The Federal Budget Debates Focus on Spending Cuts. What Cuts?

I keep hearing about cuts in spending – and how various groups will be hurt by the cuts. This is strong evidence supporting the view that the government spending process never ends. Nothing is ever temporary. Nothing is ever enough. People get quickly accustomed to higher levels of government spending and feel entitled. No wonder they demonstrate in the streets when a program is challenged.

Data I present and discuss below suggest that the period from 2007 to 2010 saw huge increases in the growth rates of government. But that is only part of a story that begins with Y2K. Government spending has been growing about twice as fast as it was during the previous decade. DURING THE 2000s GOVERNMENT GREW TWICE AS FAST AS DURING THE 1990s.  The record shows that virtually every major spending category contributed to this spending bonanza. Since the two recessions of the 2000s contributed to this spending explosion, there is plenty of evidence to support the idea that what was supposed to be temporary was truly not.  When or where did Keynes say it was okay to stimulate the economy with government spending increases and then make the new spending level permanent?

Ideologues in both parties make it difficult to solve this problem. Why? Because they delight in infuriating each other with finger-pointing and guilt tripping. It’s all Reagan’s fault! Look at deficits in the 1980s. It is Bush’s fault – look at the growth of government under his rein. It is Obama’s fault – look at the last two years.

The extremes of each party act in this immature way because they want to stick up for their constituencies. They see the present crisis as a time to help out their labor union friends or stick it to the rich. Others want to gouge Planned Parenthood or get rid of healthcare reform.

But they are missing the point. Neither Planned Parenthood nor unions caused our current problem – a budgetary mess – one that is not simply an issue of the last few years. What I show below is that defense, discretionary non-defense, and mandatory programs have all grown at much faster rates in the last decade and especially in the last three years. I won’t repeat the data about the national debt – you know indebtedness is too high and rising too fast. In my last blog I wrote about jeopardy. While we might be able to sustain high national debt for a while longer – inaction means we raise the possibility of a financial crisis worse than the last one. So we need to get moving.

So why not admit that our immediate problem is not about the needs of special interests – but rather is about attacking a mountain of debt. If government spending rose by about $1 trillion in the last recession and much of that increase was to fight a recession, surely we can find ways to reduce that spending by $500 billion or more in the name of restoring normalcy and greatly reduce the chance that a financial sneeze will turn into a devastating situation with even more draconian policy choices.

I’d like to suggest that we go back to annual government spending  growth rates of about 3-4% – but that isn’t going to get rid of the debt soon enough. Even freezing spending to current 2010 levels isn’t going to provide much relief.  Taking the budget back to levels that existed in 2007 is not as hard as it seems. As the economy improves, automatic stabilizers in taxes and spending should improve the deficit by $200 to $300 billion. That’s a good start and we shouldn’t ignore that contribution. But it isn’t enough.

Automatic stabilizers accounted for $312 billion of the overall budget deficit in 2009 and $359 billion in 2010 – meaning that roughly 25% of the deficit deterioration was caused by the automatic (without legislation) responses of spending and taxes to the downturn. Or put another way – the budget deficit increased by about $964 billion in 2009. The automatic responses or non-legislated changes in spending and taxation to a downturn in the economy accounted for about $279 billion of that increase. The remainder, or $685 billion, was how much legislated policy change contributed to the higher deficit in 2009.

The upshot is that we could return to government spending of $2.7 trillion and a deficit of about $340 billion that existed in 2007 if we focus on legislated spending decreases that total about $700 billion in the coming years. The automatic stabilizer contribution will disappear on its own accord as the economy recovers. While the number $700 billion looks large if we describe it as a cut from the expected outlays in 2011 of $3.7 trillion, they look at lot more reasonable when you realize they are from what was supposed to be a very temporary and is now a very bloated (burp) level of government. If you gain 30 pounds of unwanted fat over the holidays you accomplish very little by saying that you are going to freeze your calorie intake after Christmas. What you need to do is have a plan to eat fewer Twinkies.

