth Revolution, which Mr. Piereson is predicting. We don’t know when it will occur because we don’t know when inflation will rear its ugly head.
Wouldn’t it be much better to put our debt on a downward path, as a percentage of GDP, and avoid the otherwise very unpleasant consequences?
“I could end the deficit in 5 minutes. You just pass a law that says anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election.” Warren Buffett, 1930 –
Mr. Buffett made this quip in a recent interview with CNBC. Since the economy has historically grown at a rate of about 3%, Mr. Buffett is saying that we’ll be alright as long as economic growth exceeds deficit spending. This is generally correct but, as Mr. Buffett well knows, the situation is more complicated than this. A very good, and nontechnical, discussion of this whole subject can be found in the newly published book, “The Death of Money: the coming collapse of the international monetary system” by the financier James Rickards. Look at Chapter 7, “Debt, Deficits and the Dollar.”
Simplifying Mr. Rickards’ approach a little bit, and keeping it in Mr. Buffett’s framework, for a stable economy we need to have
G > D
where the nominal growth G = real GDP + I (I is the rate of inflation) and the deficit D = S – T (S is spending and T is tax revenue). I have included interest paid on the debt as part of total spending. As long as the left hand side is greater than the right hand side, the economy is growing faster than the deficit and the accumulated debt will shrink as a percentage of GDP. Notice that the rate of inflation affects the left hand side of the inequality while the interest rate is part of the right hand side.
Negative inflation is deflation which is clearly undesirable. The Federal Reserve’s current target for inflation is 2%. The challenge for the Fed is 1) to keep inflation high enough and interest rates low enough so that G > D, while at the same time, 2) to make sure that inflation does not grow so high as to destabilize the markets.
Given our underperforming economy with low real GDP growth, and huge deficits, Mr. Rickards is pessimistic that the Fed can continue successfully “in the position of a tightrope walker with no net … exuding confidence while having no idea whether its policies will work or when they might end.”
Thus the gloomy title for his book.
My last post, “The Big Picture on Debt,” used a chart from a recent Congressional Budget Office report (pictured below) to look at the history of U.S. debt. It is worse now than at any other time except at the end of World War II. But after 1945 massive military spending ended rapidly, the economy started growing briskly and debt as a percentage of GDP shrunk rapidly. The light purple section at the right hand side of the chart portrays CBO’s debt projection for the next 25 years. As the report itself makes clear, CBO is using favorable economic assumptions in this projection. Without these favorable assumptions, our future debt will be much worse than this. And the same trends continue indefinitely into the future beyond the 25 year window.
Right now our huge debt is almost “free” money because interest rates are so low. But this situation cannot last much longer without setting off an inflationary spiral. As interest rates eventually resume their historical average of about 5%, interest payments on our accumulated debt will skyrocket and therefore increase the size of the annual deficits.
There are only three ways to shrink debt as a percentage of GDP: 1) cut spending, 2) achieve faster growth and 3) raise tax revenue. Let’s look at each in turn:
Government spending as a percentage of GDP is not shrinking but actually growing. Primarily this is because of the massive growth of the big three entitlement programs: Social Security, Medicare and Medicaid. All other government spending is subject to Sequester limits. This is a crude and insufficient way to control discretionary spending.
GDP growth, averaging 2.2% annually since the end of the Great Recession five years ago, is much slower than the overall average growth of 3.3% since the end of WW II. Major tax reform at both the individual and corporate levels, with lower tax rates offset by closing loopholes and shrinking deductions, would give a big boost to economic growth. But there is resistance to cutting tax deductions.
Raising taxes will in principle decrease deficit spending but the trick is to do it without hurting economic growth. Both individual and corporate tax reform could accomplish this if done in the right way. See here and here for specific proposals.
Conclusion: there are concrete ways to find solutions to get our massive accumulation of debt under control and shrinking as a percentage of GDP. But the prospects for action are gloomy.
