Friday, February 5, 2010

The Federal Budget - Federal Debt

This is one of a series. For the other parts click on the links below:

The Federal Budget - Social Security and Medicare
The Federal Budget - My Budget

Debt is a big word in this country. Right now we are sitting on $12.5 trillion of actual debt (and another $10-20 trillion of defined benefit debt based on current law). Back in the 80's and 90's there was talk of cutting the debt in half. Now all we hear about is cutting the deficit in half. So let's start by defining those terms.

DEBT - the amount of money that the US owes.
DEFICIT or SURPLUS - the difference between receipts and outlays for a given fiscal year.

Now, some people think that the DEBT is calculated by adding up all of the DEFICITS (or SURPLUSES). If you are one of those, you would be wrong. That is because the DEBT is composed of two parts: public and intragovernmental. The PUBLIC DEBT is debt instruments that are held by parties outside of the federal government: Savings Bonds, Treasury Bills, etc. The PUBLIC DEBT is held by corporations, foreign governments, and individuals (like me and you). Pretty much anyone or organization in the world can buy PUBLIC DEBT.

INTRAGOVERNMENTAL DEBT are debt instruments held by other government controlled entities (like the Social Security and Medicare Trust Funds). Basically, excess receipts (above what is paid out for the year) in the government trust funds is loaned to the government (yes the same government), and in return a trust fund bond is received. Governments can do this since they have the power to print/create money. You and I and every corporation out there would go to jail for fraud if we tried such a thing with our trust funds.

So how would this look in the real world. Let's say I make a promise to my kids to pay for their college. I get a job delivering pizzas to get the extra money. And, I get a piggy bank for them and put $9,000 in it a year (all of the pizza money is earmarked for my kids college). Since they don't have any college expenses right now, I then borrow that $9,000 from their piggy bank and put a piece of paper that says I will pay them back $9,000 +3% each year in interest. I have basically created $9,000 of INTRAFAMILY DEBT.

Let's go back to the DEBT and the DEFICIT/SURPLUS principle for a minute. Each year the big thing to talk about is the DEFICIT - mainly because the DEFICIT has gotten so large that it eclipse's the DEBT of the 80's (in 1984 the DEBT was $1.56 trillion, in 2010 the DEFICIT is projected to be $1.55 trillion). The goal Obama has proposed is to cut the DEFICIT in half, which would still make it larger than any year except Bush's last year budget (2009). DEFICITs have become the natural state of the American Government.

But what about Clinton's Surplus (or the Republican Congress' Surplus depending on how you look at it)? Again lets go to the definition. The SURPLUS happened because the US had less outlays than receipts. Now, in our personal world, we look at oulays and receipts as expenses and income (or revenue). This is where it gets a little hazy. The government (by law) has promised money to certain trust funds (for instance SS) and in some cases has even set aside taxes which (by law) can only be used for those trust funds. These taxes are part of the receipts. However, the excess for the year from the trust funds is loaned to the government (by law) and can then be used for whatever spending is wanted.

During Clinton's second term, the budgets showed a SURPLUS (less outlays than receipts) each year (1998-2001: I include 2001 since the fiscal year starts in October of the previous year). However, the DEBT went up, because a portion of the outlays were "financed" with the excess money of the governmental trust funds. In other words, the PUBLIC DEBT (selling of Treasuries and Savings Bonds) may have gone down, but the INTRAGOVERMENTAL DEBT (SS Bonds) went up by more than the PUBLIC DEBT went down. Hence, total DEBT still went up. In fact, total DEBT has gone up every year since 1940 except 5 ('47, '48, '51, '56, and '69).

How would this look in real life? Let's go back to our example. We'll assume that I have a $75,000 home loan and $45,000 of IOUs in my kids piggy bank (a total of $120,000), and I bring in $22,000 a year ($9,000 from pizza money and $13,000 from my regular job). My first kid just started college and needs $8,000 a year. So, I pay that and borrow the other $1,000 (increasing my IOUs to $46,000). This gives me with $14,000 ($13,000 + $1,000) to spend freely. If it was a Clinton year, I would only spend $13,500. So total outlays was $8,000 + $13,500 = $21,500. Therefore, I have a SURPLUS of $500 which I then apply to the home loan. So my total DEBT is now $75,000 - $500 + $46,000 = $120,500. Even though I had a "SURPLUS," my total DEBT went up because for accounting I am mingling the promised college fund (i.e. Social Security and other trust funds) with my regular finances (the rest of the budget).

