Wednesday, September 14, 2011

It's The Debt, Stupid!

Bill Clinton adopted the slogan "It's the economy, stupid!" to keep his supporters focused on the primary issue in the 1992 presidential campaign. He won.

Today the appropriate focus would be on the nation's growing and unsustainable debt levels. Unfortunately, we do a lousy job of understanding what is happening and how this will affect us in the future. In fact, the government not only doesn't talk about the situation honestly or openly, but it really doesn't even account for debt properly.

Now that Greece is essentially broke, the world's financial watchdog, the International Monetary Fund (IMF), finally has admitted that it needs a better way to monitor and project the debt levels of individual countries, including ours.

IMF Says It Needs to Improve Debt Analysis is a just released report that says much about how the whole world failed to heed the warning signs and predict the Greek financial crisis. In the report, the international financial watchdog admits that it has no realistic way to monitor debt levels, including those of the U.S. and other developed economies.

Here's part of what the article says:

"Prior to the 2008 global economic crisis, government spending by rich countries was fueled by a reliance on strong growth. The financial meltdown and subsequent recession brought the debt levels into sharp focus as markets began questioning the ability of governments to pay off their huge debts. Those debt-overhangs only grew larger as advanced economies added to their burdens with massive stimulus programs. As growth projections have been repeatedly revised downward in recent months, tackling looming debt levels is increasingly urgent.

Greece is a perfect example for the IMF’s poor record on the issue.

Athens is teetering on the edge of a default with negotiations for IMF and European Union loans to cover Greece’s upcoming bills in serious jeopardy. But the IMF predicted in a 2007 economic review of Greece that its debt would only hit 98% of GDP in a worst-case scenario. Debt actually reached 142% in 2010 and some economists say it could peak around 180%.

“Before the crisis, fund analysis did not always pay sufficient attention to public debt sustainability in market access countries, particularly in advanced economies,” the fund said.

Many advanced economies would already trigger deeper IMF analysis of their balance sheets if the trigger-level is set at 60%, including the U.S. With expenditures continuing to outpace revenues, the IMF projects Washington’s debt-to-GDP ratio to rise from 99.5% this year to 112% within five years.

IMF economists estimate the maximum range that debt can be sustained without crippling the economy is between 60% and 80% of GDP.

Although some of the IMF’s board members were reticent, fund staff also said coverage of countries’ fiscal balance and public debt should be as broad as possible, taking into account liabilities such as entitlement programs."

That's a mouthful for the Greeks to swallow, for sure. But what about us? I'd say two mouthfuls at least.

In other words, we are in bad shape with respect to debt, too. Despite this simple fact, President Obama and team now want to spend another $447 billion on a new stimulus-er-jobs-program.

He also tells us not to worry, and that the new stimulus-er-jobs-program will be fully paid for by additional tax receipts and government spending reductions. Here's what I say.

How stupid, gullible or naive does he think we are? That feel-good-fully-paid-for-line is not only not true. It borders on lying.

Here's the truth as I see it.

Each time the U.S. government spends a dollar, it has previously collected only sixty cents thereof from the U.S. taxpayers. To spend the dollar, we borrow the other forty cents, and that increases the national debt, pure and simple.

Stated another way, we expect to collect $2.4 trillion in taxes this year and plan to spend a total of $4 trillion. As this happens, $1.6 trillion in additional debt will result.

Said yet differently, tax receipts will be only 15% of our nation's GDP and spending will be 25% this year.

But however we choose to say it, the answer is the same--60% revenues and 40% in new debt is the only way to get us to a dollar's worth of spending.

The debt hole is getting deeper and deeper each day, and the spending continues uninterrupted while politicians, led by the president, engage in more happy talk.

This approach will lead us down the road to certain catastrophe. The only question will then be when we get there.

To know for sure where we're headed, unless we change course, we must first know where we've been, how we got here and why (unless we change course) we're headed down the clear path to catastrophe.

To be fair, our only collecting 15% of our GDP in taxes is relatively recent. The historical norm has been more like 18%. But we're not growing like we used to either and aren't likely to anytime soon. Too much debt and too little private sector growth.

And federal government spending of 25% is relatively recent as well. The norm has been more like 20%. Too little private sector growth, too much spending and too little public sector restraint.

Thus, while historically we've incurred annual operating deficits of ~2% (20-18=2) of GDP, that's not where we are today, nor is it where we're currently headed. It's both too bad and seemingly too true, too.

Why are receipts only 15% of GDP today, and what about future years? For an answer to that, let's try an analogy. We'll compare strongly revenue growing companies to stagnant revenue growers.

Companies that experience strong growth have a much better chance of having receipts exceed spending than companies that experience little or no revenue growth. Volume works wonders, whether up or down.

The term operating leverage means simply that companies have fixed costs (buildings, equipment, management, utilities and so forth) whose costs don't change as volumes fluctuate. Accordingly, the effect of transaction related costs (inventory and labor for examples) works to the profitable advantage of companies as volume grows.

On the other hand, these same fixed costs remain the same when volume decreases. Thus, operating leverage is a strong positive when companies are growing and an equally strong negative if volumes stagnate or decline. We can call this negative effect reverse operating leverage.

Operating leverage pretty much works that way with governments, too. In fact, the leverage impact of volume or growth is even more pronounced with government than with companies.

That's because tax receipts are derived principally from personal income taxes and payroll taxes such as social security and medicare. When the economy shrinks or doesn't grow at its historical rate, tax receipts decline as personal income declines. That's how we went from 18% to 15%.

But at the same time, when payrolls and personal income decrease, unemployment, food stamps and other government provided benefits increase. That, combined with the fixed nature of entitlement spending for social security and medicare/medicaid expenditures, has caused spending to go from 20% to 25% of GDP.

Where will this lead us? Well, our national debt was less than $1 trillion in 1981, less than $4 trillion in 1991, and less than $6 trillion in 2001. It now stands close to $15 trillion.

The current trajectory would place our national debt at more than $30 trillion within less than another ten years, or well before 2021.

Suffice it to say that the fiscal path we're following is not sustainable. As a result, debt now represents our nation's single biggest problem and will for years to come.

We need to get this out in the open for all to see clearly. Only then can we begin to understand the genuine and perilous nature of our indebtedness and lack of private sector economic growth, present and projected.

We'll keep talking about this as we go along. That's for sure.

Thanks. Bob.

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