Now, if I haven’t lost you already, I’ll tell you that – boring or not – I am zealous about the economy this year. Why am I so zealous? Because we are headed for disaster unless someone changes the paradigm in Washington.
Here’s where we are headed. Unless we get our deficits under control, all of the federal government’s revenue – that’s all the taxes we pay – will go toward interest payments on the debt within 10 years. Nothing left for Social Security or Defense or whatever your favorite program is. A simple way to think about it is to look at how much money the federal government spends per household compared to the income of the average household. Here’s a chart from a White House publication on the budget:
Think about the impact of a household making $50K per year having additional debt of $30K on top of their mortgage, credit card debt, student loans and whatever. And, that’s $30K more each and every year!
But, you’ve heard all this before. You listen to cable TV, right? You’ve heard all the pundits. What am I saying that isn’t just more of the same? Well, here goes…
There are four schools of thought in economics: Classical (Irving Fisher), Keynesian (John Maynard Keynes), Austrian (Ludwig von Mises, Freidrich Hayek) and Monetarist (Milton Friedman). If I were to expand on each, this would go on for pages and pages. My goal here is to make it simple. So, where is the central truth that cuts across all four schools of thought? Here’s my try at it:
The most common measure of our economy, Gross Domestic Product (GDP), is the sum of consumer spending, investment, government spending less the trade deficit (or plus the surplus in the case of Germany or China). Simple representation:
GDP = C + I + G – Net Imports
The “C”, consumer spending, is the lion’s share of the economy (about 70%) so, in a recession, Keynesians focus on stimulating demand. Recently, that has taken the form of programs like “Cash for Clunkers” which provided a short term boost to consumers who needed to buy a car. The key is that it is short term. The data suggest that a stimulative boost today results in an equal subtraction from GDP in about three years. That might work in a short term cyclical recession but it doesn’t in a long term credit crisis like the one we are recovering from right now. It is also important to note that Keynes’ assumes that any short term stimulus that would generate a deficit would be repaid once the economy was restored to growth. With the exception of Clinton, it seems that all Presidents for the last 40 years were absent on the day they taught that lesson in Econ 101.
I’ll come back to the “I” (Investment) in a moment. Let’s skip to the “G” (Government). When the government spends money, there is no “Multiplier Effect”. In other words, a dollar spent by the government results a dollar of GDP. Whereas, a dollar spent by a business results in $2 to $3 of GDP. Why? Because businesses only make investments that will generate a return on investment. Governments are not that picky. For validation, you might want to read what Obama’s former chief economist, Christina Romer, wrote about it by clicking HERE.
Okay, back to the “I” in our formula, Investment. Investment equals savings, plain and simple. Whatever people and companies don’t spend equals investment. Sounds simple enough. But, the bigger question is where does that money go? If it’s your money, you might put it into a mutual fund or buy stocks and bonds. If it’s a company’s money, they might invest in equipment to make their businesses more efficient. Either way, investment “multiplies” in GDP terms. Another way to think about is that the only element of the GDP formula that creates jobs is the “I” – investment.
However, if the government takes away the excess capital – our savings -- in the form of taxes, there is no multiplication. So, when you hear conservatives talk about government spending “crowding out” private investment, that’s what they mean.
Okay, so what? You might ask.
That brings me to the deficit. Before I start, I should tell you that I am not fanatic about a balanced budget. In fact, I don’t think we need to balance the budget – so long as the annual deficit is less than the annual growth in GDP in percentage terms. Bear with me while I provide an example.
Suppose you own a business that generates $1 Million per year in profit. Now, suppose you borrow $10 Million dollars at 5% annual interest. That’s $500K in annual interest payments, right? No problem unless your income drops below $500K per year. And, if you invest the $10 Million wisely, you might grow your business and increase your income and create a few jobs.
Now, let’s compare that to the federal government. Our annual GDP growth is about 2% (optimistically). Yet, our annual deficit is about 8% of GDP. So, we need to fund that deficit of 8% or about $1.3 Trillion. The government does this by selling bonds (only if the Congress approves raising the debt limit). And, who are the buyers? Well, if we assume that everyone who exports to us uses the dollars received to buy US Treasury bonds, that would cover about a third of it. And, the rest? Well, the buyers of late have been investors afraid of the consequences of owning Euro bonds. Europe is a few years ahead of us and nearer to collapse.
But, the fall back, if we can’t find enough investors, is the Federal Reserve Bank. What has been referred to as Quantitative Easing or QE, is the creation of money by the Fed to buy US Treasuries. This matters a lot. When the Fed increases the supply of dollars, the value of the dollar goes down. And, the price of every commodity and product produced overseas – food, oil, manufactured goods – goes up.
A lot of people like to criticize the Fed for taking these actions; however, it’s worth remembering that the Fed couldn’t buy US Treasuries if they weren’t for sale. In other words, if Congress and the President would balance the budget, the Fed’s actions would be unnecessary.
Lower growth, higher inflation, less employment!
The four schools of economics differ on many factors or behavioral models. But, all of them would agree on these basic principles.
So, there you have it. My simplified version of the economics of our government. Government spending does not generate growth. And, deficits prevent job creation and are at the root of inflation. I could make it more complex; but, why bother?
Now, back to my zeal. If you buy into my dissertation as expressed here, you must be focused on the presidential candidate who offers the best chance of wrestling the deficit and national debt to the ground. There are no happy solutions to this problem. Any solution will cause us all to object to something.
So, the question isn’t whether we should do something about it. The question is WHO WILL LEAD?