Saturday, March 24, 2012

One Issue and Only One Issue

I’m a boring guy. While most folks like to argue politics from their heart – women’s contraception, gay marriage, the war(s) – I like to discuss data and charts. What can you expect? I studied economics in college despite its label as the dismal science. BORING… right?

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.

So, what is the impact of the national debt rising as depicted on this chart? Bear in mind that it’s going up at a rate of more than $1 Trillion per year.

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?

36 comments:

  1. Very impressive article. Thanks.

    I feel dumb when I start reading you but smarter when I’m finished.

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  2. John... great piece... does this make you a Romney guy?

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  3. Hi John,

    I plugged the 1967 figures - $3.5K and $7K - into an inflation calculator, and got $22K and $45K, respectively, for 2010. As such, the increase doesn't seem that outrageous.

    Are you coming to the reunion?

    K

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  4. Kathy,

    I don't think you can use an out of context data point to make an analogy along these lines. In 1967, the US Budget was about $20 Billion and the surplus was $4 Billion.

    Here's a good source document from the White House budget office: http://www.gpo.gov/fdsys/pkg/BUDGET-2011-TAB/pdf/BUDGET-2011-TAB.pdf

    JC

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  5. Matt Crawford • John,

    Aside from whatever else you think should be done about the deficit and debt, in what ways would you like the Goverment to collect more revenue?

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  6. Hi, Matt. I plan to use my next blog to outline possible solutions. To answer your question, I favor what many euphemistically call "tax reform", the revenue neutral lowering of rates and elimination of tax breaks and incentives. Government's provision of subsidies, tax credits and deductions distorts the allocation of capital. Better to let the market decide where to invest its money.

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  7. Matt Crawford • Setting aside the distribution of the tax burden for a moment (not that that's a trivial question), how much revenue do you think the US government should collect domestically?

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  8. John Calia • Models I have seen suggest that anything more than 20% of GDP hampers growth.

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  9. Matt Crawford • Then you'd be comfortable with a considerable tax hike, since we're at 15.8% of GDP right now? (Down from ratios of 16 to 20% in the years of Bush the lesser.)

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  10. I don't think we can balance the budget without increasing revenue.

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  11. Buck Wicklund • Hear! Hear!

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  12. Lanny Cox • In my view, until we have a Congress (both Houses) who are willing to face reality and perform their Constitutionally proscribed duties regarding budgets and fiscal policy, the nation may be doomed to staying the present course.

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  13. Bryan Baquer • John, I agree with your comments, and we surely have a difficult problem to tackle. Who will Lead? I guess the first candidate to publicly acknowledge that we actually have an entitlement spending problem, and to come clean with the American public that "the government" has created and implemented programs that are insolvent. How does one fix a problem until they acknowledge it exists.

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  14. I'm not an economist (although I did stay at a Holiday Inn Express:) At any rate, I enjoyed the article. Good analysis. I have attached a link to a rather humorous video that puts this into perspective of the average home owner-- it would be funny if it weren't true. This isn't a Repbublican problem nor a Democrat problem-- this is an American problem that needs corrected ASAP. Inflation is coming, in fact we are already seeing major hints everytime we go to the grocery store, or buy tires, or...buy gas.
    http://www.youtube.com/watch?v=Li0no7O9zmE&sns=fb

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  15. David MacDonald • John - The article addresses the scenario we have of an increasing money supply and devalued currency but for me one of the larger related issues is inflation and that is not addressed. I inflation is more money chasing less goods and services. I am not sure about you but I believe we have that happening right now. Yet the Fed is quick to point out that inflation is not a problem because they would have to raise interest rates which in turn makes the payments on the debt even more. Are we to assume that no matter how high prices go we are stuck with low interest rates until our debt is reduced significantly?
    I say we are.

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  16. John Calia • I am doing my best not to speculate or express too much that would be categorized as "opinion" rather than the simple results of my studies. So, I won't answer your direct question about what the Fed might or might not do.

