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A Renaissance View of Deleveraging

August 11, 2012 | Comments: 0 | Views: 295
Traditional analysis of debt and deleveraging (the process where households, corporations and governments are forced to reduce their overall debt) is often biased and incomplete.  Opinions of how to best manage government debt generally fall on clear lines of politics and economic self-interest; usually with one side saying the government should spend less and another group arguing the government should tax more.  Indeed, as a libertarian it would be easy for me to argue for less government spending and more austerity.  This paper will explore how politicians face a no-win situation when trying to solve public debt through a traditional partisan lens.  We will show that a multi-faceted approach to debt reduction combined with selective tax increases and a blitzkrieg approach to spurring growth will be the only option.  This paper is not intended to be a prescription for all of our fiscal issues but rather to spur discussion with some “out of the box” ideas and challenge the traditional partisan lenses in an effort to solve this issue.  

The Basics

In federal debt discussions it is important to understand two key terms.  First, there is National Debt also known as public debt.  This is all U.S. domestic debt owed in the form of US Treasuries, currently about $15.5 trillion.  National Debt is important to track because it represents the total amount we owe as well as the amount we must pay annually to service the debt.

The other key debt term is budget deficit.  The budget deficit is the amount the US overspends on an annualized basis and thereby increases the National Debt.  The drivers of the budget are pretty straight forward.  You have money received in the form of taxes, and you have money going out in the form of spending and debt payments.

Analyzing government debt is similar to analyzing that of a household or corporation.  One must consider how much total debt burden can be shouldered and what payment is affordable.  Budget deficits directly increase the National Debt, and a higher National Debt increases the servicing cost.  The interplay between deficits and National Debt make it necessary to consider risk scenarios such as large fluctuations in GDP or how higher interest rates will impact servicing cost.

The Dilemma

From 1970 to 2012 the United States total National Debt has increased from $2 trillion to $15.5 trillion.  This $15.5 trillion figure is itself often questioned because the Federal Government does not hold itself to the same accounting standards as it does corporations.  The government uses a cash accounting methodology versus Generally Accepted Accounting Principles known as GAAP.  PIMCO calculates that if the government were to include the unfunded entitlements (as would be done in GAAP) in its National Debt calculation the figure would be closer to $80 trillion.  For the remainder of this paper we will accept the government National Debt figure but readers should consider how the dilemma would change if Pimco’s calculations are correct.

From 1970 to 2012 the public debt went from 20% of GDP to 85%. Generally 100% is considered to be unsustainable.  Many people will point out that at the end of World War II the public debt was roughly 110% of GDP and the government was able to reduce this level to 20% over the subsequent 30 years.  The United States was in a situation where the government was able to lower the debt to GDP ratio through a combination of increased taxes, higher inflation, virtually zero entitlement obligations to fund and amazing GDP growth, all without having to make too many unpopular policy decisions.

In the last four years deleveraging has added pressure to dealing with the National Debt.  Roughly 50% of the National Debt has been incurred since the economic collapse of 2008 (for comparison this works out to an increase of $400 per month per person in the National Debt i.e. $400 in month one, $800 in month two $1,200 in month three etc.).  It is expected that the National Debt will increase as a way to try to offset household balance sheet deleveraging, but rarely are debts of this magnitude accepted during times of peace.  Such increases have led to political tension that is further increased by the fact that global sovereign debt appears to be reaching a breaking point whereby many governments cannot service their National Debt.  In turn this leads to questions as to our governments’ ability to service its debts.

Table S-5 below is page 210 of the president’s 2012 budget.  The budget is broken down into three main components.  Total government outlays, total receipts and the remaining deficit or surplus.  Given that the budget office is forecasting budget deficits for the next decade, we will focus our discussion on outlays and receipts and thus, how the deficits are being created.  Outlays are broken into four subcategories:

  1. Security, which includes the military, the FBI, the border patrol, homeland security.
  2. Non-security, all other administrative functions of the government.
  3. Net interest, which is the payment on treasury debt.
  4. Mandatory programs, which includes entitlement spending.  A quick look at 2012 will highlight how difficult of a situation the government faces.

In 2012 the government projects it will take in $2.469 trillion in taxes but plans to spend $3.796 trillion creating a deficit of $1.327 trillion.  Once the government pays the $225 billion in debt service expenses and the $2.252 trillion on mandatory programs there is exactly $7 million left to run the military and administrative arms of the government.

In order to balance the budget I ran a hypothetical scenario where I had complete political freedom to make any changes I deemed necessary.  In this Financial Czar fantasy scenario personal taxes increased across the board by a whopping 30% and ALL security spending was cut in half (This would have interesting implications on GDP, unemployment, and of course, national security.).  Even with these massive upsets there would still be a deficit of $800 billion.  This means, Medicaid and Medicare would need to be cut simultaneously, or social security would need to be cut entirely, or some combination of all three would need to be cut in order to bring the budget into balance.

