Written By: Philip Lockwood
While I think the three previously mentioned factors in Waiting for the other shoe to drop? can certainly derail the US Market, let’s hone in on the US national debt. As of my time writing this article the national debt is over 21 Trillion dollars, which can sound like an insurmountable number. We can focus on the number or we can assess how we are able to service this debt.
Fiscal policy is an area where everyone has an opinion, but few people can agree on any specific plan. The goal of a successful fiscal policy would be to reduce debt and stimulate the economy – the only problem is achieving those goals often involves strategies that appear to be mutually exclusive and sometimes just plain contradictory.
Debt is not necessarily a bad thing as long as you have a prudent plan to pay for (service) that debt. From my research and experience, I have learned that too little debt/credit can create as bad or worse of an economic problem as having too much, with the costs coming in the form of missed opportunities. Generally speaking, because credit creates both spending power and debt, whether or not more credit is desirable depends on whether the borrowed money is used productively enough to generate sufficient income to service the debt. If the credit creates enough opportunities to service the debt, both the lender and the borrower will be happy; if the opposite is true and the credit does not create opportunities for debt service there is a good chance that resources were poorly allocated, and no one wins.
If the debt produces enough economic benefit to pay for itself it is a good thing, but sometimes the trade-offs are harder to see. If lending standards are so tight that they require a near certainty of being paid back, that may lead to fewer debt problems but too little development. If lending standards are looser, that could lead to more development but could also create serious debt problems down the road that erase the benefits. This is why the yield curve I discussed in Recession or Expansion – The Mighty Yield Curve is so important – it has a major impact on lending and is therefore crucial to fiscal policy.
The US National Debt
In 2012 Mike Mullen, the former chairman of the Joint Chiefs of Staff, told Fortune magazine that the national debt was “the single biggest threat to our national security”. As recent as 2018 the director of National Intelligence, Dan Coats, testified before the Senate Intelligence committee “I’m concerned that our increasing fractious political process, particularly with respect to federal spending, is the threatening our ability to properly defend our nation both in the short term and especially in the long term”.
So let’s look at the three ways in which we can service our current and future debt:
If we were to try to print our way out of this problem the value of our currency would likely decrease and this often results in price inflation – purchasing power of the dollar would decrease, unless offset by a decline in credit. One extreme example of this is Zimbabwe’s period of hyperinflation. The Republic of Zimbabwe was born from the former British colony of Southern Rhodesia on April 18th, 1980. When Zimbabwe gained its independence, the newly introduced Zimbabwean dollar was initially more valuable than the United States dollar at the official exchange rates, although this was not reflected in actual purchasing power. In the 1980’s, Zimbabwe experienced strong growth and development – wheat and tobacco production was thriving and the economic indicators for the country were strong. In the early 1990’s the government embarked on an Economic Structural Adjustment Program that had serious negative effects on their economy. In the late 1990’s they compounded the problem with land reforms – taking land from white landowners and giving it to black farmers. However, many of these newly minted farmers had no experience or training in actual farming, so the country experienced a sharp drop in food production along with all other economic sectors. Unemployment rose to 80% and life expectancy dropped. The Reserve Bank of Zimbabwe tried to print their way out of the problem until their currency was not worth the paper it was printed on – Hyperinflation.
This is a very drastic example, but you can certainly grasp the risk associated with printing your way out of debt.
When we define the important players in this theory we need to look at debt, deficit, and GDP – When we look at these things individually
- Debt is the net accumulation of the federal government annual budget deficits. The total amount of money that the U.S. federal government owes its creditors.
- Deficit is the balance we run on an annual basis comparing spending vs income – a deficit year increases the debt, while a surplus year decreases the debt
- GDP is the total value of goods produced, and services provided in a country during the year
Our neighbor to the north faced nearly double-digit budget deficits in the 1990’s. By instituting deep budget cuts, often 20% or more, the nation reduced its budget deficit to zero within three years and cut its public debt by 1/3 within 5 years. They did all this without raising taxes.
Increase Federal Income
There are the main schools of thought for increasing our national income:
Interest Rate Manipulation – Maintaining low-interest rates is another way governments seek to stimulate the economy, generate tax revenue and, ultimately, reduce the national debt. Low interest rates encourage individuals and businesses to borrow more money. The borrowed money theoretically will generate increases in income and spending, this can create jobs and tax revenue. Keep in mind we have been in a period of historically low interest rates since the 2008 recession – we don’t have much room to manipulate rates.
Tax Less – The current train of thought is to increase corporate growth via tax cuts, thus increasing our National GDP. The idea is to decrease taxes paid resulting in an increase in investment into companies, resulting in an increase in company revenue, increasing GDP enough to offset the tax rate reduction and then some.
Tax More – This can be done by increasing the Federal tax rate and/or getting rid of deductions, loopholes, etc. Either way this concept would require individuals and corporations to pay more money per dollar earned to our Federal Government to help service our debt. In most cases this would result in a slow down in growth and a lower GDP, the inverse effect of a tax cut. History would tell us that a tax increase won’t work without a reduction in spending. Reference what Sweden was able to do between 1994 and 1999.
Historical Example – Truman Era
I don’t believe that any single one of those three options will solve the problem, but a combination in just the right amounts would put us back on the path of fiscal responsibility.
