Does The U.S. Have A Public Spending Problem?

by: Shareholders Unite

In answering this question, it's important to make a distinction to the short and the long-term. In the short-term, the US doesn't really have a public spending problem, as spending is what is required to compensate private sector deleveraging (spending less and saving more in order to repair balance sheets, greatly damaged as a result of the financial crisis).

Public spending is also needed to compensate for the relative powerlessness of monetary policy, the usual tool to improve demand. Interest rates are essentially zero, making monetary policy near impotent, as at the same time making borrowing for the public sector very cheap.

But, of course, monetary conditions the economy will ultimately recover, and public spending can't increase forever, the critics are right about that. Still, there are two additional points to be made here. The first is that not everybody realizes that an economic crisis automatically increases public spending and reduces tax receipts.

The structural budget deficit is one where these effects have been eliminated, that is, it's what the budget deficit would be if the economy would run close to what it could produce. An indication is the following figure which depicts the primary deficit (the deficit excluding interest payments) and the output gap (the gap between potential and actual production).

You notice immediately the high correlation, that is, the state of the public budget is mostly driven by the state of the economy. According to Evan Soltas, that structural deficit is less than 2.1% of GDP, which isn't a terribly large figure. That means that 2/3 of the deficit is cyclical, due to the bad economy.

Therefore, it isn't terribly surprising that relatively modest spending cuts and/or tax hikes worth $1.2 trillion over the next ten years would already stabilize the debt/GDP ratio, according to Richard Kogan from the Center on Budget and Policy Priorities.

Kogan also mentions something else which isn't widely known, that there have been already significant spending cuts under the Obama government, even at the Federal level:

$1.5 trillion in appropriations cuts (and another $200billion in associated interest savings), primarily through the annual caps in the 2011 Budget Control Act [Kogan]

In fact, of the roughly $2 trillion in policy savings, almost three quarters come from spending cuts and 28% from tax hikes. If you add state and local government to the picture, there is even less reason for alarm over 'runaway' public spending.

Long term problems?
In the long term, there are some worries, mainly because of an aging population. However, the US isn't really the first place to worry, as it has two crucial advantages over almost all other rich countries. First, it's the country which has the smallest public spending bar a few, like Switzerland.

Secondly, the US has by far the best demographic future. The latter especially will lead to a combination much higher public spending in areas where the population is likely to shrink, like Japan and much of Europe (pensions, healthcare) and lower tax receipts because of a shrinking working age population.

But the US doesn't suffer from such a demographic time bomb, quite the contrary, its population will continue to grow at a healthy clip. The US also doesn't have anywhere near a 'European style' welfare state, yet there is considerable alarm over "runaway" public spending in some quarters.

Take the following Investorsdaily editorial, for instance. Here is the 'alarming' perspective for 2022, that's ten years from now and the situation supposedly is dramatically worse than today:

By 2022, federal revenues will top 19% of GDP, which is significantly higher than the post-World War II average. But spending will exceed 22%, and keep climbing.

Frightening! Federal taxes of 19% of GDP, that's half of what they are in most other countries today, not in ten years. And a public sector of 22% of GDP in ten years is small, not big, and there are good reasons why the public sector grows somewhat disproportional to GDP growth in rich countries.

One of the reasons is known as "Baumol's disease." This describes the consequences of differences in productivity growth in industry, where it is easy to raise productivity, and the public sector, where by nature it is much more difficult to raise labor productivity. Government is in education, health-care, national defence, governance, all sectors for which it is very hard to raise labour productivity (through automation). However, for the sake of labour market competition and issues of fairness, it has to offer similar salaries as industry.

Industry can raise wages and pay for it through increases in labor productivity, and overall labor cost will remain flat. If the public sector raises wages at similar rates, but without the offsetting increases in labor productivity, it means that its labor costs will increase, relatively to industry (or the private sector at large, although this is a bit of a simplification).

Which means the public sector is slowly getting more expensive, even without a single new policy initiative! Is this bad? Not necessarily, because higher incomes in the private sector also increase tax income, at least partly offsetting the increase in public sector cost.

Also, as people get richer, their preferences change. They place more importance on a safe environment, on healthy products, on a cleaner environment, better schools for their children, better healthcare, etc. all sectors which make disproportionate claims on the public sector (through regulation, justice, law enforcement or direct government involvement).

So as countries get richer, the public sector gets automatically more expensive because it consists mostly of activities which can't keep pace with productivity growth in industry, and demand for public sector services increases.

There is nothing necessarily dramatic about this development, but it does mean the public sector requires more funding over time. Other advanced countries, like Sweden, Denmark, Germany, the Netherlands, Norway, have shown that this isn't necessarily problematic for economic performance either.

For instance, the Nordic countries, despite their much bigger public sectors and way more generous welfare states, are not necessarily less innovative or dynamic (see this important study by Maliranta et. al.). They might be a little less rich than the US, but they take more of their welfare in non-monetary forms, like longer holidays and a bigger safety net. And one might keep in mind that this isn't necessarily inferior, based on surveys, Stiglitz concludes:

the countries that have the highest spending on social programs are far and away the happiest...

And why would this be? Well:

They end up with economic prosperity that is broadly shared, very low poverty, low unemployment, social fairness, lower health care costs than in the United States, longer vacation times, guaranteed maternity and paternity leave, better pre-school and many more benefits that make people happy, and help them to raise happier and healthier children. In short, happier places are happier because they combine economic prosperity with social trust, a sense of equality, leisure as well as work, and good and honest governance.

