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Federal Budget Deficit will be Unsustainable 6/8/05

06/08/2005

Introduction

The US budget deficit is at record levels and is expected to expand even more as the War on Terror continues and the baby boomers born just after WWII all retire together. This deficit is so big that government borrowing will affect the whole economy. There are three general approaches to meeting these growing government expenditures: 1) Raise taxes, 2) Borrow money, or 3) Use the Fed to print money. Raising taxes is extremely unpopular and therefore less likely that the other two, which will raise interest rates and inflation. The following analysis shows how big the deficit is and how it may affect interest rates, inflation and the value of the dollar. My conclusion is that the deficit is a short term fix for the economy by providing money for consumers to spend, but that it plants seeds of longer term inflation that will be hard to control.

The accumulated Budget Deficit is rising faster than the economy

The US government spent $412B more than it collected last year. Below I show below the total accumulated debt of the Federal government:



There is an upward shift in the debt after 2001. For a more detailed look at the source of the shift, we can see the policy shift of increasing deficits that occurred after 2001 more dramatically in the annual chart below. The four tax cuts, slowing economy and the expanded cost of war contributed.



Government accounting is more elaborate than these graphs show because there are several views of what should be included in the definition of this deficit. The above charts show the increase in debt assuming that the money in Trust Funds, for example for Social Security, are a debt to the government, so last year's increase in government debt was $600B. With the more commonly quoted view that the Trust Funds don't really need to be included, so that the money in them has been spent as part of current accounting, the deficit is quoted as $412B for 2004. Neither view is right or wrong, but it is important to know what is included in the number discussed.

The reason for the big shift back to deficit has more to do with tax cuts than spending increases as seen in the chart below that tracks both. The blue line of tax receipts takes a decided dip, mostly from tax cuts, and some from a slower economy. The pink line shows increasing revenues from defense spending, but to a lesser extent. The bottom red line shows the difference between the first two lines as the deficit. The projection of future years shows an improvement in the deficit that might be optimistic.



The holders of this $7.6 trillion of debt are not just the US Public, but include the amounts in trust for various accounts like Social Security, and foreign holders who could either be central banks or the foreign public. The Federal Reserve holds $700B Treasuries as backing for the dollars that they issue. The chart below shows the categories as of the end of 2004.



An important component of our deficit is that foreigners hold a big portion, and as we will see later, their purchases have increased with our budget deficit and supported our deficit.

The Government Accounting Office is tasked with the job of recasting government accounting to try to present the situation in the way that businesses are required to do. They admit that the government accounting and methods do not meet what would be required by an auditor to sign off on the accuracy. Based on their views I display some even more astounding views of the deficit below:



We want to know which is the "right" definition of our deficit. The most commonly used version by our government is the less alarming unified budget, which acts like there is no money set aside for the Social Security Trust funds. This is probably the "right" view for short term investment considerations because it reflects the cash flows into and out of the government. In the longer term, the fact that these trust funds have already been spent will mean that future demands will have to be added to the other demands of that time frame, and the problems will become serious.

The Trust Funds were set up to accumulate money for things like paying Social Security to the many retirees that will start retiring in 2010 and beyond as they reach 65. This demographic requirement was predicted in the 1980s, and payroll taxes were increased to fund these trusts. The accounting entries are there for putting the money aside. But this money is not there. It has been spent as part of the ongoing government spending. If it were set aside, the budget would have been in deficit by about another $200 B. Another accounting entry is that the Trust Funds are accumulating interest on their balances. There is no cash flow involved. The accounting just adds an entry to the Trust Funds that shows what interest they would have been paid if they had held real investments that paid interest. In place of the payroll taxes, an accounting entry has been made that the Trust Funds are given "non-marketable securities" that bear interest rates like Treasuries. As the interest is added the deficit is larger.

Generally Accepted Accounting Principles that are used to account for business profits adjust the appearance of the business to account for future obligations. One big item is to account for pensions. Businesses do not have a reliable record of handling these calculations, but the government doesn't even try. The huge expenditures for Social Security and Medicare coverage are left to future taxpayers to figure out. Obligations are incurred every year as more workers accumulate expectations for payments at retirement. When new legislation is enacted to spend more, as it was in 2004 for a Medicare drug program, then the obligation for the drugs is an addition to future spending. Both are included in the $1600 B(?) additional obligations shown above that were taken on by the government in 2004. The resulting accumulation of future payment requirements is then even bigger. This view says that the government deficit was over $2 trillion in 2004. To say that government promises are out of control is an understatement.

Looking forward the budget deficit looks even more dangerous

Future projections of the deficit were so positive in 2001 that the government felt it didn't need to borrow money in the form of 30-year Treasury obligations, and cancelled new sales. The chart below combines data from a number of historical projections of how the government saw the future deficit, measured as the unified budget above. This was difficult to compile, and I expect such charts are not often put together, as the government would not want to publicize the poor reliability of their projections. I show lines that identify the surplus for the future years. Each successive year shows a lower surplus until the present, when only deficits are shown. The administration's promise is to cut the $400B deficit in half. Not believing this, I calculated a projection of my own as the lowest line on the chart. As with all projections, the assumptions are what produce the result, and mine may be wrong, but I believe my estimates to be more accurate than the politicians', considering their track record. I assume war appropriations will continue to be made, and that the economy will stay sluggish so that revenues will keep the deficit large.

