Seeking Alpha
Long-term horizon, portfolio strategy, bonds, dividend investing
Profile| Send Message|
( followers)  

The U.S. has no plan to eliminate its deficit. That sounds obviously misguided. Perhaps the politicians in Washington think the problem is too big, and that the deficit will and should take decades to fix?

In reality, it could be eliminated within 4-5 years.

In the 80's and 90's Canada had a debt and deficit "problem". Maybe we didn't realize that fact until the Wall Street Journal sarcastically called Canada an honorary member of the Third World. Our dollar was called the "northern peso" and we were a banana republic. Ouch, that really hurt our feelings. Well not really, we're Canadians so we cracked open a few beers and cracked off a slew of self-deprecating dollar and debt jokes.

Canada had a spending problem. In 1977, federal spending was $36 billion. In 1992 when Liberal Prime Minister Jean Chretien came to power, spending had exploded to almost $160 billion. And much of that spending had been put on a credit card. Interest payments ate up 35% of all federal spending. By 1995, Canada's debt to GDP ratio had hit 70%.

But luckily, Liberal Prime Minister Jean Chretien wasn't laughing. He took a massive deficit and turned it into a surplus in just four years. Yes, you might want to read that last sentence one more time.

Mr. Chretien took office in 1993 and put Canada on an ambitious austerity diet. Big spending cuts and some modest tax increases took the federal budget from a massive deficit to a surplus in a fiscal flash. And Canada's economic growth rate accelerated from less than 3 percent in 1993 to more than 4 percent in 1998.

What's that again, you can't have "austerity" and economic growth?

Jean Chretien was one tough hombre. One day a protestor slipped past security (that's not hard to do in Canada) and got right in Jean's face. Mr. Chretien grabbed the protestor by the throat and threw him around like a rag doll. Luckily for the protestor, Chretien's security detail finally came to life (put down their Tim Hortons coffees) and separated the two. To paint a picture, think of a 6'3" hockey enforcer grabbing the other team's fast but puny little goal scorer. This is a politician that did not fool around.

According to the IMF, the U.S. general government deficit (federal plus state/provincial) was 12.7 percent of GDP in 2009; the worst it ever got in Canada was 9.1 per cent at $40 billion. Currently the U.S. deficit is just over 7% of GDP. So currently, the U.S. is in "better shape" than Canada when Jean C put the deficit in a headlock and wrestled it to the ground. What was Canada's recipe for success?

They raised taxes.

The government in power previous to the Liberals had just taken a hodge-podge sales tax system and replaced it with the GST (a value added tax) of 8%. While advertised as a break even proposition, the GST did add revenues to the government coffers. At the time the Liberals also gently raised taxes in other areas.

They cut spending.

The federal government cut back on transfer payments to the provinces, reduced spending on many social programs. And the federal government trimmed the fat in all departments led by head of Canada's civil servants, Wayne Wouters.

"Because we had to cut so significantly, it was a bridge too far to say you could have achieved that type of deficit reduction simply through efficiency savings."

From Paul Martin, who was the finance minister at the time: "No department of government escaped untouched. Transfers to the provinces for healthcare and education were reduced, public sector employment was cut by 20 percent, the Department of Transport was cut deeply, historic subsidies in the Department of Agriculture were eliminated, and spending in the Department of Industry was cut by 65 percent. These were massive cuts, far greater than anything Canada had ever seen".

And the government of the day did cut the number of government workers via attrition - there were many incentives provided for early retirement and outright buyouts to leave the public service.

How deep were the spending cuts? Federal spending was at $122 billion in 1993, the year the Liberals took office. Spending was reduced over the next two years by $12 billion. Even as late as fiscal 2000, program spending remained below $120-billion. Adjusting for inflation and population growth, spending was cut by nearly 20%, and held there for another three years.

David Herle (who I have had the pleasure of working with) and senior political advisor to then-Finance Minister Paul Martin, says, "People need to say we have a bad economy because of the deficit. When the deficit stops being seen as a symptom and starts being seen as a cause that's when you can start to mobilize the political will for real changes". Herle continues … "But what's paramount is ensuring that people understand why you are doing this, why they have to make sacrifices and what the benefit will be. Leadership and political will is very important, most people can buy into that."

The results were financially spectacular. A yearly $42 Billion deficit was eliminated by the fourth year with ever increasing budget surpluses for 11 years after that. In 1998, the deficit had been eliminated and in the same year Canada saw the largest tax cuts in Canadian history.

In the end it all comes down to numbers. Here is THE CHART that says it all

Canada's Deficit Crisis - 1993 to 1998

(billions of dollars)
1993-94199519961997199819992000
Revenues116.0123.3130.3140.9147.5151.0155.0
Program spending120.0118.7112.0104.8106.0104.5107.0
Operating balance-4.04.618.336.141.546.548.0
Public debt charges38.042.046.945.041.543.545.0
Underlying balance-42.0-37.5-28.6-8.90.03.03.0

The key learning from the Canadian experience is that a country cannot simply grow their way out of deficit trouble. It took real restraint. Cuts are needed. Real cuts. And that means short term sacrifices for many. If the U.S. cut at the same rate as the Canadians, that would mean cutting $350 billion of federal spending over the next 4 years. When you're talking trillions, what's $85 billion a year? And we all know how much waste is in government at every level, and likely in every country on the planet. That $85 billion would not be that hard to find, or have much of an economic impact, if the true waste could be identified and government staffing levels were reduced mostly by attrition and buyout. Certainly handouts to states could also be thrown into the mix.