    However, I have addressed the impact of Fed policy in the blog and its relationship to inflation. There is an op-ed piece in today's WSJ that addresses the issue better than I can. If you are an online subscriber, you can read it here:

    http://online.wsj.com/article/SB10001424052702303816504577307403971824094.html

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  17. Linda Dolan • If you look at the data, in every year that taxes were lowered, revenue INCREASED! Look t the Reagan cuts and the Bush cuts. When people have more discretionary income, and businesses have more income, they expand, spend more, and the economy grows. When you tax into oblivion, people clutch their purses.

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  18. David Rettig • I wish I could go to my employer and say "I need to spend more money, give me a raise."

    The government should try living within its means not taking more of my money.

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  19. John Petterson • @Linda - please tell me that you do not believe that the 50's and 60's were so terrible for both businesses and individuals? The top marginal income tax rate was 70% to 90% throughout those decades. It did not hinder the growth of the country or of businesses at the time. You cannot believe that cutting taxes and continuing to expand spending will lead to a healthy economy. And history tells us that the government - regardless of which party wins in November - will continue to spend more. Bill Clinton was the only president in the past 30 years who was able to contain spending to income, and that was only because he raised taxes and the economy was in a period of explosive growth during his terms.

    Look at http://www.dailykos.com/story/2011/04/13/966570/-Just-Restore-the-Clinton-Tax-Rates- for a real view of what Clinton's tax increase and Bush's tax cuts did for the government's revenue and deficit. You can verify the numbers elsewhere if you disagree with the writer's politics. These are the most recent tax changes and thus are more relevant to the current situation than any earlier changes. After Clinton raised the top tax rate, the government's revenue increased every year and the deficit dropped every year. After Bush subsequently cut the top tax rate, the government's revenue dropped for three consecutive years, then started to grow (because the economy grew) but took two more years just to get back to where it was in 2000. So while spending grew by over 33% in this same time frame, income was flat and this lead to a shortfall of over $1 trillion per year!

    There is a fantasy that is brainwashed into some people that providing money in the form of tax cuts leads to higher tax revenues. The country's economic growth has been responsible for virtually all of the growth in government revenue in past years. It is like the government saying that the 55 MPH speed limit was responsible for the entire drop in highway deaths, when car safety improvements had a much bigger impact than the speed limit.

    There were times in the past when the country was able to SURVIVE tax cuts. But that was always due to a healthy growing economy - tax cuts never led to a balanced budget. And the country at that time of those cuts did not spend $200 Billion per year on interest payments like we do today.

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  20. Pat Shuman • The interesting thing about data is how easily it's manipulated. Whenever someone suggests I look at the data, the first thing I look at is its source. I think if people would just look around them, they would find a much better measure of how society is functioning. Don't be swayed by some think tank with an agenda. Just look around. Seek out meaningful data from multiple sources, then form your own conclusion, based on reality, not spin.
    The effect of tax cuts, and the % of GDP those revenues represent, is easily compared over the decades using commonly available sources, that just give you numbers without value judgements behind them.

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  21. @John: 50s growth occurred when the US had no global competition owing to the destruction of the world's manufacturing capacity during WW II. The impact of high tax rates during that time came home to roost during the 70s. Businesses did not invest in plant and equipment during the previous 2 decades because of high marginal rates. The lowering of rates by, first, JFK and later by Reagan increased the "I" in the GDP formula and led to the growth of the 80s and 90s.

    The Bush tax cuts of the 2000's were damaging because of the expansion of money supply related to the Fed's rate cuts. Cheap money inflated asset prices and all GDP growth was debt related.

    None of these decades are comparable. Each was unique in some way.

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  22. Scott Moss • I saw Erskin Bowles and Alan Simpson on Charlie Rose last night. The Simpson Bowles plan is not perfect but it is bipartisan and it is a good start. If Grover Norquist can get our senators and congressman to take a no tax pledge, we need the same kind of citizen activism to support this solution. As Alan Simpson said, it must be the right thing to do if it pisses everybody off.