“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe.”
Ludwig von Mises, Austrian economist, 1881 – 1973
The economist/investor John Mauldin writes a weekly newsletter, “Thoughts from the Front Line” (http://d21uq3hx4esec9.cloudfront.net/uploads/pdf/140426_TFTF2.pdf) which offers good general insight. In the latest issue Mr. Mauldin writes “For all intents and purposes we have adopted a trickle-down monetary policy, one which manifestly does not work and has served only to enrich financial institutions and the already wealthy. Now I admit that I benefit from that, but it’s a false type of enrichment, since it has come at the expense of the general economy, which is where true wealth is created.” Mr. Mauldin also quotes the economist William White, “When you talk about crisis resolution, it’s about attacking the fundamental problems that got you into trouble in the first place. And the fundamental problem we are still facing is excessive debt. Not excessive public debt, mind you, but excessive debt in the private and public sectors. … With ultra-loose monetary policy, governments have no incentive to act. But if we don’t deal with this now, we will be in worse shape than before.”
What then should government do? The best single thing is to develop a concentrated focus on boosting the economy. This would put millions of people back to work and raise salaries for the entire workforce. Tax revenue would rise and both public and private debt would be paid down more quickly.
The way to do this is with fundamental, broad-based tax reform. This means lowering tax rates for both individuals and corporations, paid for by closing loopholes and shrinking deductions. This would have the effect of taking from the rich and giving to the poor, i.e. putting more money in the hands of those who are most likely to spend it, thereby creating more demand leading to faster economic growth.
It’s not that hard to figure out!
The House Committee on Financial Services recently held a hearing on the topic “Why Debt Matters.” One of the speakers was David Cote, CEO of Honeywell International. He pointed out that the percentage of world GDP generated by the developed countries (the U.S., Western Europe, Canada and Japan) is predicted to decline from 41% in 2010 to 29% by 2030. High growth developing economies are expected to grow in GDP from 33% in 2010 to 47% in 2030. In order to compete in this new world we need an “American Competitiveness Agenda.”
Mr.Cote suggests eight components: debt reduction, infrastructure development, better math and science education, immigration reform, tort reform, stronger patent support, more energy generation and efficiency, and trade expansion. “To compete effectively on the increasingly competitive world stage, we have to have a strong balance sheet. We don’t have a strong balance sheet today and it will worsen over time with our current plan. … In 2025, just 11 years from now, we will be spending a trillion dollars a year just in interest.” And this is assuming no more recessions in the meantime! Our public debt level today, at 72% of GDP, is higher than at any time in our nation’s past, except for during World War II when the survival of the free world was at stake. And while public debt will be 78% of GDP in 2023, which might not sound much worse than today, it is also projected to be much higher, 99% of GDP, by 2033. Is this really the legacy that we want to leave for our children and grandchildren? Some people say that we should run even bigger deficits right now until we are fully recovered from the Great Recession. But this is what we’ve been doing for the past five years and it’s not working. How much longer do we wait until we change course?
It’s possible to shrink our deficits and speed up the growth of our economy both at the same time. This is what Mr. Cote is saying and what I am constantly talking about on this website!
“Low interest rates aren’t working, but we need a debate about what will,” declares The Wall Street Journal’s William Galston yesterday in “Soaring Profits but Too Few Jobs”. “Corporate profits after taxes in the fourth quarter of 2013 rose to an annual level of $1.9 trillion – 11.1% of GDP, a postwar high. Meanwhile, total compensation – wages and benefits – fell to their lowest level of GDP in at least 50 years.” “Businesses are sitting on tons of cash . . . and they’re choosing to invest their capital in hardware, rather than hiring. The reason: they believe that investing in technology is likely to have a better effect on sales than hiring more people.” Furthermore, “today’s (low) interest- rate regime lowers the cost of capital – and therefore of capital investment relative to labor.”