Unfortunately, this is an Obama year, so the result is much different. Kid still needs $8,000, I still borrow the extra $1,000. However, I also need to take out a home equity loan of $17,000 to finance the remodeling that I am doing. So, at the end of the year I have receipts of $22,000 and outlays of $39,000 ($8,000 + $1,000 + $13,000 + $17,000). A DEFICIT of $17,000, although our total DEBT went up by $18,000 ($17,000 + $1,000). And if you want to have my numbers more closely reflect reality, just add seven 0's on to each one.

Now, can you really count the IOUs in my kids' college fund as debt? If you want to argue that no, it is fake anyway then look at the consequences. I tell my kids I am welching on the promise and they get all huffy. Since I am there dad, they can't get rid of me, however, they do eventually go off to college and work their tails off to pay for it. They don't ever trust me again, particularly with money matters and come to visit on the occasional Thanksgiving or Christmas. I grow old, and spend my lonely last years in a retirement home because my kids don't really like me and aren't going to pay for some nicer digs.

OK, so what about from a government standpoint. In theory, the government can just do away with the trust funds and make all of those IOUs worthless. In practice though, you would have to get 218 Congressmen, 60 senators, and a president to go along with it. None of these people would ever have a glimmer of ever holding public office again, and more than likely would face death threats if not actual assassination attempts (people get a little crazy when you take away their duely "earned income.") The chances of that happening are 0.

So what is going to happen? Well, when the second child goes off to college and I now need $16,000 a year, I can always get another job delivering pizzas. Except that there isn't not enough demand for that and all of the prime pizza delivering time is already being taken up by my 1st pizza delivery job. So eventually, I am going to have to start using my regular income. But we have already shown that is not enough, and so I'll have to take out another home equity loan.

Of course the bank isn't going to lend me money forever (just like investors will eventually stop buying US debt). At some point, they will say that my house isn't worth the risk of another loan. For them it is easy, they have a tangible point. For the real world, there is no known value that people will stop buying US debt, however, it is there somewhere as the debt grows faster than the economy, we get closer to it.

When that happens, the government still has another trick up its sleeve that I don't. It can print money. Now, with my laser printer and the right paper I could make an approximate facsimile of US currency and might even pass it off to the colleges as real money (kids DON'T try this at home - it is called counterfeiting and is illegal). Of course once they find out, the game is up and if they don't throw me in jail the minimum the college will accept is a certified bank transfer.

When the government continuously adds money to the supply, the hoi poloi eventually get nervous and inflation can happen. Rampant inflation. Not the late 70's type of inflation. We're talking Weimar Republic inflation right before its demise. Or Zimbabwe inflation. It is really the financial death spiral of a government. The paper money becomes nearly worthless, so more of it is printed until it gets to the point that the paper itself is worth more than the amount denominated on it. Lots of bad things can happen during this time.

So, let me introduce a term I made up: CUMULATIVE PRIVATE DECREMENT. The cumulative private decrement is a measure of the sustainable level of public debt (I exclude intragovernmental debt because it would make it look so much worse and all intragovernmental debt is funded by the private sector in the end). The % Private Decrement is first calculated by adjusting the % change in publically held debt and the % change in private GDP (GDP - government spending). The cumulative value is then added over a given period of time. I chose 1950 as my starting point since the budget figures for debt start in 1940 and I didn't want to start in the middle of a war (it tends to make the numbers look a lot worse since there is always massive spending during a war).

Basically, what this means (if I did my math right) is that public debt has increased 465% more than the economy as a whole has since 1950 (and really since 1970). From 1950 to 1970, debt growth was actually slightly less than the growth of the economy. This is sustainable. A government can increase its debt indefinitely as long as the means to service that debt (growth of the private sector) is also increasing at the same or faster rate. However, since 1970 the US has steadily increased its public debt at a rate that exceeds the economic growth of the private sector. The disappointing part is that the budget outlook for the next five years continues this trend. Public debt is expected to increase faster than private GDP. In other words, the situation is only going to get worse. And that's before you add in my less rosy predictions from The Federal Budget - Spending Projections.

Where the tipping point is, I don't know. I don't have plans to sell off the US Savings Bonds that I have. Then again, I don't have any plans to buy more in the immediate future either.

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