Tuesday, October 22, 2013

Deficit Spending Gone Wild

For the fiscal year ended September 30, 2013, the US recorded the smallest fiscal deficit in five years. At just over $1 trillion, statesmen and economists from across the nation congratulate themselves on a job well done. The sequester and rising tax rates aside, this feat is universally attributed to economic growth (and the resulting tax take on that growth), the Keynesian "prescription" for economic recovery that has kept Paul Krugman's bearded face affixed to a regular column over at the New York Times. Those proclaiming victory over recession quickly point to a reduction in the ratio of deficit to GDP, now falling for the US to a modest 6.55%.  A further sign of our progress in righting the ship.  

From the nosebleed seats at which we climbed to watch prior years' deficits spiral up to $1.4 trillion, this new level of spending beyond our means has to appear humble, noble, if not awe inspiring. Of course, not a moment has been wasted by those in Washington seeking to claim credit for this accomplishment, eager to compare our new economic prudence to those unprincipled nations of peripheral Europe, still wracked by deficit spending. While the US deficits still exhaust more global capital than the next 7 major industrial nations combined, this must all be taken in context, you see.

The US, they are quick to caution, has carefully managed its fiscal deficit down to a rate below that of many third world nations, the UK and of course the European periphery, where in recent years the much maligned Spain and Greece have flagrantly floated deficits of 13.3% and 24.23% of GDP, respectively.

But this has us thinking. Where exactly is it written that government deficits should be measured in relation to gross domestic product (of all sectors of the economy) in order to weigh their significance to an economy (or the prudent management of governmental budgets)? Well, yes, in the treaties creating the EU, where all participating nations pledged to limit deficit spending to under 3% of GDP. But no one paid attention to that, with literally every nation in the EU (including Germany) breaking this promise, often repeatedly. Is GDP the appropriate measure to judge how modest or excessive deficits have become? Or is the measure of deficits to governmental revenue a more appropriate measure of the extent to which a government is leveraging its tax base?

And that's the thing about the trillion dollar plus deficits that the US has racked up in each of the past five fiscal years. It's the amount that the deficit exceeds the revenue base that to us, is so startling. It implies that all things being equal, tax rates would have to increase by nearly 50% to balance the budget. Measured in this light, even the most recent US fiscal deficit of $1.09 trillion places us second only to Greece in quantifying our flagrant mis-management of the Federal budget.

Tuesday, October 8, 2013

What's at Stake with the Debt Ceiling and Fed Tapering

The media these days is feasting on the political posturing in Washington over the debt ceiling. Fueling hysteria is, of course, something of a preoccupation of the American media. The public, always eager to line up on the left or right of any issue, has its opinions of who's to blame for the crisis and what should be done to resolve it.  But what's really at stake?  And how does the Fed's decision to taper its QE program fit into this?

Few would argue that taking the country to the brink of default over the debt ceiling makes sense. Truthfully, this is highly unlikely.  The debt limit debate is something of a sideshow for political junkies only. There is little likelihood of an actual default on the debt.  Despite the impending debt ceiling of Oct 17, the Treasury has the existing authority to refinance maturing notes.  While the gov't is shutdown and even if the cap isn't lifted, which it will be, the Treasury will continue to take in $250 b a month in revenue which can easily be prioritized to pay the $30 b or so for interest. Political theater. Good for ad revenue, bad for just about everything else.

But this controversy does raise the question of what our national debt looks like currently and, given the massive deficits financed over the past five years, how fast and far it has grown. Here's a picture of where we are now. Yes, it's the slope that matters and as you can see, it has steepened considerably in recent times.

But many believe the national debt is not a serious problem for the country and point to the interest on the national debt to make their point. As can be seen from our next chart, total interest has actually been falling as a percentage of total US government expenditures. In fact, interest on the national debt now comprises the smallest portion of the Federal Budget the country has seen in the past twenty years!

Here's another take on the US debt burden, showing total net interest in dollars compared to total Federal spending over the past twenty years. Again, it's hard to see what all the fuss is about (the source for all of this data, by the way is the Federal Reserve Bank of St.. Louis).

But here's the rub.  Look at what has happened to the rate of interest accrual on the debt or the net cost of capital for the US government over the past twenty years.  By taking the total net interest payable by the US each year and dividing by the total debt outstanding, we can calculate the implied average cost of that debt.

So now we begin to have a much clearer picture of what's going on. The decline in interest rates over the past five years resulting from the Federal Reserve Bank's unprecedented policies of zero interest rates and quantitative easing have greatly reduced the cost of funding the national debt. We can refer to this as the "Benanke Bequest". In fact, as we now know, the Fed has suppressed interest rates to where they are below the rate of inflation, such that "real" or inflation-adjusted rates of return on US Treasury securities are negative. Economists have referred to negative real rates as "financial repression" to imply a significant and, again, nearly unprecedented repression of the assets and wealth of savers in the US.

This fundamental issue of the effects of financial repression on savers, senior citizens and young families, aside, concern also rises in terms of what the US debt burden will look like when interest rates in the economy are normalized.  For this, we look to the following chart.  If we recompute total interest expense for the US over the past twenty years using the historical average rate of 5.5% (twenty year average) we see the very significant difference between actual and normalized interest expense for the US, as a percentage of total spending. Quite a different picture!

Lastly, we can plot this differential separately for the period 2008 - 2013, to give us a sense of how much added interest expense we avoided, due to the Bernanke Bequest, and what we very well may soon be looking at funding in the years ahead.  Note the scale is in billions of US dollars.  At 25% of total government spending, the interest on the national debt suddenly appears unsustainable.

In our view, this consern is what is causing the Fed to hesitate on tapering its purchases of Treasury securities under QE. The fact that the mere mention of tapering sent the debt markets into a downward spiral this past June-July has frightened the heck out of the Federal Reserve. Because, more than anything, the Fed is well aware of the role the Bernanke Bequest has made in allowing the US to shoulder the crushing additional debt load of the past five years. At the same time, the Fed is equally aware of the effects of continued monetary printing on debasing the currency. The Fed has thus painted itself into a corner. Taper and risk unsustainable levels of interest on the national debt (and also likely crashing stock and bond markets). Continue QE indefinitely and risk a currency crisis. Don't look to Washington to figure this one out.