Over the weekend, an email string came my way quoting Warren Buffett’s comment on CNBC that he could eliminate government deficits in 5 minutes by passing “a law that anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election.” Watching that interview, I felt that either Buffett was kidding, or that he didn’t consider his words very carefully. But responses to my comments indicate that many people feel otherwise, that our current high level of government deficits is the result of decades of government incompetence. Some feel that we shouldn’t have deficits at all, while another thoughtful person asked me why we need deficits.
There’s no accounting for government accounting.
First, a note on government accounting: it’s very weird. Everything is expensed, even the purchase of long-lived assets. When a company buys a factory or you and I buy a house, the entire purchase price is not an expense. The house, for example, becomes an asset, the mortgage a liability, and the only expense is interest on that mortgage (and property taxes, insurance, maintenance, etc.). But we don’t expense $1 million when we buy a $1 million house. Why the government does this, expensing $1 billion when they finance construction of a road or bridge, for example, makes no sense. But that’s the way it’s always been done.
Thus, budget deficits (which represent the difference between tax revenues and expenses, including things the government buys that retain value) are deceptive because they assume that all spending is an expense and none an investment. Likewise, the total federal debt (the government’s accumulated liability as a result of all prior budget deficits minus surpluses) is deceptive because it fails to account for assets owned by the government, which are substantial. The key number to look at is not the size of the debt, but what it costs to service it (pay interest and required principal), just as a bank looks at our ability to make the payments on a mortgage rather than the size of the loan.
In 2001, when the federal debt was 56% of GDP, net interest costs were 2.03% of GDP. In 2010, with federal debt 2/3 higher at 93% of GDP, net interest costs were only 1.43%! This is obviously because interest rates are so much lower now than in 2001. So the government is currently having no trouble servicing its debt; the concern is about the future, as the debt level climbs and interest rates probably do as well. But I’m getting ahead of myself.
Why do governments borrow?
Budget deficits occur because governments periodically borrow money to finance their operations, just as individuals borrow to finance homes and cars, and companies borrow to finance factories and equipment. Without credit, the economy would barely grow, as borrowing is an efficient way of temporarily transferring capital from those who have more than they currently need to those who need more than they currently have. Lending and borrowing occurs both through banks and within the bond and credit markets.
Federal government borrowing has historically increased during two periods: war and recession. This makes sense. During wartime, government spending ramps up dramatically and resources are pulled from the private sector to finance the war effort. The US federal government first took on debt in 1792 when, at the urging of Alexander Hamilton, it assumed the Revolutionary War obligations of the 13 colonies. At this time, the federal debt was about 35% of GDP. The US was able to completely pay off its debt by 1835; it would have done so sooner if not for the War of 1812.
Federal debt then stayed very low until the Civil War, when it reached 33% of GDP. Once again, the government gradually paid it down, but never again completely paid it off. After reaching a 20th Century low of 7.3% of GDP in 1916, federal debt again shot up to 33% as a result of WWI. In 1929, on the eve of the Great Depression, debt was down to 16% of GDP, but rose rapidly during the 1930’s as the Depression took its toll and the government embarked on the New Deal. Federal debt reached 50% of GDP by 1940, but soon increased at a far faster rate owing to the massive deficit spending required by WWII. (Question: If a 3% ceiling had been in effect then, would Congress have allowed Hitler take over all of Europe, while we succumbed to an invasion by Japan?) Federal debt peaked at 122% of GDP in 1946.
The US managed to pay down its debts from WWII at a rapid rate, helped in no small part by inflation. Because of strong economic growth and rising inflation, debt decreased from 48% of GDP in 1964 to 33% in 1974 despite the Vietnam War. Debt to GDP was 32% on the eve of Ronald Reagan’s election.
After the deep recession of 1982-83, federal debt reached 40% of GDP in 1984, as you might have expected. But then something happened that had never occurred previously: the federal debt increased dramatically during a period of both strong economic growth AND the absence of a shooting war. From 1984 to 1990, federal debt rose to 55% of GDP as annual deficits exceeded 3% every year except 1989. During this period, military spending increased substantially, while domestic programs were cut and tax rates lowered.
The first Iraq war and the recession of 1990-1991 caused the federal debt to increase again, reaching 66% of GDP in 1995. Then it started to drop for the first time since 1980, declining to 56% of GDP by 2001 despite a recession: 1998 through 2001 were all years of budget surplus.
In 2002, we had a deficit of 1.5%, which continued to increase and peaked at 3.5% in 2004 (higher even than in 2008, when it was 3.2%). Though the economy was growing nearly 3% per year during this period, we were financing two shooting wars: one in Afghanistan and one in Iraq. One might naturally think that these wars were the main cause of the increasing deficits.
Houston, we have a (revenue) problem.
However, if you look closely at federal receipts and expenditures during this time, you’ll see that the deficits were not caused primarily by increased spending, but by too little revenue. For the first time since the 1980-82 recession, federal government revenue as a percentage of GDP decreased significantly, falling faster than at any time since the late 1940s (when spending also dropped precipitously). In 2000, federal revenue was 20.6% of GDP; by 2004 it had falling to 16.1% even as spending rose from 18.2% to 19.6%.
As a result of this revenue/expense mismatch, the federal debt increased from 56% of GDP in 2001 to 63% in 2004. While a 7% may not seem like much in the context of what has happened since, the seeds of the current debt overhang were planted back then in the form of tax cuts.
Then came the Great Recession of 2007-2009. 2009 saw an annual deficit of 10%, the largest since 1945, and brought total federal debt to 85% of GDP, about where it was in 1950. Owing to the worst recession since 1937, tax revenues plummeted while government spending rose. The deficit fell somewhat in 2010 (as banks paid back TARP loans) but will rise again this year to about 10.9% of GDP. It’s then projected to fall rapidly, even without dramatic cuts in the budget or tax increases, hitting 3.2% in 2015. Total federal debt is expected to peak in 2013 at 106% of GDP and then fall slowly, again in the absence of any changes in the current rate of spending or tax increases.
The huge annual deficits of the past few years were, in my opinion, necessary and unavoidable. What was unnecessary and avoidable were large increases in the federal deficit during the 1980s and early 2000s, causing our debt to reach levels unseen since WWII. In both cases the deficits were caused by major mismatches between revenues and expenses, the 1980s from both tax cuts and defense spending increases, the 2000s mainly from tax cuts. The problem we now face can only be solved by addressing both sides of the equation, cutting expenses and raising taxes simultaneously (the typical ratio in the past has been 2/3 spending cuts, 1/3 tax increases). I hate to pay taxes as much as anybody, but I don’t see another way out of this pickle.
It’s not a crisis yet, however. We came out of WWII with much higher debt levels and suffered a severe recession in the aftermath of the war. Yet we managed to pay down debt rapidly through a combination of spending cuts, tax increases and inflation. There’s no reason we can’t do the same thing now.
But impose arbitrary ceilings that don’t account for war or recession? Not a good idea, Warren.
Now if only our politicians could stop stonewalling and make some decisions….
Dr. Ken Waltzer MD, MPH, AIF, CFA
Founder and President – Kenfield Capital Strategies (KCS)