Social Security and Medicare will grow causing bigger deficit

The problem with Social Security is not whether there are the proper government spending programs, but that there will be so many more retirees. Payments for social security aren't saved up and paid out later to retirees. Payments are immediately spent on current retirees. So the key ratio is how many workers are earning paychecks that can be taxed for each retiree. The number was around 15 workers for each retiree when the program was started in the 1930s. With better health care people live longer. The boom of babies that were born just after WWII will retire together after 2010. Regardless of what government program we adopt, that 2 workers are supporting one retired person with aging medical needs, will place a burden on our society. The number of workers to retirees is now 3 and it will drop to 2. The chart below shows projections.



The costs in excess of revenues for the important components of the Social Security and Medicare programs are graphed below as a share of GDP below. The biggest is the Supplemental Medical Insurance (SMI) which is what we call Medicare. It now covers drugs. The Hospital Insurance (HI) grows, while the Old Age Survivors and Disability Insurance OASDI, which is commonly called Social Security, grows but levels off. The combination of these items doesn't look unmanageable shown as a % of GDP, but it is extremely big. To put the 12% number in perspective, all government expenditures in 2004 were $2.3 trillion, which is19 % of GDP of $12 trillion. The current requirement is less than 1% of GDP with surplus in OSDI and deficit in Medicare. 12% of GDP for retired people on top of all other obligations is unmanageable.

The administration recognizes a problem and has tried to take on a piece by offering to privatize a small portion of the social security problem. The proposal is not achieving acceptance, but even if it did, it would not fix the basic demographic problem. No one has a proposal to even try to fix the Medicare problem.



Future Obligations of Social Security and Medicare, as % of GDP


The future obligations of these programs are calculated at the astounding level of $40 trillion, a completely unsustainable requirement for the government going forward. This can not be met out of existing government revenues. Retirees are a big voting block and to threaten cuts is called the "third rail" by politicians. The name refers to the high power electric third rail in New York subways that will electrocute anyone who touches it. So benefits are not likely to be cut. Tax increases could help, but are also not popular.

Iraq war costs contribute to a bigger deficit

The war is not over, and costs are continuing. The administration regularly reminds us about Iranian and North Korean threats, so the policy is to continue in an aggressive stance. A comparison of the cost of Vietnam to the Iraq war shows in real dollar terms that we are spending more now than we did during that war, which cost 57,000 US lives and led eventually to the inflation of the 1970s. The chart below shows the comparison:



An ongoing cost of the war will be caring for the severely injured veterans for many years.

Simplified view of our government response to deficit

The government can meet obligations by raising taxes, cutting some obligation, or in conjunction with the Fed, printing money for the difference. The chart below shows these alternatives:



Government borrowing will put a demand for credit on the credit market. If there is an excess of demand from the government wanting to borrow, or to sell Treasuries, then the interest rate that they will be forced to pay will be higher than without their demand. If there are too few lenders, then rates will rise to attract more credit, and so the interest rate is the result of the tug of war between these forces. Borrowing more is likely but it is so big that credit markets are likely to have difficulty providing the loans of trillions needed without requiring much higher rates. Higher rates will increase the government's payment of interest on its accumulated debt. This interest now is $320B. If interest rates doubled, the interest payment would double, and the deficit would increase by that amount too, causing a weaker currency and higher interest rates feeding back on the deficit.

Another alternative would be for the Fed to create demand deposits to buy Treasuries, giving the government the money to spend. (This is how they "print money".) The additional money supply will filter into the system from the government. When the Fed buys Treasuries, the banks have new money to loan or invest. This process provides more money chasing the same amount of goods and assets, so prices rise. There is a delay before the inflationary effect is measured, but the printing of money by the government adds no new physical things to the US economy and no new wealth is created. This inflationary money printing is often called a hidden tax, as the government gets what it wants, and everybody holding dollars loses, as the purchasing power of the dollar drops. This is the normal state in a world of currency that has no anchor like a gold standard. The question is how high inflation could rise; not whether there will be inflation. How much inflation is related to how big the deficit is.

Help from foreigners in handling our government debt

The following chart shows the purchases of our government debt by foreign central banks overlaid with the growth of our Federal debt held by the public. There has been strong support from foreigners:



Interest rates are at 45 year lows. The growth of our government deficit was large in the 1970s after the Vietnam War and Johnson's War on Poverty, which greatly expanded our government debt at the time. We briefly achieved a surplus, but are now accumulating more government debt.

A comparison of the rate of growth of government debt to the interest rate suggests that increasing debt might bring rising rates. While the relationship is not strong, the chart below shows the new rise in debt growth even as interest rates have stayed low. Foreign purchases of our Government debt with trade-won dollars have supplied the government's demand for credit, as shown above, but there may be limit to that source.

Conclusion

The US budget deficit will lead to a weaker dollar and higher interest rates. That means alternatives to US-dollar-denominated assets must be an important part of a portfolio. The US avoided a serious recession in 2001 by cutting taxes and increasing spending so that the economy recovered even after the stock market debacle. We now have more debt than ever, not only for the Federal Government as described above, but also for mortgages for consumers and for foreigners from our trade deficit. The looming increase in the number of retirees means that the government has very big obligations and big deficits ahead. The deficits will be financed by either borrowing more money, or by printing more money. Borrowing will drive interest rates higher; and printing will drive the dollar lower. The likely outcome will be a combination of these. If inflation rises, US interest rates would rise, and many parts of the economy could turn down, like housing, stocks and consumer spending. Because of the size of the amounts involved, and the speed of today's currency and interest rate markets, the shift could move very fast in a downward spiral.


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Final note: I have written this piece and the one before ("The Trade Deficit is Unsustainable" – See archives) as background data for an analysis that shows how these two big financial forces interrelate. The twin deficits are important drivers in the bigger Credit Market. I will publish an upcoming piece on the Credit market showing how these forces will affect interest rates, inflation and the value of the dollar. There are other blocks of analysis to be described.

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