And on to the revenue side of the ledger.

And as I stated in this article, corporate tax receipts are near the lows of the last few decades as a percentage of GDP. Corporations and small businesses are paying less and less of their "fair share" to use Obamaspeak. More normalized revenues from corporations could bring in an additional $100 billion per year. Currently corporate tax receipts are only $241 billion in an economy with a GDP of 15.5 trillion dollars. In fact, if U.S. companies actually paid the 35% federal tax rate, corporate tax receipts would add an additional $500 billion to government revenues, and cover almost half of the annual deficit.

But we'll just take that additional $100 billion for now. Would you like a receipt?

Increase tax rates on the top 50% of income earners (who now pay 97% of all income taxes) by 8% over 4 years -and a slightly higher rate on those with income above $250,000 would generate another $100-150 billion per year. Remember, the Liberals in Canada were able to gently raise taxes and that had very little effect on the economy, and the Canadians actually accelerated economic growth as confidence improved.

We have now cut the deficit in half, from 1.1 trillion to $550 billion.

Now let's look at projected GDP growth rates and the resultant increase in government revenues due to a larger economy and a greater number of workers. Current government projections call for revenues of $3.6 trillion in 2016, an increase from $2.5 trillion in 2012. That seems a little lofty. And in fact, if that were to occur, that means that essentially the U.S. could simply keep federal spending where it is today, the budget would be balanced and the deficit would be eliminated by 2017.

Instead, let's use the recent growth rates in government receipts coming out of the recession.

Revenues increased 20% from 2009-2012. It is certainly possible that government receipts could again increase by 25% from 2012-2016 given the current rate of slow but steady growth. That gives us federal receipts of $3.1 trillion in 2016. That's $600 billion more than today.

And there you have it. The deficit is eliminated with a $50-100 billion buffer to cover any increase in borrowing costs that may occur.

We eliminated the deficit with $600 billion in "organic" growth from a larger economy, we reduced government spending by $350 billion, and tax increases produced another $200-250 billion.

The current U.S. "plans" on the table call for some small trimming and deficits that run for more than a decade. That's called playing deficit chicken. The U.S. currently has the benefit of very low borrowing rates, likely about 1/7th of what Canada had to pay back in the mid to late 90's. If borrowing costs/rates increase, even normalize, watch out. You'll need to take the words fiscal cliff and add words like Armageddon or Apocalypse, or other names you'll find attached to teenagers' shoot 'em up video games. But it won't be a game.

According to the U.S. real time debt clock, debt to GDP will be 132% in 2016 if we continue on the current path - we can see that estimate thanks to their handy time machine function. And in 2016, the U.S. will have an annual deficit of still almost half a trillion dollars.

Looking at President Obama's deficit plan, the Committee for a Responsible Federal Budget, a bipartisan organization that is very keen on debt reduction, crunches the numbers in the President's 2013 budget and finds that by 2022, Obama's program trims the deficit by $2.4 trillion. Over the next decade, Obama's budget would rack up several trillion$ of additional debt with ongoing deficits.

From the president's budget paper on the White House web page, and on the subject of the president's plan to reduce the deficit by 4 trillion over the next decade.

This would put our nation on the right course toward a level of deficits of below 3 percent of GDP by the end of the decade.

No mention of eliminating deficits there. But then the White House Budget Office notes …

Beyond 2022 ... the fiscal position gradually deteriorates mainly because of the aging of the population and the high continuing cost of the government's health programs.

Hmmm? I'm assuming the White House budget office is in the same building (aka White House) as the president and the staff who wrote the president's budget? Perhaps they should talk? And the above "rosy" projections or course assume that U.S. borrowing costs will remain at the lowest levels in the history.

The debt servicing levels are now at all-time lows. Borrowing to spend is cheap. But it is estimated that every increase of 60-70 basis points will add $100 billion to U.S. debt servicing charges.

According to the NY Times, the average rates that the government pays to investors in its debt have declined in each of the last five years, from 4.92 percent at the end of 2006 to 2.24 percent at the end of 2011. Rates have edged even lower so far this year. Adjusting for inflation, the government is borrowing at virtually zero cost.

While public debt doubled over the last five years, from less than $5 trillion to more than $10 trillion, the debt servicing costs remained about the same. Those rates could change in a heartbeat.

The administration's recent budget projects that rates will increase gradually over the next decade, the additional interest payments would approach $1 trillion.

The U.S. is at the point where the deficit situation has to be distilled down to its simplest terms. We have two lines representing government expenditures and government revenues. That revenue line has to get above the spending line. Or better yet, the expenditure line has to move down, even modestly, to get below the revenue line.

When you accomplish that bit of simple math, you're good. Hopefully (and soon) politicians will act as if they are smarter than a fifth grader.

What can be learned from the Canadian experience is that it will take two major forces. First there must be incredibly strong political leadership. And secondly, deficit elimination must become a national mission shared by all.

If those two forces come together, the U.S. could certainly eliminate the deficit, within a few years.

Seriously.

Source: How The U.S. Can Slay The Deficit In 4 Years