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  23. @Scott. I would vote for Simpson-Bowles, Domenici-Rivlin or Ryan's Roadmap. Anything that would send us down the path toward resolution. Any of them will be painful. Every dollar spent by the US government is important to someone. So, there will be a lot of squealing when (or if) we do something.

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  24. Jeffery Pyle • @John P: You don't believe that people having more money to spend and invest leads to economic growth (everything else being equal)?

    How exactly does the economy grow, then? Do you believe higher taxes lead to more growth?

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  25. John Petterson • Jeffery: Q1 - I do think more money being spent expands the economy. I just believe that putting that money in the hands of the people who are more likely to actually spend it - rather than the 1% who are more likely to simply bank it - will do more to expand the economy. And creating investments without a market for the goods and services that are being invested in does no good - it drives supply up without increasing demand, thus ending up with more businesses running at a loss.

    Q2 - No, I understand that is not a direct cause-effect relationship. And I am not advocating higher taxes for the sake of higher taxes. But having the federal deficit continue to extend the federal debt is killing the country. The economy cannot stand for that to continue. And there are not enough socially acceptable budget cuts available to bring us close to balancing the budget today without raising revenues - at least not until the wars and other short term financial hits can be safely stopped. So the short term way out of this mess to balance the budget with taxes on those who will not starve to pay the bills. I see this as a necessary step to get out of the financial mess. The economy is tuning upwards (although it is by no means recovered yet) thanks to the stimulus packages that Bush put in place and Obama continued. Now we have to get out from under the debt to let the growth bring us back to a healthy status.

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  26. Michael Taft • What few fail to realize is a couple of generations back, there was no Federal Income Tax. First enacted in 1862 to support the Civil War, retracted in 1872, enacted again in 1894 only to be declared unconstitutional, and then passed with the 16th Amendment in 1913. Now it is so out of control, we need to expand the bureaucracy to meet the growing needs of the bureaucracy. All of the government programs that take from the earners and give to the "needy" are creating a system not unlike that at the fall of the Roman empire. So many workers on the government dole that the economy implodes.

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  27. Glenisson de Oliveira, Ph.D. • John: I am unconvinced of your analogy of government borrowing being similar to a business (others talk about household income). You say that if you make 1M and have to manage 500k worth of interest from a 10M loan, you are fine. The problems I have with this type of analogy are that 1) the government does not produce anything per se (it takes in the form of taxes to support its activities), so the expectation that borrowing may be a good investment on the basis of some sort of return is never true. As you said, "government spending does not generate growth."); 2) this analogy tends to use GDP as a measure of total value in assessing government debt. A percentage of GDP, similar to some acceptable percentage of a business or household income, is said to be a reasonable amount to borrow. That implies that the whole productivity in the economy belongs to or at least is available to the government. The measure should really be what the government is "raising" through taxes, or what it could reasonably raise. It is not reasonable that taxation could be 100%, or there would simply be no productivity. I think of the Lafferty curve, when considering reasonable maximum revenues – there is a true limit, and it is much less than the GDP. You indirectly allude to that type of analysis by referring to behavioral models.

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  28. @Glennisson. You're right when you fault the government to business analogy. I was trying to find a concise way to say that a deficit is not a problem for us if GDP growth exceeds the deficit. As for the Laffer curve (or other predictive models), I have tried in this blog post to stay away from predictions. My objective was to find the common ground for all of the models. It is certainly true that "it is not reasonable that taxation could be 100%". It is also not reasonable that it could be 0%. Most studies I have read would set a limit on government spending around 20%. Anything above that would hamper growth unreasonably. Our current predicament is that revenue approximates 16% of GDP and spending approximates 24%.

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  29. Robert Spencer • John Calia, I see many want to raise taxes here because they trust the government to spend it wisely and to not increase their spending further. Which to me is a completely unjustified faith. The gentleman extolling Clinton forgets his balanced budgets only occurred during the time the Congress was controlled by the Republicans.

