October 25, 2014

Cutting Non-Defense Discretionary Spending Just Isn’t Enough

Cutting discretionary spending alone is not going to solve our fiscal woes. Entitlement reform must happen if we’re to maintain our economic strength.

That, or raise taxes. A lot.

Adding up the Federal Balance Sheet

Click to see larger image.

Do you know your net worth? If you add up all your assets (cash, property, etc) and subtract all your liabilities (debts), do you know what you are worth?

As a person, your net worth on paper doesn’t really account for your intangibles, like personality, education, or dashing good looks. Just your value if you sold everything you own.

Now how about the United States?  What is the net worth of our “of the people, by the people, for the people” government? If we were to add up all the assets and liabilities, what would our country be worth (or owe, as the case may be)?

The question matters. Though we hear a lot of talk about deficits, earmarks, and budget cutting, there is a world of difference between what politicians usually deal with–discretionary spending–and what is the biggest debts on the US balance sheet–the entitlements.

Let’s look at the stuff we hear a lot about: cutting  the discretionary spending in the federal budget. In reality, this is one of the smaller items on the federal balance sheet, but it’s the one that gets the most play in the news.  For example, look at this visualization by William Gross:

Look at “Non-Defense Discretionary” on line three of this (extremely) simplified  federal budget. In 2011, non-Defense Discretionary items will make up just a quarter of the budget. Over the last 40 years, it makes up on average only 23%. I doesn’t change that much. In other words, when we hear about politicians cutting discretionary items, they’re just chopping at the leaves, but leaving the trunk relatively unscathed.

That trunk is the other 75% of the budget. It’s stuff that Congress doesn’t mess with, can’t mess with, or, and here’s the kicker, is afraid to mess with. We’re talking entitlements, defense, and interest payments on the debt the United States owes to creditors. This means Medicaid, Medicare, Social Security, the Departments of Defense and Homeland Security, and, of course, interest payments on debt to, increasingly, people who live overseas and have loaned the US government money.

Of those, the scariest, the piece of the budget that is the largest, and that is going to grow the fastest in the coming decades, too, is the entitlement part. It’s Medicaid, Medicare, and Social Security. And it’s not even funded. The Congress has promised these benefits to people without coming up with a way to pay for them.

Remember, were talking liabilities, here, and unlike Defense spending, which has been fairly constant over the last forty years, entitlements will grow at a rate faster than tax revenues.  Because they are unfunded, and because they will grow rapidly over the coming decades, the government will need to borrow to pay for them. As  a result, as they grow, they’ll be paid for with more debt, which will increase the size of the interest payments.

Check it as Gross explains the danger:

The above four multi-trillion-dollar liability balls are staggering in their implications. Remember first of all that the nearly $65 trillion of entitlement liabilities shown above are not some estimate of future spending. They are the discounted net present value of current spending should it continue at the projected demographic rate (importantly ­– it is much higher than the annual CPI + 1% used as a discounter because demand for healthcare rises much faster than inflation.) And while some Honorable Congressional Le Pews would counter that Medicaid is appropriated annually and therefore requires no discounted reserve, those words would surely count as “sweet nothings,” believable only to those whom they romance every several years at the polls. The incredible reality is that the $9.1 trillion federal debt that constitutes the next-to-tiniest ball in our chart is nothing compared to unfunded Medicaid and Medicare. It is like comparing Pluto to Saturn and Jupiter. The former (the $9.1 trillion current Treasury debt) does not even merit planetary status in our solar system of discounted future liabilities. It’s really just a large asteroid.

Look at it another way and our dire situation becomes equally revealing. Suppose that the $65 trillion of entitlement liabilities were fully funded in a “lockbox,” much like Social Security is falsely imagined to be. Just suppose. And say the cost of that funding (Treasury debt) was the same CPI + 1% that was used to produce the above discounted present value in the first place. Actually, that’s not a bad guesstimate for the average yield of all Treasury debt. If so, then the interest expense on the $75 trillion total debt would equal $2.6 trillion, quite close to the current level of entitlement spending for Social Security, Medicare and Medicaid. What do we pay now in interest? About $250 billion. Our annual “lockbox” tab would rise by $2.35 trillion and our deficit would be close to 15% of GDP! The simple conclusion would be this: Unless you want to drastically reduce entitlement spending or heaven forbid raise taxes, then Pepé, you’ve got a stinker of a problem.

What would happen if we threw in agency debt and student debt, too, liabilities that the federal government insures?  Add another $65 Trillion to the debt side of the balance sheet.

Oh, and what about the assets side? Well, if our GDP is $14.9 Trillion and our tax revenues are estimated at about 35% of GDP, then do the math: we’re on track to never pay down our debt.

Indeed, because entitlement costs are going to continue to grow, and faster than inflation, sometime in 2040, mandatory budget items will exceed government revenues (or taxes collected).