The following table summarizes the issue. The first and second columns show that government spending was about $1.8 trillion in 2000 and it subsequently increased to about $3.5 trillion by 2010. That’s an increase of about $1.5 trillion – or an annual compounded growth rate of 6.8% per year.  The third and fourth columns show what federal government outlays “would have been” in 2010 had government spending grown at a compounded 3.6% per year (same as the previous decade) or at 5% compounded per year. These amounts ($2.548 trillion/$2.914 trillion) are clearly less than the actual amount of spending in 2010 of nearly $3.456 trillion. The final column shows the extra or excess spending – actual in 2010 less what it might have been if growing at 3.6% or 5%. As you can see the range is from $542 to $900 billion.  Even if government had grown as fast as 5% per year we would still be able to reduce over $500 billion out of government spending. Friends – this $500 billion is not a cut – even if government had grown at 5% per year for 10 years it would have increased by $1.125 trillion during the decade. Of course if we think government should have grown at only 3.6% per year then we could reduce government spending by $908 billion and still have a government that showed considerable growth for a decade.

Total Fed. Outlays: Actual, Ideal, and Actual Less Ideal  

   (1)        (2)           (3)              (4)              (5)                   

2000     2010   2010 3.6%   2010 5%  Excess3.6/5             

1,789    3,456    2,548          2,914        908/542

Here are some further figures to ponder (All from the Congressional Budget Office http://www.cbo.gov/budget/budget.cfm )

Government Outlays        Compounded annual growth rates

2007 to 2010               8.2%

            2000 to 2007               6.2%

            1990 to 2000               3.6%

It is worth recalling that the increase in government spending after 2007 came at a time when the budget deficit was $342 billion and helped move it to $642 in 2008, $1.6 trillion in 2009, and $1.4 trillion in 2010. CBO estimates a deficit of $1.5 trillion in 2011.

This same decade-doubling pattern of spending growth shows up with respect to discretionary Domestic Non-Defense spending – with the annual rate of spending growing at twice the rate of the 1990s. Discretionary Defense spending also grew rapidly from 2007 to 2010 but it grew less fast than non-defense discretionary outlays and the decade of 2000 appears to be making up for no growth in Defense spending in the previous decade (and of course a reaction to global terrorism).  In 2010 Defense spending was $689 billion or about 20% of total government spending of $3.5 trillion. Domestic Non-Defense spending was about $614 billion or 18% of total government outlays.

Government Outlays: Discretionary Spending         
Compounded annual growth rates

Domestic Non-Defense       Defense

2007 to 2010               10.2%                           7.9%

2000 to 2007               6.4%                             9.3%

1990 to 2000               5.1 %                           -0.2%

The biggest part of the budget ($1.9 trillion in 2010 or about 55% of total spending) comes from what we call Mandatory spending. Between 2007 and 2010 total Mandatory spending increased by 9.5% per year. That compares to 6.2% between 2000 and 2007 and 5.3% in the 1990s. Consider these increases from 2007 to 2010:

            Compounded annual growth rates, 
Mandatory Spending           2007 to 2010

            Total                                     9.5%
             Social Security                    29.2%

            Medicaid                             12.6%

            Social Security                       6.5%

            Medicare                               6.0%

Mandatory spending, as the name implies, is not quickly changed. But since it is a major part of annual federal government spending and the budget deficit, it is too large to be ignored in this discussion. Since these programs are open-ended and change automatically with the economy, we can expect that spending on Social Security, Medicaid, and other programs will a decline automatically as the economy continues to recover. I discussed this above. But it is not unreasonable as we think beyond the next few years into the coming decade that restructuring of Mandatory spending be a key part of a fiscal solution. Evaluations of recent budget proposals show short-term deficit remediation followed by a period of deterioration…because of Mandatory spending increases as the baby boom generation ages.  Any plan that only addresses the next few years is going to be deemed a failure. So why waste time with solutions that are bound to fail? 

Obama Plays Alex Trabek with a Bull in the China Shop

There is much being written and said about the President’s new budget for 2012.  So much is being communicated that it is impossible for most of us to digest it all. In fact, confusion might be the intended strategy – so I have tried to boil it all down to a couple of main points. But let’s start with a silly Davidson story about a bull in a china shop.

“Sir, there is a huge mean bull wrecking your china shop”.  The owner replied, “I don’t see a huge mean bull wrecking my China shop.”  The man protested, “But look around you at the devastation – broken pottery and glass everywhere. Look at that big hairy animal in the middle of the shop.”

The discussion went on… The manager first said the breakage was not so bad and that he had a good insurance policy. He went on to explain that his shop was in a rough neighborhood and he had reported the problem to the police who would search around the neighborhood looking for culprits. He pointed out that even if there was a bull in his shop, that there was really little he could do. While some people might want him to shoot the bull, he would never resort to such violence. And, of course, trying to coax the animal away might lead to it running down the street and injuring other people. The manager decided to move some of his valuables out of the shop. Give me a little credit for not bringing in bull-c___. 

