By Jason Born, CFA
We, as a nation, have become addicted to spending by the Federal Government and that addiction has gotten more severe in recent years as our dealer (Washington D.C.) has successfully tried to ensnare us further in order to solidify their positions as our overlords. Despite prominent Nobel Laureates claiming otherwise, our current path, if maintained, leads us to the very end of our Republic as we know it, or want to know it. In this paper, we will use the Federal Government's own statistics where possible. We will refrain from siding with any one party's or candidates proposals because we view this as something completely separate from politics. This is an American issue that can be solved with simple logic and the quaint science of mathematics. The problems and their repercussions are vast, the solutions are easy.
As with all issues, first we must identify the problem. We went to the budget pages of the White House (link) for help in identifying what is causing our ballooning debt. There are many fine historical charts and spreadsheets in the link provided, but we wanted the cleanest, most comparable data possible. We chose to study the gigantic Table 1.3 in the link which lays out Federal Government Receipts, Outlays, and Surpluses or Deficits in Current Dollars, Constant Dollars, and as Percentages of GDP (1940-2017). The data show that from 1940 to 2011, outlays as a percentage of GDP have averaged 20.6%. Now, if we take out the years for WWII when we fought on two global fronts which required uncharacteristically large spending, the average becomes 19.5% (it is interesting to note from other sources within the White House link provided, that prior to 1940, the Federal outlays as a percentage of GDP averaged in the single digits!)
The same White House link shows that over the past four years the outlays have averaged 24.4% and are projected to average 22.7% for the coming four years. Fear not, this is not an overt attack on the current administration as the previous administration averaged outlays of 20.5%, itself elevated from the average.
Absent WWII, the Federal receipts as a percentage of GDP averaged 17.4% since 1940. The current administration had to contend with a much lower number of about 15.2% due to lower tax revenues following the recession. See below for a table summarizing this information.
So the numbers themselves show that we had a temporary receipt problem due to the recession. That is fixing itself. However, a nonpartisan review of the numbers shows we've got a spending problem that, according to White House projections, continues into the future.
Before we tackle the easy solutions to fix our spending addiction, let us affirm why it is important to address it and why, if unchecked, it means economic disaster for our nation. In the same link and same table, the data shows the annual deficit continuing through 2017. It declines as a percentage of GDP according to these same projections, a good thing. The table also shows receipts climbing as a result of higher tax rates, better compliance, or solid economic growth. We won't waste time quibbling with any of the assumptions that went into these projections. We will, however show the implications if these results were actually to occur.
As we pen this paper, the Federal Debt (not counting the things the Federal Government chooses not to count - of course!) stands at $16.2 trillion (USDebtclock.org). Today's debt amounts to about 101% of GDP. Excluding WWII years, the Federal Debt at year end has averaged 58% of GDP. Depending on a host of factors, the annual interest cost today, with low rates, is about $300 billion.
Using White House projections (dangerous under any administration) from Table 7.1 in the White House link above, the debt will stand at about $21 trillion in 2017, about 105% of GDP, not a positive trend. Again, depending upon a host of factors the cost to simply pay the interest on that debt in 2017 is close to $1 trillion as interest rates rise to more normal levels (we've strayed from the Federal projections here, preferring to go with historical rates for U.S. Treasuries going back to 1798 which are available from the Federal Reserve). See summary tables below.
Returning to White House numbers, Social Security will eclipse defense spending by 2017. SS is projected to cost $1 trillion. Medicare/Medicaid will also eclipse defense spending and cost about $1 trillion in 2017. Add in our estimated interest cost of another trillion and you get $3 trillion of outlays before you even pay to run the Federal Government (defense, commerce, state, etc.). While admittedly arbitrary, historian/economist Niall Ferguson suggests that when a country begins to spend more on interest costs than they do on defense, it is a sure sign that said nation is in decline. Furthermore, our $1 trillion assumption for the interest expense for the Federal Government in 2017 is predicated on a return to the long run median rate for Treasuries. However, there is historical precedent for the marginal investor demanding considerably more in interest from sovereign debt as over the years governments of all sorts have increased their spending and debt loads beyond 100% of GDP. If this jump in rates was to occur, the ability of the Federal Government to fund itself for basic functions, let alone be flexible for emergencies, disappears.
