Real-World Effects Of Treating A Country's Budget Like A Household Budget

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by: Derek Tomczyk, CFA

This is a third in a series of articles on debt, debt burdens and economic growth. It's been two months since I've written and posted the first article in the series on the relationship between the debt/GDP ratio and economic growth. In the article I explain that cutting spending and/or increasing taxes during an economic downturn is mathematically guaranteed to depress the economy further and increase rather than decrease the deficit and debt. It is a self defeating approach to balancing the budget which can only lead to economic ruin. The fact that such "debt cutting" policies were actually followed by European nations under the label of "austerity" is really hard to understand, until you realize that these policies were inexplicably supported by economists at organizations such as the IMF.

The good news for the world economy as a whole is that the IMF has come around and admitted their error. They are absolutely shocked that it turns out raising taxes/cutting spending cannot reduce your deficit while you have a weak economy. I'm glad they realize their mistake but the question remains why world renowned economists blundered and almost lead the world into an unnecessary economic collapse. To be sure, there were some economists that were predicting these dire outcomes for austerity, but they were ignored and ridiculed by people who should have known better.

This mistake, which without a doubt added years to the world recession, and probably will continue to do so (since politicians don't like to backpedal too fast), is even more inexcusable since there is plenty of historical evidence showing what happens when a country tries to eliminate their debt burden through actual debt reduction. I already looked at the only time the US has ever reduced its debt burden while maintaining growth in "The Amazing Dissapearing Public Debt Burden" (spoiler: it didn't involve paying off any debt) so now let's take a look at another episode where instead the deficit hawks took over.

In 1918 the United States entered World War I and in 1916 it began its deficit spending in order to finance their war effort. The US economy was struggling prior to that point with declining GDP in 1914 and only a meager recovery in 1915. It was only when the deficit spending started that the economy started showing life.

US Debt and GDP between 1910 and 1934Click to enlarge

The debt burden of the country, the only relevant measure as I prove in my previous articles on this subject, started receding as the GDP increased, however, this was not enough for the deficit hawks at the time. They needed outright debt reduction because next-generation/be-responsible/dollar-will-collapse. In general the exact same arguments you hear today. At first it was decided to close the deficit gap by drastically raising taxes on the rich. This approach failed as it just created incentive for wealthier people to lower reportable income.

Then it was decided that the wealthy were being over-taxed and if only they had their taxes lowered the economy would be flourishing. The highest marginal tax rates were drasticaly reduced and the stock market rallied. However, while this approach created a stock market bubble, it ultimately failed to create a sustained recovery when the great depression returned both the GDP and stock market prices to pre-1920 levels and the debt burden (debt/GDP) hit new records.

Click to enlarge

If you think the above explanations are simplistic you are right. I am not trying to write a detailed history of public or economic policy during the above period of time but rather I am trying to illustrate the relationships between public debt and economic growth variables that have held over the past 100 years. The only thing that stayed consistent between 1919 and 1931 was that the public debt level continued to be reduced. The debt/GDP ratio was also falling due to the reduced debt but GDP growth remained anemic and eventually proved to be temporary. Regardless of the reasons for the debt reduction, this does not support the idea that reducing the US debt level would spur economic growth through some type of increase in confidence. It also shows that debt burden (debt/GDP) reductions driven primarily with concern for the debt portion of the ratio ultimately end up failing on both the debt burden reduction and economic growth fronts.

The questions begs then why both candidates for president are running on debt burden reduction strategies that have clearly failed in the past. I believe the answer has much to do with the average American citizens experience over the past 5 years. Notice that the general public was not particularly concerned about debt/GDP ratios or debt increases until after 2008. This is not because either has increased any faster post 2008 than in the 50 years preceding:

Click to enlarge

It is rather purely psychological in that the voting public now considers debt a bigger problem than they did before. They consider it a big problem because they experienced debt problems on a very personal and immediate level and it's very easy to create parallels between your own situation and the country situation.

To illustrate another way, most Americans considered housing an extremely safe investment in 2007 and considered housing an incredibly risky investment in 2011. The reality is the exact opposite of course but it should help illustrate why debt is all of a sudden such an important public issue. Personal or anecdotal experience trumps history, statistics and logic every time. It is also why both sides of the political spectrum have rather cynically used the public obsession with debt as a way to try to win political favor from the electorate. They are both trying to prove they are better deficit and debt fighters at a time when the economy does not need any deficit or debt fighting.

The reality is that you cannot treat a country debt problem the same way you treat a household debt problem. The major difference being that what a single household spends has nothing to do with their income. What a country spends is entirely also its income. In fact as described in my previous article and as the IMF has now figured out the impact of spending cuts on income is a reduction of more than 100%. The impact of a household spending cut on its income is exactly 0%.

In summary, if you really care about future generations, reduce the debt burden (debt/GDP), not the debt. American history tells us that the only realistic way to reduce the debt burden is through growth in the GDP component and never through the reduction of debt. It really doesn't matter whether you raise taxes or you cut spending to try to reduce the debt, they are both equally bad approaches. If, however, you require more recent proof just take a look at Europe. Contrary to popular belief most of European countries had no public debt issues prior to the 2008 recession(go ahead look it up on Google's excellent public data charts). The GDP collapsed due to private debt levels and the public debt increased as a response to this crisis, and in turn the response to this public debt increase was austerity through spending cuts and tax increases which delayed de-leveraging on both public and private fronts. These policies have not worked to help the economy in Europe, or in fact even to reduce the debt, and will not work in the US either.

The good news is the tax hikes proposed by Obama are nowhere near as drastic as those in 1918 and the spending cuts by Romney are nowhere near as bad either. There is also a good chance both candidates are simply playing to the public knowing full well the historical record and planning to run deficits. Ironically, it is the US governments lack of ability to follow through on debt reductions that has helped the country lead the meager world economic recovery and is likely to continue to do so. The US economy and ETFs like SPY, QQQ and DIA should continue to outperform the rest of the developed world, not despite, but because of the lack of meaningful public debt reduction.

Disclosure: I am long SPY, QQQ, DIA. 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.