Point one is that even though a bull might be staring him in the face, Obama prefers to pretend like it isn’t there. While he might not believe in American Exceptionality he seems to believe that we can be exempt from the laws of economic gravity that weigh on every other country. If there is one salient and imposing truth about our economy it is that we had a huge and supposedly temporary surge in government spending during the last few years. If temporary changes in the government budget were legislated to counter a decline in private demand that was associated with a recession, then it seems that seven quarters after the end of the recession we would be focused on removing the stimulus. Of course, there is a legitimate debate about how quickly to remove it and I am not against a gradual removal. But I do believe policy credibility is important right now and a slow removal would require two things: (1) a strong statement about its importance and (2) a legislated multi-year process. 

There was no sense of urgency in the discussions of the budget for 2012. Yet this budget or anything like it puts the nation in harm’s way because it ignores what we have known for decades – that we spend too much and save too little. What does it take for our government to face up to reality – especially when other countries are getting the message and doing something about their own financial situations? Jeopardy is a very popular game but the word jeopardy is one I used many times with my kids. You place yourself in jeopardy whenever you make a decision that increases the risk of something bad happening to you. If you drive too fast you get places quicker. It might even be fun and exciting. But driving too fast places you in jeopardy since you might get an expensive citation or worst, you might injure someone.

Government spending and deficits make it possible for a nation’s people to have more now without paying for it now. But it comes at a cost – a future cost. If government deficits lead to critically large amounts of debt for a nation then the nation puts itself in jeopardy. At the moment all might seem well but all it takes is a negative blow to the solar plexus and the country could get doubled over in pain. It seems to me that the experience of the last recession should have been instructive. But apparently it wasn’t informative since we HAVE A MUCH LARGER DEBT BURDEN NOW and we pretend that having deficits of more than a trillion dollars in the coming years are okay. Even worse, while the current budget envisions the debt to GDP ratio slowing, it admits that any remediation is temporary and that it will resume its upward climb because of issues with Medicare and Social Security.

Clearly, then, this budget for 2012 offers no way out of jeopardy since it does nothing to provide a strong statement and action plan for improving the nation’s debt burden. It will be no black swan the next time a sudden macroeconomic shock negatively impacts Main Street or Wall Street or both. If you thought the recent recession was bad, just wait until the bond vigilantes suck their formidable assets out of US markets because we were the last kid on the block to learn from the last recession. 

Some would have you think there is a tradeoff or a distributional issue involved with attempts to solve the national debt problem. For example, the President’s plan has two disgusting features. First, it points its spending axe at programs aimed at those with low incomes. I am sure he knows that these aspects will never be legislated in a split government. He’s already heard a few explicative deletives from his friends on the left about the cruelty of his proposals. Second, he also plans higher taxes on those with incomes above $250,000. After compromising on this issue last year he tries it again because it looks good to his constituents to go after the rich. Of course, this will not be passed this year in a split government.  Much of what he has proposed, therefore, is disingenuous. Worse, it pits the poor against the rich. Yet today there is no real tradeoff. The poor and the rich will do better when the economy improves. It won’t improve until we recognize the bull in the china shop – until we seriously try to fix our real and looming debt burden.

Finally, he continues his theme from the State of the Union Address of proposing more spending on infrastructure and other competition-enhancing measures. It is true that our nation needs to be more competitive in the future. But risking our money on dubious government supported boondoggles rife with crony capitalism and corruption is not the right way to do this. I cannot remember a time in my life when there was more incentive for engineers and scientists and other entrepreneurs to be sequestered in their garages late at night trying to find solutions to so many pressing health, energy, and various high tech issues. The rewards for their successes are infinite compared to the extra pittances the government can hand them. If we do want to very carefully find new ways to support them with better infrastructure we should do it within the confines of a strong national financial and economic plan. These entrepreneurs don’t need handouts. They need a stable financial system with a large pool of saving that comes from both domestic and foreign sources. A bull in the middle of the china shop will do nothing to help American be more competitive. But it will generate a lot of c___ if we continue to ignore it.  