Meanwhile,” Republicans are banging away at the Affordable Care Act while Democrats are busy scheduling votes on a grab bag of subjects designed to boost turnout from the party’s base in the fall elections. The economic problems we face are getting lost in the partisan din.”
We are in a very tough situation. Raising interest rates might give a marginal boost to hiring more workers over capital investment but it will also greatly increase interest payments on our massive and rapidly increasing national debt. And meanwhile we have a stagnant economy with millions of people either unemployed or underemployed. What should we do? How about
Boosting the economy with lower individual and corporate tax rates, paid for by cutting back on tax preferences. This will especially help small businesses grow and hire more employees. It will also encourage multinational corporations to bring their foreign profits back home for reinvestment.
Addressing rising income and wealth inequality by establishing an annual 1% wealth tax on individual assets in excess of $10 million. This will raise about $200 billion per year and could be used to set up a huge infrastructure improvement program to put millions of people back to work.
Interest rates will eventually return to normal levels of 5% or so and this will create a big squeeze on the federal budget. So we also need to get federal spending under control as soon as possible. But this is a separate issue.
Just boosting the economy and putting people back to work while addressing inequality in a very visible way will get us started on a path to recovery.
Last month the Congressional Budget Office issued the report “The Budget and Economic Outlook: 2014 to 2024”, giving an updated prediction on economic performance. It predicts continued slow growth of GDP leveling off in the next few years at a rate of about 2.2% per year. The public debt (on which we pay interest) will be 74% of GDP this year and increase to 79% of GDP by 2024. Federal revenues will grow this year to 17.5% of GDP while federal spending will be 20.5% of GDP. The problem is that the gap between revenue and spending will get worse as indicated by the chart below. CBO estimates that interest rates on three month Treasury bills will rise from 0.1% today to 3.7% in 2018, and higher in subsequent years, which means that interest payments on our public debt will increase dramatically as shown in the chart below. Inflation is predicted to average about 2% over this time period. Unemployment will slowly drop to 5.8% in 2017 and not reach 5.5% until 2024. In an article two days ago, an economics reporter for the New York Times, Floyd Norris, writes that this is “A Dire Economic Forecast Based on New Assumptions”. Mr. Floyd argues that it is unlikely that we will continue to have both anemic growth and high interest rates at the same time. Of course, if the economy does grow more quickly, then government revenues will also grow faster which will slow down the growth of the debt. But CBO predicts that our recovery from the Great Recession will continue to be tortuously slow.
The problem is that when interest rates do go up, as they will sooner or later, interest payment on the national debt will rise quickly, as shown in the CBO chart. This is going to happen and will be unpleasant to deal with. Are we going to have slow growth in the meantime, with high unemployment along with it, and then also have expensive debt payment later? This is indeed a pessimistic prospect!
We have a continuum of choices:
Do nothing until the big crunch hits in a few years (like Greece)
Cut spending dramatically, including for entitlements (politically infeasible)
The Congressional Budget Office has just issued the report ”The Budget and Economic Outlook: 2014 to 2024”, giving its usual objective and nonpartisan look at our prospects for the next ten years. My purpose today is to give a simple interpretation of its basic data. In my next post I will address the implications of this interpretation. The first chart above shows a forty year history of government deficit spending. The average deficit for this time period is 3% of GDP. From 1982 – 1987 the deficits were worse than this and from 2009 – 2013 they were much worse. The real problem is the accumulated deficits, i.e. the debt. The second chart above shows the public debt (what we pay interest on) all the way back to 1940 as a percent of GDP. As recently as 2008, the public debt was below 40% of GDP. Now it is 73% and climbing. This is very serious for two reasons. Right now our public debt is almost free money because interest rates are so low. But when interest rates return to their normal level of about 5%, interest payments will explode and be a huge drain on the economy. In addition, these CBO predictions assume continued steady growth of the economy. If and when we have a new recession or some other financial crisis, there will be much less flexibility available for dealing with it. Now look at the last two charts. The first one shows the rate of GDP growth since 2000 which has averaged about 2% since the end of the recession in June 2009 and is projected by the CBO to level off at this same rate over the next 10 years. This is an historically low rate of growth for our economy. The final chart shows the gradual decrease of the labor force participation rate over this same time period. These two graphs are related! When fewer people are working, the economy simply will not grow as fast.