Balancing the budget using traditional politics is in fact impossible.  Effectiveness of tax policy will be limited by the diminishing and even negative returns outlined in by the Laffer curve assuming of course you can get these changes through congress.  Any spending cuts will be hotly debated and the most needed cuts to entitlement programs will prove politically unsavory.  Moreover, the magnitude of cuts needed would most likely put the economy into a deep recession or depression and may even spark riots. In order to successfully navigate out of debt and deleveraging politicians should consider a different approach.

Looking Forward

"People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them."

Warren Buffett in Fortune, December 2001

Politicians are afraid to make the necessary decisions to ensure the long-term economic wellbeing of our country because of the political fallout that may occur; it is wishful thinking to believe that we will magically grow out of our debt like we have been able to in our not so distant past.  They are akin to CEO’s of publically traded companies that make terrible decisions for the profitability of the company over the next thirty years because their bonuses are based on quarterly results.  This is a call to action.  The economy should be viewed as a business that belongs to every citizen and policies should be made in ways that will help that business grow sustainably. Policies that cause this business to stagnate should be halted.   Similar to the growth that pulled the world out of the dark ages, we need our own renaissance.  Below are a few ideas.

One policy that would promote growth would be a complete overhaul of the tax code.  It is interesting that the IRS defines “wealthy” differently than the rest of the world.  Usually when people discuss someone that is wealthy it is based on that individuals’ total net worth.  Rarely is there a mention of how much an individual made in one particular year or quarter.  Moreover, some of the richest people in the world amass fortunes but pay themselves very small salaries.  Some even donate these mega fortunes upon their death skirting the IRS altogether.  Take for instance the low incomes of Mark Zuckerburg, Warren Buffett and Bill Gates relative to their Net Worth.  Each of these individuals have pledged their Net Worth upon death to the Gate’s Foundation skirting taxation entirely.  It would seem a pro-growth tax code would be one that minimized annual taxation and maximized the taxation on wealth amassed during one’s life.  Allowing business owners and entrepreneurs to utilize their assets during their careers would be a pro-growth measure.  Similarly, taxing large fortunes that now go completely untaxed and are often donated in a way that helps foreign countries would be a pro-growth initiative for the United States.  Such a tax policy when coupled with a consumption tax would spur investment and savings and would have the added benefit that the government would be an equity partner in the growth and ingenuity of its citizens versus its current roll where it is viewed by many as one of the biggest road blocks in business.

Policy makers should also take steps to reduce regulation and red tape; regulation not only slows business it adds to the fixed costs in starting and maintaining a business.  Reducing barriers in business should be the goal.  Tax incentives in the form of payroll reductions should be given to businesses that are seen as high growth such as information technology, nanotechnology, clean fuel, bio technology, etc.  It is possible that innovation is highly mis-valued by politicians.   As recently as 1995-2000 technology turned deficits into surpluses.  Technology may also offer economic growth and qualitative changes that are yet to be fathomed.  It is highly possible that even though we live in the age of technology advancement has not been at the pace it could be.  The legendary technology investor Peter Thiel’s Founders Fund (early investor in Facebook) has a tagline of “We wanted flying cars, instead we got 140 characters.”  This tagline is designed to show the complete disconnect of what people once believed could be the trajectory of technological advancement and what actually became reality (140 characters describing the character limits in twitter).  Perhaps we don’t have too much debt but rather not enough technological advancement.  It often seems that politicians work ferociously to maintain the status quo.  Instead policies should be made to stir up the status quo; indeed disruptive technologies need policies that promote disruption. 

In the process of reducing government road blocks to business, policy makers would reduce the size of government and reduce the budget deficit.  While this will be a good start, further cuts are critical.  The Military, administrative departments, and entitlement benefits all need to be scrutinized.  Deep cuts are necessary but the question is, where will they come from?  Nobody wants cuts. Either to what has been promised or to programs they take advantage of.  Discussions about where to make cuts are highly sensitive and even politicians, who are paid to make these tough decisions are not having an open dialog about how to make the situation sustainable.  So I pose this question to politicians and their constituents, both of whom have interest in the long term well-being of our nation:  How could our current fiscal policies particularly regarding Military, Government Programs, and Entitlement Benefits be reformed to promote sustainable growth?

Investible Themes

We now live in an era where policy makers directly impact investment returns. Sovereign debt in developed economies looks to be very questionable when one takes into account the rate or return for the risk being taken. Globally, interest rates on the debt of developed economies would give the appearance that these securities hold little risk. My analysis above shows how the United States will have a very difficult time making the necessary policy changes to avoid default on its debt. Other developed economies appear to be in a similar situation with many even in a far worse predicament. Investors should weight their holdings of developed country debt proportionately to the level of sustainable actions being taken by policy makers. Similarly, on a longer-term basis, the credit spreads between the debt of emerging markets and developed economies appears to be too wide and we would predict these spreads to narrow overtime without sustainable policy response; as the market comes to value risk more appropriately emerging market credit will be priced with a lower risk premium than it does today and developed economies with a higher premium. When it comes to a ten-year treasury bill yielding 1.58%, and policies that promote the status quo, we can only say buyer beware.

White House proposed budget (pg 210)

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