Of course, there are those that argue that the European model is bankrupt, like the Wall Street Journal:

Europe's vaunted social model has struggled to generate growth or jobs for decades.

Jeff Sachs advises them to get a fact checker over this. The five biggest European welfare states have lower public deficits/GDP lower public debt/GDP and lower unemployment compared to the US.

However, Europe's problems are related to the euro and are distinctly more recent as it has seriously hobbled the continent. The deflationary workings of the euro is very much like that of the gold standard in the 1930s. It's therefore more than a little curious that many of the greatest critics of the European model also are in favor of a return to the gold standard.

And, as Antonio Fatás points out, even during the euro years, the performance of the labor market has actually been better in the euro area, despite recent euro induced crashes in countries like Spain, Greece, Portugal and Ireland, here is the chart from his article:

This doesn't mean things are ok, far from it, but the welfare state or running away social spending has little to do with the eurozone crisis, with the possible exception of Greece. But, as Bruce Barlett and others have noticed, the US isn't going to turn into Greece anytime soon (or ever):

What got Greece into trouble- as well as every other country that has meaningfully flirted with bankruptcy - is that they borrowed money in a foreign currency. [Barlett]

That doesn't mean the US can borrow forever (although and historical examples after WOI and WOII and the more recent Japanese experience suggest that debt/GDP can be run up way more than at present in the US).

As Bruce Barlett noticed:

A recent study from the Bank for International Settlements in Switzerland, which is the central bank for the world's central banks, suggests that there may actually be too little government debt to go around. The demand for safe assets is so great that governments with the ability to borrow in their own currency have no effective limit on how much of their debt markets will absorb.

However, besides having a small state and much better demographics (crucial advantages for the sustainability of the health of long-term public sector finance), the US is notably different from most other advanced economies in a third aspect. The US suffers from an extraordinary inefficient healthcare sector, the only part where spending is indeed way too onerous.

According to the OECD, the club of rich industrialized nations, the US spends nearly 17.6% of GDP on healthcare while the average for the OECD is 9.5%. This is a truly remarkable gap, as these other countries mostly have lower GDP as well, leading:

The United States spent 8233 USD on health per capita in 2010, two-and-a-half times more than the OECD average of 3268 USD (adjusted for purchasing power parity). [OECD]

The US doesn't exactly produce better health outcomes (one could even argue the contrary). It has fewer doctors per capita than the OECD average (2.4 per 1000 population, compared to 3.1 for the OECD), less curative hospital beds (2.6 per 1000 population versus 3.4 for the OECD). It has more fancy technology, but this doesn't seem to have made much of a difference; life expectancy in the US has risen less (almost 9 years between 1960 and 2010 versus 11 years for the OECD and 15 years for Japan):

As a result, while life expectancy in the United States used to be 1 ½ year above the OECD average in 1960, it is now, at 78.7 years in 2010, more than one year below the average of 79.8 years. [OECD]

So the more 'socialist' healthcare systems of many other advanced nations are way cheaper and often produce better results. This is no surprise for economists who realize that healthcare is plagued with market inefficiencies:

Doctors and hospitals in the U.S. have every incentive to spend on unnecessary tests, drugs, and procedures. [Robert Reich]

What's even more remarkable is that the socialized parts of US healthcare are the cheapest by far, which leads Reich to conclude that:

we'd do better to open Medicare to everyone. Medicare's administrative costs are in the range of 3 percent. That's well below the 5 to 10 percent costs borne by large companies that self-insure. It's even further below the administrative costs of companies in the small-group market (amounting to 25 to 27 percent of premiums). And it's way, way lower than the administrative costs of individual insurance (40 percent). It's even far below the 11 percent costs of private plans under Medicare Advantage, the current private-insurance option under Medicare. [Reich]

The Reich article is also particularly good at pointing out that apart from healthcare, there really isn't much 'runaway' public spending in the US anywhere else in the public sector.

What should investors take away from all this?

  • Public finances are not nearly as bad as is routinely portrayed in most of the financial press. The biggest part of the public deficit is caused by the weak economy, not by any 'runaway spending.'
  • Even long-term, the US is in much better shape than most other advanced countries because it enjoys the combination of a much smaller public sector and a much better demographic future, and significant cutbacks at the Federal, state and local levels have already taken place.
  • The US isn't on it's path towards a 'Greece style collapse' because unlike Greece, its debt is issued in its own currency.
  • As long as the private sector is deleveraging, there is no need for immediate cutbacks in the public sector as this risks compounding the low private spending. Also, interest rates won't rise as long as the private sector is deleveraging, because this generates a savings glut, so bond investors have little to fear immediately.
  • Baumol's disease and changing preferences slowly increase the size of the public sector, but experiences from countries like Germany, Sweden, the Netherlands, Denmark, Finland suggest that even a much bigger public sector does not necessarily compromise economic performance much, if at all and there is solid evidence it improves the welfare of most people.
  • The US does have a long-term spending problem and it's in healthcare. Compared to other advanced economies, the US suffers from a particularly inefficient, wasteful and outsized healthcare sector.

Why all the alarm in much of the financial press? Well, for a part this is ideological. We have no problem people preferring a small public sector, as long as one realizes there are no compelling economic reasons for that. Part of it, we guess is that macroeconomics is counterintuitive, especially when the economy suffers from zero interest rates and a deleveraging crisis.

Balancing the books for the public sector when deficits get large might be appropriate for households and firms, but one has to realize that the economy as a whole is subject to a different dynamic. It's an (almost) closed system, if private and public sectors both start to balance their books, a downward spiral is inevitable, especially when monetary policy cannot offset such a fall in spending.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.