The Bear’s Lair: Debt and Taxes become more inevitable

The White House’s 2019 Budget is pure fantasy, but it assumes a deficit in the year to October 2019 of $984 billion. However, Congress’s 2-year Budget deal has added at least $80 billion more spending, pushing the deficit well over $1 trillion. Since we are at the top of a business cycle, with unemployment around 4%, this is very disquieting. However, the driver of current deficits is more a past lack of productivity than a burst in profligacy, and it is there that we must look for a solution.

Even with the deficits above, the Budget is said to be too optimistic, because it assumes a growth rate of 3% per annum over the next 10 years, considerably higher than has been achieved in the last decade. We are almost bound to get a recession over the next few years, which will push the deficits much higher, probably over $2 trillion.

The United States is still a considerable way from the brick wall of bankruptcy. Debt held by the public is around 80% of GDP, and if rapid growth happens as the White House predicts, will not rise much in the next decade. However, there is also debt held by the social security trust fund, which will all be needed by the time the trust fund runs dry in 2033; include that and debt rises to about 110% of GDP. Nevertheless, even if the White House is somewhat over-optimistic, 110% of GDP is a long way from the highest level that has ever been successively dealt with, around 250% of GDP, brought down to lower levels by Britain after 1815 and after 1945, and the level at which Japan’s public debt stands today.

These excessive deficits should not be blamed on any great profligacy on the part of President Trump, or even on that of the Obama Administration in 2009-17, both of them aided by an irresponsible Congress. Both Trump and Obama are too fond of spending money, and Congress is grossly irresponsible, but Presidents have been profligate and Congresses irresponsible for several decades now. However, the United States’ deficit problem has recently been exacerbated by two factors: the destabilization of Social Security and Medicare through the retirement of the baby boomers and the last decade’s excessively slow productivity growth.

The social security “bulge” has been a known problem since the social security reform of 1983, which increased the retirement age from 65 to 67, starting in 2027. It is actually a combination of two problems: the “bulge” from the retirement of the baby boomers and the gradual extension of life expectancy. The “bulge” problem was nearly but not quite solved by the 1983 reform; by 2033, the youngest cohort of the baby boomers will be 69, already mostly retired, and the oldest cohort will be 87, already mostly dead.

In other words, the bulge problem can be solved by a fairly small increase in social security contributions or can be allowed to hit retirees with an unpleasant but not fatal drop of about 25% in their pension post-2034. The longer-term actuarial problem can then be fixed by continuing the delaying of retirement dates by 1 month a year after 2027, so that retirement comes at 68 in 2039, 69 in 2051, 70 in 2063, etc. See, that wasn’t too difficult, was it? We still haven’t solved the Medicare/Medicaid trust funds bankruptcy, however..

The last decade’s excessively slow productivity growth is a more fundamental problem, since it affects the entire U.S. economy. Eyeballing it, the productivity growth deficiency ran at about 1% per annum in the eight years 2009-16, more in the latter years of that period. Because of it, after eight years, the U.S. Gross Domestic Product is roughly 8% of GDP lower than it “should” be. As a result, budget revenues are about 2.5% of GDP less than they ”should” be (including social security contributions) and expenditures are about 1.5% more than they “should” be.

Knock out that gap of 4% of GDP, and the budget is close to balance, with a deficit of less than 1% of GDP (as it should be at this stage in the economic cycle.) Even though Presidents are profligate and Congresses irresponsible, therefore, their budgetary weaknesses, as distinct from their other policy weaknesses that caused the productivity deficit, are not primarily responsible for the budget deficit problem.

Having identified the cause of the budget problem does not get us much closer to solving it. There are three possible causes for the appalling productivity performance of 2009-16. First, it may as Professor Robert Gordon has suggested be only the first stage of a productivity slowdown that is expected to last for the remainder of the 21st Century, because our innovation is no longer proceeding at the rate it did during the first and second Industrial Revolutions. In that case, we’re stuffed. The productivity malaise of 2009-16, which showed strong signs of lifting in 2017, is in fact permanent and likely to get worse as innovation slows to a halt around 2100.

In that case, there is no way to get our politicians’ bad spending habits within control. In about 20 years’ time, the United States will default on its debt. After that, with an apparently unstoppable influx of progressively less capable immigrants, declining education standards domestically and no credit rating, the country is doomed to an impoverished future. It is not just a question of not getting any richer; the country is doomed to get much poorer and continue its impoverishment thereafter. So we had better hope that, as appears likely, Professor Gordon was wrong.

At the other extreme, the productivity dearth will have been caused by some combination of Obama’s over-regulation and crazed Fed monetary policy, and we have the will not to make either mistake again, for decades to come (it is by no means clear that we have learned our monetary policy lesson, in particular). In this best case scenario, the lost 8% of GDP growth will turn out not to be permanently lost, but instead, even if we have to a suffer a recession to wipe out the excess mal-investment of the “funny money” years, growth will generally run faster than average over the next decade or so. Provided that the politicians are restrained, that would reduce the budget deficit to zero by say 2027 and solve all our problems. Birds would sing, the sun would shine, and we would have achieved Nirvana. I’d say this extreme was also unlikely, hopefully slightly less so than the Gordon gloom.

In the third case, which I regard as most likely, we avoid repeating the horrid mistakes of the Obama years and proceed from here at a decent growth rate, with any short-term recession being made up quickly. However, the 8% of lost GDP is lost forever. In this case, we must first be vigilant against a resumption of the policies that caused productivity growth to disappear, namely excess regulation and funny money. Even without such policies, we still need to beat up politicians to reduce spending and/or to increase taxes, ideally before a financial crisis forces them to, at which time it would be more difficult.

Binding future administrations not to regulate is tricky, but there are two other steps we can take to keep policy on a better path. First, the U.S. needs to pass detailed fiscal responsibility legislation, similar to New Zealand’s 1994 Fiscal Responsibility Act, but ideally more restrictive. Budgets need to be mandatorily agreed on a two-year basis, before the start of the first of the two fiscal years concerned (another two-year Budget would be agreed in the following year). The President (or alternatively the Speaker of the House of Representatives) should have a line-item veto, so that extraneous spending proposals can be removed. If the Budget in any given year is running a deficit of say 5% of GDP, the next two Budgets must close a minimum of 20% of that deficit in each year, by spending cuts or tax increases, – so in that case they would have maximum deficits of 4% or 3% of GDP. Any “emergency” spending items must be paid for, either by new taxes or by cutting out other spending. There are many “fiscal responsibility” provisions that can be designed, the ideal legislation would include several of them, and would be amended by trial and error as we saw which ones worked.

On the monetary side, the Fed must be “Volckerized,” so that never again can it run a program of negative real interest rates for longer than a year or so. Ideally, it will be mandated to proceed by means of a nominal GDP target, and will be told to aim for zero (NOT 2%) inflation, year-in, year-out (the supposed potential economic damage of deflation is at this point wholly unproven and likely to be fictitious). By forcing the Fed to target inflation and ignore unemployment, we can prevent it from engaging in damaging experiments such as in 2009-16.

Even with fiscal and monetary legislation as above, it will be a long and difficult task to return the Federal Budget to balance. However, for the sake of all those living in the United States after 2033, it must be done.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)