Putting Deficits into Perspective

Discussions regarding Federal Deficits lack perspective:

“Real” verses Nominal Deficits – Deficits are always discussed in nominal terms, whereas inflation constantly diminishes the size of the “real” debt.

• For example, if National Debt begins the year at $10 trillion and the nominal deficit is $200 billion, no “real” deficit has occurred, if the inflation rate is 2% or above.

“Relative” verses Nominal Deficits – GDP growth is normally expressed as a real percentage, making comparison with nominal deficits more difficult. However, “relative” debt growth is critically important – growth in nominal debt matched against the growth rate in nominal GDP.

• For example, if nominal growth in GDP is 5% (3% “real” and 2% inflation), then with National Debt at $10 trillion, any nominal deficit less than $500 billion represents an improvement in indebtedness relative to the size of the economy.

• The argument “debt on the backs of our children” looks only at one side of the ledger, since along with debt we leave an economy large enough to support that debt, as long as relative growth is roughly equal.

• Since relative growth is the important factor, “paying off the debt” should not be part of the discussion, since the attempt to do so would either require higher tax rates that slow economic growth and may not improve relative debt, or lower tax rates that are not low enough for the economy to achieve its full potential. Tax rates should be set to average moderate decreases in relative debt, taking into consideration normal business cycle reductions in both revenue and growth rates.

Government numbers are worthless, when analyzing relative improvement or deterioration, since they do not reflect the present value of commitments made during the year and the increased liability caused by inflation or cost of living adjustments, on commitments made in prior years. To get an accurate picture, some form of “generational accounting” will be required.

Future Deficits – Future Entitlement driven deficits will play havoc with credit markets and with the economy, because they represent excessive transfers from the productive to the non-productive. Missing in these discussions is the other side of the ledger. Entitlement transfers will not be lost to the economy, but will become revenues for bloated medical and support services for the aged.

Don’t expect the productive economy to absorb these excess costs through taxes. As workers become a scarce resource, they will demand that after-tax compensation rise in real terms, and they will get it through free-market competition for their services. The political power of retirees will be outweighed by the economic power of workers. To avoid salary induced hyper-inflation or skyrocketing inflation-fighting interest rates, eventually benefits must be cut deeply enough to match nominal debt growth with nominal GDP growth.

As long as relative deficits do not grow, credit markets should continue to absorb debt. However, our current grossly excessive deficits will soon result in increased interest rates, resulting in increased interest cost that will compound the relative deficit problem. As interest rates move up, a premium will be added to compensate for increased interest rate and market risk. Since much of our outstanding debt is short term, interest rate increases will not only affect debt from on-going deficits but existing debt being rolled over.

Monetization of debt may be theoretically justified to fight current deflation, but it significantly increases future interest rate and/or inflation risk, since the only way to keep future inflation in check will be to issue enough additional debt to reabsorb excess capital, at a time when credit markets will already be clogged. Such inflation fighting action will be politically unacceptable, since high interest rates will choke off any 2010 recovery, just prior to 2010 elections.

A detailed plan to get back to relative debt balance must be announced soon, before the lid blows off credit markets. Because growth rates are so important to relative debt, any realistic plans must include actions that promote business development and reduce government interference.

Disclosure: Long APL and HL.

Comments

[fireball:]

you are right about entitlments. they are to much. the contract is broken. the u.s. government will default on the system we were forced to participate in. i do not believe that will stop them from becoming more and more coercive to maintain and force new participation. that is not just or fair but we are talking about government. best to prepare for the worst in the area of retirement.
your article makes sense. i think politicians are going to continue toward national destruction instead. to cut off welfare and stipends will probably cause violence from the parasites. they will not disapoint the voters they buy nor the voters that buy them.
start getting ready to take care of your own. take very good care of your body.

May 25 09:13 AM

[farmer448:]

The only problem with the analysis is we have things like TIPS and cost of living adjustments. People forget that in the inflation of 1973 through 1980 the middle class was again hosed. Thus the use of inflation as a hidden tax was greatly reduced.


Congress has a lot of tough issues on its plate. It is time for the electorate to force congress to act or do not re-elect them.

May 25 10:06 AM

[the Gnome:]

By and large, I agree with your article. One point that seems at odds with reality is when you say...

"The argument “debt on the backs of our children” looks only at one side of the ledger, since along with debt we leave an economy large enough to support that debt, as long as relative growth is roughly equal."

You ignore the real (present) problem of piling up of debt for additional transitory consumption. This is not 'relative growth' because it is gone for the economy before the taste leaves the mouth.