Luckily, we don’t have to look too far back in history to find an example of a time that implementing a mix of these options worked well for the United States. The Truman Model would be one example of a time we were able to create a surplus and decrease our national debt. In 1946, with WWII drawing to a close, President Truman took federal spending from eighty-five billion dollars to thirty billion dollars, firing ten million federal employees. He called it war demobilization. By combining tax deductions to stimulate the economy and serious spending restraint, he got our debt back in order. In 2018 we have the deductions, but we are not following through with the decrease in spending. As of today, September 28th, 2018, the national debt is 113% of GDP. Until we address spending I don’t believe there will be a resolution to this crisis.
The fastest growing expense in the federal government is interest on debt. We are projected to have a trillion dollar annual deficit by 2020. By 2024 our interest costs are projected to exceed what we spent on the 2018 military budget. You don’t receive any sort of economic growth or stimulus paying interest on the debt. The 2nd and 3rd largest budget items in our federal government are Medicare/Medicaid and Social Security. Let’s break down the first two items.
As we become less healthy and have more baby boomers enrolling on this program, costs will grow. Additionally, medical expenses continue to increase, and we are living longer. Based on the trustee report from the congressional budget office, Medicare/Medicaid can no longer pay for itself by the late 2020’s.
When Social Security started off in 1935 we had 42 people putting money into the program for every 1 person taking money out. Back then you had to be 65 to draw on social security and the average life expectancy was age 62. Think about that for a second. Nowadays, we have 2.7 workers putting money in for every 1 person taking money out. People are living longer, and they can take reduced social security at age 62. We hear that 10,000 baby boomers are retiring a day, but that is only an average. If we look at the number one birth year in the United States of America it is 1957 followed by over 4 million births in each of the following seven years. Based on this information 70% of the baby boomers will retire between 2022 and 2029 and we hardly have the money now to support those people based on their social security payments. We know based on the congressional budget offices numbers that social security hits a wall during the early 2030’s.
In 1912 congress controlled about 97% of the federal budget. The only part it did not control was interest on the debt, as we did not have a federal reserve and did not have the ability to manipulate interest rates. Today congress controls about 30% of the budget as many of the budgetary items are now non-discretionary (Medicare, Medicaid, Social Security)
We can look historically, and you can certainly make an argument that we are at extremely low tax rates. During the WWII era tax rates were has high as 92%. The entire decade of the 70’s the highest marginal tax rate was 70%. The tax rates didn’t decrease until some of the Ronald Reagan years when he decreased the marginal rate from 70% to 50% and later to 28%.
Unfortunately, most of our fiscal problem is in some sense a future problem not a past problem. It is not only servicing the debts we have accumulated but it’s the debts we have yet to accumulate. For instance, Social Security is indexed to the consumer price index, when that price index increases the benefits increase. In 2018 Social Security recipients received an increase of 2.8% based on the cost-of-living adjustment. As we run at a higher rate of inflation Social Security benefits will increase. Likewise, Medicare benefits are essentially benefits in kind – due to monetary policy, prices in general rise, causing the prices of doctors to rise and thus require more money to pay those expenses.
As the debt and interest on the debit continues to go up, it could be predicted that our economy will become sluggish and resources will not be available for continued growth. I would call this a slow spiral like the fable of the frog in the boiling water – while it feels good at first, eventually the frog begins to feel the heat.
The scariest part of all of this is the off the book debt, such as a young worker paying into social security taxes. The government calls the money they pay back in the future “transfer payments”. They effectively borrowed the money from the ‘worker’ and promised to pay it back in the future, but did not use the words borrow or repayment of principal plus interest and as a consequence that doesn’t get put on the books and add to the deficit. If you add together the off the book numbers in addition to the on the book debt numbers you get the ‘fiscal gap’. The fiscal gap in the U.S. is something near 10 times the current debt of 21 billion dollars. The ‘fiscal gap’ is not subscribed to by everyone but if you would like to see who subscribes to this idea you can go to www.theinformact.org. There, you will find a bill looking to force our government agencies to use fiscal gap accounting like many other major countries currently use. The fiscal gap accounting numbers are a non-partisan talking point as they have been censored by both Clinton and George W Bush.
To make up for the liabilities we are incurring I would guess we would need to utilize a combination of all the things discussed so far – increased taxes and decreased federal spending. There is a new four letter word in Fiscal Policy and it is Math! If, like me, you believe there will be an increase in baby boomers on Social Security and Medicare and a decrease in the workforce, you may also think that we are headed towards a financial cliff. Part of the problem is congress caters to short term thinking, because you rarely get elected if you deliver bad news. But the closer we get to the cliff, the sharper we have to turn.
The question I have for you is do you think the ratio of debt to GDP is at a safe level, or will we have to take action one way or another to fix this fiscal malfeasance. The question you have to ask yourself is what do you think that action will be? Once you come to the conclusion the next step is what can I do to position myself for retirement success.
Look for some solutions in next months newsletter entitled “Ice Cream or Spinach”.
|Philip Lockwood | Founder + Managing Partner|
|Address: 3100 Ingersoll Ave. Des Moines, IA 50312
Website: Lockwood Financial Strategies
Securities offered through Parkland Securities, LLC, member FINRA (FINRA.org) and SIPC (SIPC.org). Investment Advisory services offered through SPC, a Registered Investment Advisor. Lockwood Financial Strategies, LLC is independent of Parkland Securities, LLC and SPC