The Growing Federal Annual Budget Deficit, And Projected Cumulative Debt (Article 4 Of 10)

by: BeatlesRockerTom

Summary

In addition to the Medicare and Social Security unfunded liabilities, the annual Federal budget deficit, and resulting Federal budgetary debt, continue to grow.

The current combined Federal debt for all of three liabilities above is approximately $20 trillion as of this writing. http://usdebtclock.org/.

As deficits continue annually, debt 'held by the public' may rise from 77% of GDP ($15T) at the end of 2017 to 91% of GDP ($26T) by 2027.

A study conducted by economists Rogoff and Reinhardt shows that once debt hits 90% of GDP, future annual GDP could reverse to -0.1% annually.

Under current laws, the cumulative unfunded obligations for Social Security, Medicare, and the Federal Budget are projected to reach $49 trillion in 75 years.

Note: This article is the fourth in a series of ten articles addressing the future of slow GDP growth, high Federal debt, and strained household finances.

THE FEDERAL ANNUAL OPERATING DEFICIT AND CUMULATIVE DEBT

Take a look at this web site which tracks the cumulative Federal Operating Budget debt on a running basis. As of this writing, it shows $20 trillion (rounded up) of cumulative Federal debt: U.S. National Debt Clock : Real Time

THE NEXT RECESSION WOULD MAKE IT EVEN WORSE

If we have a recession in the next 10 years, it will only get worse. In his article dated May 22, 2017, John Mauldin addresses the potential impact: The Great Reset: How Should We Then Invest?

"History shows it is more than likely that the US will have a recession in the next few years, although one doesn’t appear to be on the near horizon. But when it does come, it will likely blow the US government deficit up to $2 trillion a year. Obama took eight years to run up a $10 trillion debt after the 2008 recession. It might take just five years after the next recession to run up the next $10 trillion. Here is a chart my staff created in late 2016 using Congressional Budget Office data, showing what will happen in the next recession if revenues drop by the same percentage as they did in the last recession (without even counting likely higher expenditures this time). And you can add the $1.3 trillion deficit in this chart to the more than $500 billion in off-budget debt, plus higher interest rate expense as interest rates rise."

"Whether the catalyst is a European recession that spills over into the US, or one triggered by US monetary and fiscal mistakes, or a funding crisis in China, or an emerging-market meltdown, the next recession will be just as global as the last one. And there will be more build-up of debt and more political and economic chaos."

"If I’m right about the growing debt burden, the recovery from the next recession may be even slower than the last recovery has been – unless the recession is so deep that we have a complete reset of all asset valuations. I don’t believe politicians and central banks will allow that. They will print and try to hold on as long as possible, thwarting any normal recovery, until markets force their hands."

Tom, here - Mauldin thinks that one trigger for the next recession could be an overshoot by the Federal Reserve in the rate at which it increases the Fed Funds interest rate. From his July 22, 2017 article: Three Black Swans

"What happens when the Fed raises interest rates in the early, uncertain stages of a recession instead of lowering them? I’m not sure we have any historical examples to review."

"Deflation in an economy as debt-burdened as ours is could be catastrophic. We would have to repay debt with cash that is gaining purchasing power instead of losing it to inflation. Americans have not seen this happen since the 1930s. It wasn’t fun then, and it would be even less fun now."

Tom, here. In his writings, Mauldin has been vocal about his lack of confidence in the Fed, and the Fed's potential to raise rates and trigger a recession. Mauldin's illustration is presented, not to support or refute his opinion, but solely to provide a discussion to demonstrate the following: Our current Federal debt load is high (Operating, Medicare/Medicaid, and Social Security debts). For this reason, we are positioned for potential risks which could stem from greatly expanding these Federal debts when (not if) the next recession occurs.

THE TEN-YEAR, 90% U.S. DEBT PROBLEM

A report by the CBO dated June 29, 2017 addresses the annual operating deficit and debt, and combines it with Social Security and Medicare debts to project results out for 10 years. It expresses the projected debt in 2027 in terms of percentage of annual GDP, rather than in a dollar amount.

https://www.cbo.gov/system/files/115th-congress-2017-2018/reports/52801-june2017outlook.pdf

Per page 5:

"As deficits accumulate in CBO’s baseline, debt held by the public rises from 77 percent of GDP ($15 trillion) at the end of 2017 to 91 percent of GDP ($26 trillion) by 2027 (see Table 5 on page 18). At that level, debt held by the public would be the largest since 1947 and more than twice the average over the past five decades in relation to GDP (see Figure 4).

Beyond the 10-year period, if current laws remained in place, the pressures that are projected to contribute to rising deficits during the baseline period would accelerate and push debt up even more sharply. Three decades from now, for instance, debt held by the public is projected to be nearly twice as high, relative to GDP, as it is this year—a higher percentage than any previously recorded in the nation’s history." (Tom here, Note, that includes in 1945 when WWII-related debt was at its peak).