Ouch. As Gross says, were out Greeking the Greeks with our debt, here.

In the real world, when things get this bad for a company, or for a person, they become insolvent. Since were talking about a country here, and not just any, but one of the most successful countries, bankruptcy is not exactly an option. It would destroy the world economy.

Instead, Gross anticipates four avenues the government can take to diminish it’s debt problems, none very attractive, and none very wise:

  1. Contractual abrogation. In other words, it will stop paying its debts and honoring its contracts. Extremely unlikely.
  2. Speeding up and increasing inflation. Dramatically. He thinks this is likely, but not sufficient.
  3. Push down the value of the dollar. Already happening.
  4. Decrease Treasury yields to historic lows, penalizing savers, and hope not one complains.

Or they could just reform entitlements. Entitlements are the heaviest weight on the federal balance sheet, and they are the part that will grow over the coming decades. Get entitlements under control, and suddenly the federal balance sheet is more manageable.

Who’s going to take it on? It’s political suicide for any serving politician to take on entitlements, and I doubt any of them currently serving has the courage, or the brains, to figure out how to do it.

Maybe it’s something that takes a whole generation. Maybe it’s time for the Baby Boomers to step forward. As Michael Kinsley recently wrote in The Atlantic Monthly, maybe it’s time for the descendants of the Greatest Generation to step forward and take one for their kids. Maybe it’s time to take one for the team:

So what do you give the country that has everything? You give it cash. The biggest peril Americans now face isn’t Islamo-fascism. It’s our own inability to live within our means. It would be nice to give our country the wisdom and self-discipline to stop running up the credit card. And we should try. But it’s unlikely that we can remake the national character (including our own) in 19 years. What we can do is offer a lecture and a fresh start. We should pass on to the next generation an America that’s free from debt. Instead of ignoring it, or arguing endlessly about whose fault it is and who should pay for it, Boomers as an age cohort should just grab the check and say, “This one’s on us.”

(h/t to PIMCO)

Why the federal budget is like a road trip…at 174 miles per hour.

I had lunch with a fascinating guy today: Matthias Shapiro, or @politicalmath if you’re on Twitter.

Matthias has done a few amazing visualizations on YouTube to demonstrate the realities of America’s budgetary problems. He explained to me that he got started when he heard President Obama offer, early in his term, to cut $100 billion million from the federal budget.

“It struck me as cynical,” he said. And it is. The numbers are so big that cutting $100 million, while a lot to the average guy, really doesn’t amount to much more than a drop in the bucket for the federal government. Shapiro decided to make a video about it, and 1.5 million views later, it remains one of the best visualizations of how little the Obama Administration has done to bring order to the American fiscal house.

A more recent one, seen here below, shows just how fast the current Administration is spending. It might give us a clue as to why so many people are, for lack of a more accurate phrase, freaking out at the speed with which the Obama Administration’s own budget over the next six years is borrowing and spending.

If it’s a roadtrip, we’re now ripping through Arizona. It’s a little scary, and not a bit unsurprising that so many people want the keys back from the guy in the driver seat.

For more great visualizations, check out Shapiro’s videos on YouTube, here.

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Federal budget outraces CPI by four times

Did you know that federal spending has increased  faster than consumer prices?

Four times faster?

From 2000 to 2010, federal spending has increased 106% while prices (according to the Consumer Price Index) have only increased 26%. In other words, while the cost of stuff has risen only 26%, the government is spending roughly four times more than if it had increased spending to match increased costs.

To be sure, a few things have happened in the last ten years that have affected the increase in federal spending faster than consumer prices. There was 9/11 and wars in Iraq and Afghanistan. There was a recession, and there still is a recession.  But even so, shouldn’t federal spending increases match consumer price increases, at least somewhat?

Mandatory Spending or Discretionary Spending?

Right now, a lot of the debate over the size of the federal budget  centers around “discretionary” versus “mandatory” spending. As one economist (Arnold Kling) points out, budget items in the later group aren’t so mandatory as they may seem.

The data indicate that it is not very difficult to increase Federal government spending, in spite of the large portion that is mandatory. Why not? Some hypotheses:

1. We tend to see discretionary increases in “mandatory” spending. As in the prescription drug benefit. Note that at the time the prescription drug benefit was enacted, nobody said, “You know, on the whole, the elderly are doing fine. We want to provide prescription drugs as an in-kind benefit, but maybe we should cut back on other transfers to the elderly in order to maintain generational balance.”

2. The government’s “cost of living” goes up much faster than the CPI. For example, with Medicare and Medicaid, outlays are tied to health care costs, and we all know that health care costs are rising faster than inflation.