US Policy, Idaho, Onion Dip, and Rising Interest Rates

The news today was full of stories about rising interest rates. Rates are said to be rising because of a growing economy. The impacts of interest rates are one of the most complicated and misunderstood aspects of macroeconomics. Consider the popular discussions about interest rates over the last several years:

·         Interest rates rose before the onset of the current recession – that was bad.

·         Interest rates fell as the recession took hold. That too was bad.

·         The Fed instigated a policy to reduce interest rates further and that was good.

·         Interest rates are rising now and that is bad.

You might be saying – how can all that be true? It is possible only if you understand a little about cause and effect.  Here comes some macrofun! First, interest rates are fundamentally driven by changes in the demand and supply of credit. Whenever the demand for credit (borrowing) outstrips the supply (saving), interest rates rise as borrowers compete in a market that has an insufficient amount of saving available for their needs. The borrowers include households, firms, and the government.

Second, interest rates reflect the impacts of inflationary expectations and risk. If inflationary expectations rise or if financial risk rises – the savers demand a higher interest rate to compensate them for reductions in buying power associated with higher expected inflation and increased risk.

Third, while the above factors cause changes in interest rates, interest rates cause changes in the economy. Economists might use words like – “once interest rates change they create impacts in other markets for goods, services, equities, foreign exchange, etc”. So a full discussion of the impact of interest rates would include all the following:

·                X changes and impacts credit demand and/or supply

·                 Interest rates change

·                  Interest rate changes cause changes in spending, exchange rates, output, employment, etc

With this information and $3 you can get a coffee at Starbucks. You can also see why it is difficult to characterize and forecast interest rate issues. For example, interest rates were rising before the recession largely because spending in the economy was so strong that it created huge demands for credit. That might be considered a good thing because along with the higher interest rates was a very low unemployment rate. We like low unemployment, right? But wait, interest rates were also high because inflation and expectations of inflation were rising and the risk of a financial bubble were increasing. So the Fed decided to tighten the money supply and slow things down a bit. To do so the Fed drained money from the economy by selling government bonds. That added to the demand for credit even further and raised interest rates. The result was a clear realization by us all that housing and stock prices had peaked which quickly created a whole host of negative impacts on both Wall Street and Main Street. THE FED POLICY WORKED in the sense that it stopped the problem of rising spending. Of course, it worked too well since the unintended impacts on a very leveraged and interconnected global financial sector was a financial and real crash. Summary – rising interest rates were a sign of an economy growing too strong and they were bad because they led to a deep and long recession as well as a very weak recovery after the recession.  Whew—all that makes me hungry. Reward yourself with a trip to the refrigerator.

The above sequence of events led to very low interest rates – a mirror image of what came before – falling and low interest rates as a consequence of very weak aggregate demand, lower inflationary expectations, and a Fed that was buying bonds faster than a fox can eat lunch in a Kentucky Fried Chicken Store. Low interest rates were bad because they were associated with insufficient borrowing, weak demand, and the resulting very high unemployment rate. The lower rates were thought to be good because the Fed’s policy appeared to be necessary to resuscitate spending and the economy.

So let’s jump to today’s headlines which announce higher interest rates. Is that good or bad? You might be guessing from the above logic (optimistically assuming that you are still awake) that the answer is yes AND no. And you would be correct. Today’s higher interest rates are the direct result of a stronger economy and rising demands for credit. That’s good. Of course, today’s higher rates are also the consequence of rising inflationary expectations. That’s good news too if you worry that inflation is too low. Of course, if you look at any chart of inflation rates over the last 50 years you will notice that inflation has a tendency to rise beyond its goal value once it gets started moving upward. It isn’t the kind of thing that you can easily manipulate. It is a bit like that potato chip thing. Once you eat one salty, crispy chip with onion dip there goes Idaho.  So rising inflation is considered by some of us to be a problem. Not because we love Idaho but because without better policy we might be back where we were before the latest calamity hit.

Could today’s small interest rate rise really warrant all this concern? After all, Mr. Bernanke says that inflation is below target and we have lots of economic slack and high unemployment.  Bernanke might say – let’s wait until we see that we are clearly growing too fast. But that’s exact the issue. First there is the Idaho thing. 

Second, we have an unprecedented amount of liquidity just waiting to be spent thanks to the Fed’s policies the last years. Third, our government has an unprecedented amount of fiscal stimulus interacting with rising private demands. The firecracker might be wet and hard to light how. But watch out when the sun comes out.