Per page 6:

"Such high and rising debt would have serious negative consequences for the budget and the nation:

- Federal spending on interest payments would increase substantially as a result of increases in interest rates, such as those projected to occur over the next few years.

- Because federal borrowing reduces total saving in the economy over time, the nation’s capital stock would ultimately be smaller, and productivity and total wages would be lower.

- Lawmakers would have less flexibility to use tax and spending policies to respond to unexpected challenges.

- The likelihood of a fiscal crisis in the United States would increase. There would be a greater risk that investors would become unwilling to finance the government’s borrowing unless they were compensated with very high interest rates. If that happened, interest rates on federal debt would rise suddenly and sharply."

Tom - back again: The four potential problems above are all concerning. High debt handcuffs a government, and the 'suddenly and sharply' rise in interest rates per the CBO comment above poses a major threat.

WHY DOES SURPASSING FEDERAL DEBT OF 90% OF GDP MATTER?

According to the Economist: The 90% question

"In a 2010 paper Carmen Reinhart, now a professor at Harvard Kennedy School, and Kenneth Rogoff, an economist at Harvard University, seemed to provide an answer. They argued that GDP growth slows to a snail’s pace once government-debt levels exceed 90% of GDP."

"The 2010 calculation was a relatively simple one. The authors had already drawn on two centuries of public-debt data for their seminal 2009 financial history, “This Time is Different”. In their paper Ms. Reinhardt and Mr. Rogoff sorted the figures into four categories of indebtedness and took average growth rates for each. They found that public debt has little effect on growth rates until debt reaches 90% of GDP. Growth rates then drop sharply. Over the entire two-century sample (from 1790 to 2009), average growth sinks from more than 3% a year to just 1.7% once debt rises above the critical level. In a shorter post-war sample the decline is more dramatic; average growth drops from around 3% to -0.1% after the 90%-of-GDP threshold is attained."

Note that 'debt held by the public' excludes investments made by one government agency of bonds issued by another. For example, funds received by the Social Security Administration that are invested by purchasing Treasury bonds.

The formal report was accompanied by a CBO summary report: An Update to the Budget and Economic Outlook: 2017 to 2027

"The projected rise in deficits would be the result of rapid growth in spending for federal retirement and health care programs targeted to older people and to rising interest payments on the government’s debt, accompanied by only moderate growth in revenue collections. Those accumulating deficits would drive up debt held by the public from its already high level to its highest percentage of gross domestic product (OTC:GDP) since shortly after World War II."

MORE DEBT + HIGHER INTEREST RATES = RUT ROW!

From John Mauldin's article referenced at the beginning, he quotes financial journalist Terry Savage:

"Interest on the national debt is the third largest component of our annual Federal budget – after social programs and military spending. In the most recent fiscal year, we paid $240 billion in interest on the national debt. That was a relatively low cost, because the Fed has kept interest rates artificially low for years – as savers can attest."

"The Congressional Budget Office estimates that every percentage point hike in rates will cost $1.6 trillion over the next ten years! And that’s without adding to the debt itself every year, by running budget deficits."

"That 1% rate hike will take roughly an additional 3% of our current tax revenues every year. Governments must cover higher interest costs with additional taxes, lower spending, or an increase in the deficit (which means more total debt and even more interest rate cost)."

Again, we can't predict whether interest rates will go up or not. That's not the point. The point is, there is a potential that it could, and if it does it presents a significant risk to the annual Federal operating budget due to the present high level of debt, and the amount of increased interest expense which would crowd out other expenditure needs. Add another risk to the list (i.e., that of your garden-variety debt spiral, on Federal steroids).

THE $49 TRILLION, 75-YEAR PROBLEM

Near the end of the July 13th, 2017 aforementioned report (page 201), the CBO provides a projection of the unfunded liability gap for Social Security and Medicare (HI and SMI funds) for the next 75 years:

"From the 75-year budget perspective, the present value of the additional resources that would be necessary to meet projected expenditures, for the three programs combined, is $48.9 trillion. To put this very large figure in perspective, it would represent 3.9 percent of the present value of projected GDP over the same period ($1,250 trillion)."

Easily overlooked is the term 'present value'. To get a handle on the size of this figure, the universe is estimated to "only" be approximately 13.8 billion years old. This $49T projected unfunded liability budget gap is roughly 3500 times larger. Another way to put this into context: The entire U.S. GDP for 2016 was a little under $19T. List of countries by GDP (nominal) - Wikipedia

From page 206:

"Medicare and Social Security benefits can be paid only if the relevant trust fund has sufficient income or assets." That is, any supplemental funding to resolve the funding gap requires a formal action of Congress in order to fund Medicare and Social Security costs in excess of revenue inflow. Congress has to pass some act to fund the expenses, funded by some source, when the fund balances are depleted.