Check out the rest of his analysis here. Noting that, with the exception of “net interest,” every major category in the federal budget has seen an increase in spending greater than the consumer price index, Kling argues that if we cut spending back to 2000 levels–without touching defense, Medicare, or Social Securitywe could slash $500 billion from the federal budget.

That’s a healthy chunk of change, and a simple idea. Roll spending back to 2000 levels, and then start looking at entitlement reform for other budget constraints and deficit reduction.

Here’s his data:

Spending, in billions, vs. Consumer Price Index

Spending Category 2000 level 2010 level Percentage increase
Consumer Price Index 174 219 26 %
Total Federal Outlays 1789 3721 108 %
Defense 294 719 144 %
International 17 51 197 %
Health 154 372 141 %
Medicare 197 457 132 %
Income Security 254 686 170 %
Social Security 409 721 76 %
Net Interest 223 188 -16 %
Other 240 526 119 %

Get it? Prices have risen only 26%, and federal spending should have risen about the same, even accounting for defense, Social Security, and Medicare. But it hasn’t. Federal spending has increased far faster.

Kling puts in a last word:

Or maybe the answer to the paradox is that when it comes to the Federal Budget, spending is discretionary when somebody proposes an increase in its rate of growth but mandatory when somebody proposes a decrease in its rate of growth.

Are politicians really just “the slaves of some defunct economist“?

The Federal budget is a curious thing. It alone in the world of finance and spending–from individual home budgets, corporate coffers, Wall Street, and state budgets–is controlled by persons whose primary interest is not responsibility, but reelection, and who spend based on good ideas for benefits, not the realities of economics.

Few things secure reelection like bringing home the bacon or signing a revolutionary new program. Yet the law of unintended consequences is stronger than all the political clout or well-meaning programs in the world.

So it is: well-meaning Congressmen (and Congresswomen), Senators, and Presidents head off to the marbled halls of Washington, D.C. to make plans and pass laws that their constituents will love back home, solve society’s problems, and make world a better place.

Then, the plans hit the real world, and little do  politicians know what results will really happen.

As I’ve quoted before, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

The road to hell, or rather, bottomless debt, is paved with good intentions. So, perhaps, is the road to Washington, no matter how little men “really know about what they imagine they can design.”

Recommended reading for more: The Road To Serfdom, by F.A. Hayak.

Cover of "The Road to Serfdom: Fiftieth A...

Cover via Amazon

(h/t Library of Economics and Liberty)

The answer to why Americans are OK with more spending

Yesterday, just before the State of the Union speech, I had an insightful conversation with a family member. This person is taking his first class in political science, something like a Polisci 101 class. He called me to ask some questions for an assignment he was working on.

“What does ‘non-security, discretionary spending’ mean,” he asked. “I guess the President is going to cut it, or freeze it, or something.” He paused. “It’s supposed to be in the speech tonight.” That would be the State of the Union, I mentally added.

“That phrase,” I said, “refers to items and projects in the federal budget that don’t relate to national security–like the military–and that can be adjusted from year to year, or that we have a choice about whether to spend money on them.”

“So what is non-discretionary,” he asked back.

“Things that must be in the budget, things that are fixed,” I said. “Things that Congress can’t really adjust because they are dependent on other factors, like how much Medicare or Social Security will cost that year.”

“Healthcare?” he asked.

“Yeah,” I said. The other side was quiet for a moment. Then he said thanks, and hung up. Two minutes later, my phone rang again, and he had another question.

“So,” he started. “How will cutting ‘non-security discretionary’ spending affect me?” I thought about his question. “Will it, like, lower my taxes?”

“Not much,” I said. “Most of the federal budget is spent on the non-discretionary things, so the discretionary non security items don’t account for much. And we spend more than we make.”

” More than we make? We pay for the budget with taxes, right?”

“Yeah, but the federal government has to borrow to pay for it, because it doesn’t collect enough taxes for everything.  So taxes pay for some of it, but not all of it,” I said, unsure where this was going.

“How much?” I wasn’t sure how much, but I was pretty sure it wasn’t all. In fact, I was positive.

“We don’t pay for most of it. We raise a lot of money in taxes, but we don’t pay off how much we borrow, ever. With only one exception (I think), we’ve run a debt since the early 1980s.”

“So we’re spending more than the taxes pay for?” He was incredulous, shocked.

“Yeah. A lot more.” I was surprised. Doesn’t everyone know this?

“No way,” he said. “That’s crazy.”

Yeah. It is crazy. But what struck me, and perhaps what is more crazy, is that it’s probably something that few people realize. The federal government spends more than it taxes. Further, it has done that for several decades, and it is projected to continue doing that for the foreseeable future.

And I doubt there are few Americans that realize it. The government is, largely, providing something for nothing and no one is paying for it. The next time you complain that the government owes you something, remember: it’s not paid for–it’s bought with a credit card. The federal credit card. And no one is paying that credit card off.

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