    What about the other side of that equation? Is there a tax rate in relation to GDP that would hamper growth? If our tax burden as a percentage of GDP was 10% would that be bad for us assuming an appropriate debt load.

    As far as there being no socially acceptable cuts possible in the Federal budgets then maybe its time we consider that some people are just unreasonable. We can find no improvement in nationwide education since the creation of the Education Department. So why do we have it?

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  30. @Robert. Generally, I agree with you but would not take the partisan view. But, as I pointed out in my blog posting yesterday, every dollar of the Federal budget is precious to someone. I heard from liberals who thought we should make severe cuts to the Defense budget. Would you sign up for that?

    My central point is that the national debt is a threat to our economic and national security and the only solutions will require compromise from all sides.

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  31. Robert Spencer • So much of what the Defense Budget includes is really non Defense spending. Everything should be cut back to the enumerated powers eventually. I'm a libertarian/conservative so I don't have the same hot buttons as a typical Republican. Smaller government leads to more freedom.

    What your charts couldn't show in this piece is that this large government we have leads to a misallocation of resources. I do think you touched on that though. (read your article a few days ago now.) What liberals always fail to realize is that they could deliver more money to those in need if they kept the government out of it. Being a libertarian I think all charity should be voluntary.

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  32. @Robert. I was right there with you until the last sentence. Even the most conservative of the economic schools, the Austrian School, would provide basic support for the less fortunate. In fact, the term "social safety net" was coined by Freidrich Hayek in his seminal work, The Road to Serfdom.

    Here's what I wrote in my blog on the topic in January of last year:

    "Hayek, who had the advantage of observing governments in action in the 20th Century (Smith lived his entire life in the 18th), also espoused the creation of a “safety net”. In his most read work, The Road to Serfdom, he said: "There is no reason why, in a society which has reached the general level of wealth ours has, the first kind of security should not be guaranteed to all without endangering general freedom; that is: some minimum of food, shelter and clothing, sufficient to preserve health. Nor is there any reason why the state should not help to organize a comprehensive system of social insurance in providing for those common hazards of life against which few can make adequate provision."

    The blog post was one of my most read, called Adam Smith: Communitarian. Here's a link:

    http://whowilllead.blogspot.com/2011_01_01_archive.html

    Thanks for the stimulating dialog.

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  33. Robert Spencer • I think Hayek would agree with me at this point if he could see the destruction of the family largely due to the welfare state. The uncontrolled vote buy through both welfare and corporate subsidies. He didn't have the benefit of hindsight.

    That last sentence does bother people but it comes back to who owns you. The answer should be you. If you then own yourself then you also own what you produce. The government taxes to provide for the common defense but it is theft to take money from you and give it to another. That is a principle that I hold and feel is justified.

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  34. Matt Crawford • @Robert Spencer: "The government taxes to provide for the common defense but it is theft to take money from you and give it to another."

    If the government spends for *any* purpose, they are taking the tax money and giving it to others. That's what spending is. To say that doing one thing with it is theft and another is not is willfully blinding yourself.

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  35. Gower D. Talley MBA • @Matt – Robert made an important distinction that you are missing – it seems intentionally.

    It is one thing to tax for the purpose of funding the common, necessary and constitutionally authorized functions of government (defense, roads etc). It is quite another thing to use the coercive power of government to take privately owned resources from a private citizen (that would have otherwise been available for that person’s personal and discretionary use) and to give those resources to a 2nd private citizen “in cash” for that 2nd person’s personal and discretionary use.

    There is a clear distinction between funding the operation of government and direct wealth distribution.

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  36. Robert Spencer • Matt, maybe I have willfully unblinded myself. Gower did an excellent job of explaining the distinction. Although many people believe it is right and necessary for the government to redistribute private income. I believe the damage done by such policies are exactly why we have many of the issues we have today. The biggest issue being that no one can find money to cut from the Federal Budget, even as their are entire government departments that can not show an improvement in their area of concern as the result of their existence.

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