So we've got a spending problem which has led to a debt problem, both of which, if continued, jeopardize the ability of our Federal Government to fund itself and operate without a dramatic rise in tax rates - which will certainly be squandered on the next "necessary" program like all previous tax hikes from all sorts of administrations. Our assertion here is nearly inarguable when one studies our government expenditures for the past 100 or even 200 years.
Let's drill down to see what we currently and what we will spend most of our money on according to the White House budget office. The table below showing spending as a percentage of outlays and the table above showing debt to GDP are likely the most important in the paper. Study them.
Please note that from a purely financial perspective each of the departments above, with the exception of defense, is claiming an ever-growing slice of the pie in percentage terms (if you're curious to see how massive they grow in dollar terms, use the White House link and click around). Medicare shows the largest growth, followed by the interest on debt (in this case using the White House's own numbers), and then SS.
So while we applaud politicians for discussing the role of Federal Government spending in a myriad of issues such as PBS funding or the Department of Education, unless they seriously talk about one of the four departments listed above (preferably all four) they waste their time and ours as those departments alone will make up 84% of the budget which itself includes a barely-believable six percentage point decrease in defense. Just like the last time your family had a cash flow crunch, the first thing you tackled was not buying generic cereal instead of Kellogg's (K). To the contrary, you handled the biggest expenses first - shelter, car, energy, cable, etc.
We've spent a lot of time, text, and tables to convince you of the problem and its serious nature. The solutions are quite simple for those interested in governing rather than denigrating opponents to assure election or re-election as the case may be.
Solutions to the biggest financial problems in order:
1. Medicare/Medicaid - Just like private insurance companies must do, increase premiums and deductibles. Since somewhere along the line it's been decided that a progressive tax system is fair, increase the premiums and deductibles more for higher income folks and a little less for low income folks. All participants must pay premiums and deductibles to make sure proper market signals or incentives are conveyed. Remove all these payments from the general Federal Budget.
2. Interest - Immediately extend the average maturity of the Treasuries issued to take advantage of the current low rates for as long as possible. This must be done in conjunction with both a Medicare and a SS fix or else the inevitable is just delayed.
3. SS - For those in or fast approaching retirement change nothing except increase the amount of SS taxed for high income folks. For those fortunate enough to be young, raise the age of retirement (remember when SS came about the age or retirement was 65 while the life expectancy was 66). Such a change still achieves the aim of the program which is to prevent our seniors from dropping into poverty. Oh, and don't say, "I paid-in and so I deserve it." In reality, ever since the program's inception, no one has "paid-in" to SS. Every dollar you've "paid-in" was immediately transferred to the Federal Budget as are all tax receipts in order to be spent as the government went along (salaries, roads, etc.). Remove all SS tax receipts from the general Federal Budget to prevent them from being spent on other stuff.
4. Defense - Continue to spend more than any other nation on the planet on defense in order to prevent war. Then demand with a real, bipartisan threat of impeachment that no president start a war without a Congressional declaration. Forcing a president to follow the Constitution in this case saves mountains of "unexpected" expenditures from efforts as diverse as Vietnam, Iraq II, Libya, and, God-forbid, Iran or Syria or North Korea. If small amounts of troops or treasure must be sent hither and yon periodically, precise, short term exceptions can be made.
That's it. Making these small changes or something like them, alter all the forecasts for the better. The world and rating agencies such as S&P and Moody's see that we are serious about our finances. Therefore, the world lends to us at continued average or cheap rates. We honor our promises to seniors and take care of the less fortunate. We defend ourselves and preserve the ability to project power to keep foes away from our shores. Once these changes are made, we can return to bickering about smaller fiscal issues with a clear conscious and ample breathing room as growth resumes.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.