Maxed out!

As we’ve discussed previously, uncertainty remains an ongoing theme in the U.S. economy. From the businessperson’s point of view, pitfalls are obvious and opportunities scarce. Weak consumer spending, zero interest rates, confusing health-care and financial regulation and the looming fiscal cliff have combined to knock economic “deciders” into their bunkers. The best evidence of this is the steady decline in new orders for capital goods (see chart below), which has accelerated in recent months.


After rebounding sharply from the great recession, business confidence and investment have been leaking away since mid-2010 like helium from an old balloon. No matter how much money the Fed prints, risk remains a four-letter word. What action by policy makers could reverse this drain? What course correction would give businesses enough certainty about long term prospects to begin investing again?

We think the number one confidence builder would be an ironclad plan to return federal spending to less than 20% of GDP and keep it there. As the following chart shows, federal spending today consumes 24% of GDP. This is up from 19% just before the great recession, and a post-WWII average of about 20%. Federal revenues have averaged 18% of GDP over this same 67-year period, and are currently running at 16% due to the recession. What this graph proves is that the economy can function quite readily over the long term with an annual Federal deficit of 2% of GDP. Understanding why this is so, and why there is such fear of runaway debt at this point in our history, comes down to basic math.


As noted, the Federal deficit has averaged about 2% of GDP since the end of WWII. Compounding this annual increment for 67 years brings us to today, where our debt has now surpassed our economy in size. Simple math shows that once the debt grows this large, any sustained rate of interest on that debt which is greater than the rate of economic growth bankrupts the government. This is because, in such a situation, more than every dollar of growth goes to pay interest.

Nominal GDP today totals $15.5 trillion, and is growing at about 2% annually. Federal debt is just over $16 trillion, and is in fact growing much faster than the economy, at about 7 percent per year. (The 2012 fiscal deficit was just announced at $1.1 trillion, and $1.1 trillion/$16 trillion = 7%.) But even ignoring the growth, our argument holds. The effective interest rate on the Federal debt was 3% in fiscal 2012. Given that economic growth was 2%, we’re already stuck in the mathematical pickle described above. Our economy is growing more slowly than our interest bill, and we’ve begun borrowing just to pay the interest on our credit card!

In this sense we’ve already passed the point of no return, and we believe the majority of American business people realize it. That’s why they’re frozen. The Federal Reserve can print money to buy long-term Treasury bonds to try to drive down Federal borrowing costs till the cows come home, but Ben Bernanke and company can’t fight basic math. The only solution is to get the true source of the problem, which is runaway Federal spending, under control. The steady blue line on the graph above shows that the private sector will happily (?) provide 18% of GDP to the Federal government over the long term, regardless of the tax rate or the general condition of the world economy. This 18% number has held firm whether the highest marginal tax rate was 91% (1950s) or 28% (1980s). The Federal government needs to live within, or at least close to, this 18% boundary. The postwar history of the U.S. demonstrates that an economy compounding at 4% can readily support debt compounding at 2%, even from elevated levels. (U.S. debt reached 121% of GDP after WWII; spending discipline combined with rapid growth in the 1950s to bring it back down.) The reverse is most certainly not the case, particularly when the artificially low interest rates of the Bernanke era become a thing of the past.

by Charlie Smith