It reminds me of the joke about the guy who falls off the top of a very tall building and as he is flying by the 10^th floor on his way down to the street a person sticks his head out of a window and asks “how are things going?” The guy responds that “things are fine so far.”  Well things are going fine right now as interest rates begin rising. I just hope Mr. Bernanke and our federal government don’t wait until too late to reverse engines. If not for America than please think about the potatoes in Idaho. 

State of the Union -- My Elephant Sat on Sputnik

Like many of you I sat in front of my TV with a bowl of JD and watched the President give his annual lecture to the freshman class – err I mean give his Annual State of the Union Address. This year I missed getting the chance to gaze into the eyes of Nancy Pelosi for an hour or so and was disappointed that Speaker Boehner did not cry one time. I know this post comes a little late but I wanted to have a little time to steal the best ideas from the 8 zillion people who already weighed in on the speech.

One response is that I really should be happy about the speech. I have been moaning about the negative tone of partisan politics and so I should really be elated by the fact that both the left and the right decried the speech a horrible disappointment. If both extremes were unhappy with the President, then it should follow that he took a big dive into the middle thus moving away from the extremes. But unfortunately I don’t see it that way. I think they are both right to be unhappy. And the reason is that the President may have proved to both sides and all of us just how thin his knowledge and experience really are.

Writing in the Financial Times on January 27, Robert Reich spoke for the left when he (Why our Sputnik Moment will fall short) said the following, “What he (Obama) should have done is talk about the central structural flaw in the US economy, the dwindling share of its gains going to the vast middle class, and the almost unprecedented concentration of income and wealth at the top.”  I won’t quote anyone from the right but it was pretty clear they were very disappointed to see him stress increased government spending as the way to improve America’s wellbeing in the future. He acknowledged a national debt challenge but didn’t seem very worried about it.

As one dedicated to the arcane science of simple cause and effect, I share the negative assessments of his speech largely because the president talked about lots of policy but hardly ever told us his view of the exact nature of our most pressing problems – or the causes of them.  While his smile and rhetoric are rare and his solutions dazzle the mind, his absolute lack of any sincere attempt to link his latest policy proposals to any realistic explanations of problems suggests to me that he doesn’t really understand them. Where is David Letterman when we need him – with a top 10 list of America’s worst economic problems?

To elaborate the point – while I don’t agree with Reich about the relative current importance of income distribution issues – one wonders after the speech what Obama thinks about that. Will emulating the Sputnik fervor with respect to education, green energy, and infrastructure alter the relative positions of the rich, the middle class or the poor? If so, can he explain how and why?  So much for people interested in policies to improve income distribution. Don’t we have a housing/financial crisis? Did we solve it already? Is it not REALLY important that our policy somehow connect to this problem? Shouldn’t he have spent a little time on this one thing that seems to have set off the worst recession since the day when bread cost 7 cents a loaf? Of course, if he thinks the housing/financial crisis is over or lacking interest, then maybe he might have discussed the fact that three years worth of federal government deficits are expected to exceed $4 trillion dollars between 2009 and 2011. Or maybe he thinks that’s honky dory and doesn’t need our attention in the coming year.

Reich has his stuff and I have mine – but the real truth here is that our President seems to have jumped on a satellite with the Dallas Cheerleaders and Dr. Phil – with the result a breathtaking lecture that continued his theme of hope and change without any real discussion of cause and effect.

Worse yet, hidden in a smoke screen of working together was an apparent switch to a new horse called competitiveness – without any real attention to what it means and how you get it. You don’t have to be a Republican to wonder what is the connection between some diffuse and rosy mention of improving education and what it really takes for the US economy to be more competitive. Democrat or Republican, you don’t really want to experiment with the people’s money right now betting on a very new horse.  If you were critical in any way of the stimulus story, then imagine what you are thinking about an abrupt turnaround of policy in the name of government policy induced competitiveness.

One more point. One theory is that Obama is weak when it comes to cause and effect. Another one is that he is VERY strong at politics. Notice that by switching horses and by agreeing to discuss details of tax restructuring, education, healthcare, and competitiveness policy—he will turn the spotlight away from him and towards all those folks who will debate themselves hoarse in the time leading up to the next election. Obama comes off looking like the great compromiser and both democrats and republicans will look like warring tribes of the bush.

The cat is out of the bag or you might say the elephant is in the gift shop – Sputnik is a great diversion but I think we would be a lot better off if we just erased our memories of his speech and started over – with some simple discussion of cause and effect and what our most pressing problems are today.