High debt and slow growth are big problems for an economy. We’re falling more deeply into this perilous state of affairs all the time. We need to take strong measures to break out of this dangerous trap!
I have been writing this blog for just over a year. It addresses what I consider to be the two biggest problems faced by our country at the present time. First is our enormous national debt, now over $17 trillion, and the huge annual budget deficits which are continuing to make it worse. The second problem, of equal magnitude, is our slow rate of economic growth, about 2% of GDP annually, ever since the Great Recession ended in June 2009. These two problems are closely related. If the economy grew faster, federal tax revenue would grow faster and the annual deficit would shrink faster. Not to mention that a faster growing economy would create more jobs and lower the unemployment rate, which is still a high 7%.
The impediments to solving these problems are huge. Our public debt, on which we pay interest, is now over $12 trillion or 73% of GDP. Although it may stabilize at this level for a few years, it will soon begin climbing much higher, without major changes in current policy. This is primarily because of exploding entitlement spending for retirees (Social Security and Medicare) who will increase in number from about 50 million today to over 70 million in just 20 years. As interest rates return to normal higher levels, just paying interest on the national debt will become, all by itself, a larger and larger drain on the economy.
The impediments to faster economic growth are increasing global competition, such as inexpensive foreign labor, as well as rapid advances in technology, such as electronics and robotics. Both of these trends reduce the need for unskilled workers in America which in turn holds down wages and slows down economic growth.
At the same time we have an antiquated tax code to raise the huge sums of money necessary to pay for a large and complex national government. It worked fine through the post-World War II period, as long as the U.S. had the dominant world economy with little significant competition from others. But this situation no longer exists. We now have a tax system which doesn’t raise enough money to pay our bills and at the same time is so progressive that the highest rates (39.6% on individuals and 35% for corporations) are not sufficiently competitive with other countries. This discourages the entrepreneurship and business investment we need to grow the economy faster and create more jobs.
We have an enormous problem on our hands! Is it possible to fundamentally change our tax system to turn things around? My next post will answer this question in the affirmative!
The lead story in this week’s Economist, “The Perils of Falling Inflation” and a recent article in the New York Times, “In Fed and Out, Many Now Think Inflation Helps“, both make the case that the U.S. core inflation rate of 1.2%, excluding food and energy prices, is dangerously low, risking deflation. “Rising prices help companies increase profits; rising wages help borrowers repay debts. Inflation also encourages people and businesses to borrow money and spend it more quickly.”
But there is another distinctly different point of view. In a Barron’s column last week “Deflating the Inflation Myth”, Gene Epstein points out that “business activity is motivated by profit, not prices.” He shows with a chart that profits decreased during the highly inflationary 1970’s and 1980’s but they have been increasing since the end of the recession in 2009, even with very low inflation. The key to boosting the economy is more business investment and risk taking but a higher rate of inflation is not the way to accomplish this.
In a speech at the Economic Club of New York in June of this year, former Fed Chair Paul Volcker said that “the implicit assumption behind that siren call (to let inflation increase) must be that the inflation rate can be manipulated to reach economic objectives – up today, maybe a little bit more tomorrow, and then pulled back on command. All experience amply demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse.”
As soon as interest rates go up as they surely will in the not too distant future, interest payments on our now enormous national debt will skyrocket and become a huge drag on the economy. If and when inflation goes up, it will pull interest rates up along with it. Let’s not push inflation, and therefore interest rates, up any faster or higher than necessary!