We seem to be in uncharted territory; but that is only due to our infantile belief that we cannot suffer the same fate of so many other 'lessor nations' in past memory.

May 25 11:04 AM

[Ned Williams:]

Farmer:

I totally agree that we need to reboot, with a whole new attitude from our legislators. That's the point of my upcoming book, Fixing Everything. We need a new framework for spending.
On the subject of TIPS and "cost of living" escalators, as the ratio of workers to non-productive decreases, demand for their services will go up. Competition for their services will drive up real take-home demands at an accelerating rate that will stay ahead of such adjustments, creating a hyper-inflationary spiral. The only way to stop it will be to cut benefits.

Ned


On May 25 10:06 AM farmer448 wrote:

> The only problem with the analysis is we have things like TIPS and
> cost of living adjustments. People forget that in the inflation
> of 1973 through 1980 the middle class was again hosed. Thus the
> use of inflation as a hidden tax was greatly reduced.
>
>
> Congress has a lot of tough issues on its plate. It is time for
> the electorate to force congress to act or do not re-elect them.

May 25 12:28 PM

[Gregman2:]

Thanks for this. The CBO data in terms of interest on the debt starting in 2014 is more than sobering. And I think it's adjusted for inflation.

May 25 02:28 PM

[edgebander:]

While your math is correct your logic seems a little flawed, the reality of the situation is that we don't have a two percent inflation rate, and we don't have a 200 billion dollar deficit, what we have is a roughly ten times that amount, so to suggest that we can just inflate away the dangers of the spiraling deficit is totally irresponsible, and potentially dangerous.
The reality is there are many people who believe that deficits are normal and should be viewed as the cost of doing business, well I hate to say it but that is absolute baloney. The nominal and real costs of servicing the debt in future years will take away the governments ability to actually have government. Include in that the costs of social security and medicare and your talking about a yearly shortfall of twice what it is this year. Unless you can somehow comeup with a way of GDP growth in the neighbourhood of fifty percent year over year for ever your initial comment is irresponsible and minimizes the real and nominal threat of deficits and deficit spending. Not to mention the fact that TIPS adjust UPWARDS to cover inflation.

Good Luck with your book

May 25 06:22 PM

[Ned Williams:]

edgebander

Current government spending is outrageous and the inflation risk is incredibly high. This article is not intended to justify any spending commitments under the last two administrations.
The book supports a citizen revolt, by presenting a rational plan to get government spending under control. It's no good to throw the bums out, if you don't have specific instructions for the new bums.
Spending will be limited to 20-22% of GDP. It is only that high, because the plan is intended to be revenue and expense neutral (pre-bailout), and because it will take approximately 30 years of increased interest expense to work off legacy costs from excess entitlements and the portion of the bailout spent before we retake control or before credit markets slam on the brakes.
Once you've gotten spending under control, limited debt financing is a reasonable way to finance it, but before you can discuss such a plan, you must put deficits in perspective.

Ned

May 25 08:02 PM

[ART DAVE:]

one more factor not considered in the analysis in not well covered. that is the factor of

1.currency and
2. to whome the government debt is owed.

1. CURRENCY: currency is considered this analysis indirectly in inflation. if us dollar declines, the inflation will increase. so, authomatically debt will grow. however, unique thing about us dollar is that this currency is perceived to be superior currency of past decade and lot of funds and specially foreging funds have moved into us dollar keeping currency from declining at a rate which it should. in the event that extra oridnary amounts of borrowing occurs by us government, and rest of world appetite will die and usa will see large depreciation in currency to make up for depreciation we have not seen in last 5 years. the effect may be similar to overvalued stock going down in value at a faster rate than market it should to compensate for the past. resulting inflation and deficit spiral will be harder to control. this leads to my second point:
2: TO WHOME DEBT IS OWED.
large percentage of usa debt is owed to foreigners. thus, payment of interest goes out of the country and has little impact in wealth builging or income of citizens of the country. as opposed to couuntry (such as india, 95% debt is owed to country's own citizen). so when government pays interest, most of the money remains in economy. lot of middle and lower middle income people rely on interest income as a way for building wealth, income and consumption. this is feasible if country has large internal savings rate (in india 35% vs in usa 5-7%).
the other factor is that when debt is largely internal, negative impact of large debt also has an opposite impact that is increase in income of holder of debts which are citizens of their own country. debt is some time inevitable (such as world wide recession/deflation that creates extremely slow growth and government stimulus is required) but if debt is owed to your citizen, at least it also has a silvelining as mentioned above. that is not to say government debt can be increased carelessly but when required in careful manner can be good if it is owed to your own citizens.

May 25 10:22 PM