A Renaissance view of Deleveraging - Part 1

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 Pimcos 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 presidents 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 (see below) 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.