"From a budget perspective, however, general fund transfers represent a draw on other Federal resources for which there is no earmarked source of revenue from the public."

This last quote above is another way of saying that any increase in funding dedicated to the shortfall in Medicare and Social Security funding will come from the Federal government's general fund (or other sources) in the form of new tax income, new debt, or from reducing other Federal expenses.

No matter how many ways you try to consider possible funding solutions, the $49T present unfunded gap for projected costs of Medicare and Social Security in the long-term is unsustainable, and unfundable, at $49 trillion. We will never reach this level because the Federal Government won't be able to borrow this much to continue to pay it out. Cuts in expenditure levels appear unavoidable.

PREVENTATIVE CARE IS BETTER THAN CRITICAL CARE

Perhaps something will propel the economy to begin a significant secular growth trend, which may result in a continued substantial increase in Federal Tax revenues. On the other hand, as of this writing we're in the third longest economic expansion in US history, surpassed only by that of the 1990s and 1960s. Therefore, it may also be the case we could face a recession (or two) prior to 2027, which could worsen the Federal debt situation presuming tax receipts decline and deficits widen.

In the absence of major economic growth which would increase tax revenues, it's evident we need to make changes in government finances to prevent the debt from surpassing 90% of annual GDP. The President and Congress will need to:

1) Curtail the rate of growth of budgetary spending, and possibly raise tax revenues in some fashion to limit the growth of the Federal operating deficit/debt, or both.

2) Address the Social Security and Medicare funding gaps, through either increased tax income, a reduced rate of growth of spending, or perhaps both.

SUMMARY

So it merely takes steps 1 and 2 above: It's just that easy, eh? All of the above will be likely be necessary to prevent debt from exceeding the 90% GDP level by 2027. We had better hope inflation doesn't take off (however unlikely that may be), which would raise interest rates causing the interest expense on the Federal debt to grow even greater, crowding out money available for other expenditures.

Voters understandably expect a continuation of entitlements, and the seniors who will benefit from them represent a large, growing, and powerful voting block. But for 10 years or more we've witnessed a trend of Congressional polarity, gridlock, rancor, and animosity. As of this writing, it appears unlikely that Congress will begin to focus on, and agree to, putting the nation's future financial stability first. This would necessitate reducing the rate the Federal deficit gap by some combination of raising revenues (taxes) and slowing the rate of growth of expenditures, freezing or cutting them. Presuming there is no change, it is projected that in 10 years, the Federal debt will reach the 90% of GDP at which point it becomes exceedingly difficult to ever reduce the debt (absent drastic spending cuts and tax increases).

To reverse course, this might require some degree of slower growth if not austerity, until we lower the total Federal debt as a percentage of GDP. In the U.S., there have been very few years where the government ran a surplus (the 1990s being the last time). While it is not impossible, it might be improbable if for no other reason given the size of the Boomer retiree voting class and the pressure applied to elected officials to prevent entitlement cuts.

Looking back to post-1945 war debt, which reached 112% of GDP History of the United States public debt - Wikipedia , we outgrew the debt as triggered by the tax revenues from the significant post-war expansion resulting in part from the return of soldiers entering the workforce. Combine this with a surge in technological development as never seen before. If we are fortunate, fate will again supply technological breakthroughs, for example in medical care, AI, or perhaps green energy sectors, just to name a few. If this occurs resulting in greater tax revenues, and coincides with adjustments to Medicare and Social Security spending combined with prudent Federal budgetary spending policies, we may be able to slow the rate of debt growth.

BOTTOM LINE

1) Cumulative Federal Debt (Operating, Medicare and Social Security) is projected to grow from its present 77% of GDP (2016) to 91% of annual GDP by 2027.

2) Based on two centuries of sovereign government debt analyzed by economists Rogoff and Reinhardt, once the public debt achieves the level of 90% of GDP, subsequent annual growth shrinks to 1.7% annually. In a shorter post-1945 sample, growth shrinks to an annualized rate of -0.1%.

3) The government would be significantly handcuffed with regard to solutions to the high debt problem, and we could face interest rate increases which could occur 'suddenly and sharply'.

4) Based on the CBO report, we only have 10 years, give or take, to prevent borrowings from accelerating from the present 77% of GDP level to the critical 90% level.

5) Presuming no change in the current laws affecting tax revenues and expenditures, the CBO projection of the rate of expenditures for entitlement programs, less revenues, results in a $49T present value funding gap over the next 75 years. It's questionable that the Federal Government could ever borrow that much, which means at some point in time, cuts in expenditures may be unavoidable.

Disclosure: I am/we are long EQIX CONE COR MSFT O HASI JCAP UNIT STWD HD LOW.

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.

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