James Grant: Federal Debt - The Road To Confetti - Hedge Fund Alpha (formerly ValueWalk Premium)
James Grant - Federal Debt

James Grant: Federal Debt – The Road To Confetti

Federal Debt – The Road To Confetti by James Grant GrantsPub

April 15 comes and goes but the federal debt stays and grows. The secrets of its life force are the topics at hand-that and some guesswork about how the upsurge in financial leverage, private and public alike, may bear on the value of the dollar and on the course of monetary affairs. Skipping down to the bottom line, we judge that the government’s money is a short sale.

Diminishing returns is the essential problem of the debt: Past a certain level of encumbrance, a marginal dollar of borrowing loses its punch. There’s a moral dimension to the problem as well. There would be less debt if people were more angelic. Non-angels, the taxpayers underpay, the bureaucrats over-remit and everyone averts his gaze from the looming titanic cost of future medical entitlements. Topping it all is 21st-century monetary policy, which fosters the credit formation that leads to the debt dead end. The debt dead  end may, in fact, be upon us now. A monetary dead end could follow.

As to sin, Americans surrender, in full and on time, 83% of what they owe, according to the IRS—or they did between  the years 2001 and 2006, the latest period for which America’s most popular federal agency has sifted data. In 2006, the IRS reckons, American filers, both individuals and corporations, paid $450 billion less than they owed. They underreported $376 billion, underpaid $46 billion and kept mum about (“nonfiled”) $28 billion. Recoveries, through late payments or enforcement actions, reduced that gross deficiency to a net “tax gap” of $385 billion.

This was in 2006, when federal tax receipts footed to $2.31 trillion. Ten years later, the U.S. tax take is expected to reach $3.12 trillion. Proportionally, the 2006 gross tax gap would translate to $607.7 billion, and the net tax gap to $520 billion. To be on the conservative side, let us fix the 2016 net tax gap at $500 billion.

Then there’s squandermania. According to the Government Accountability Office, the federal monolith  “misdirected” $124.7 billion in fiscal 2014, up from $105.8 billion in fiscal 2013. Medicare, Medicaid and earned-income tax credits accounted for 75% of the misspent funds—i.e., of those wasted payments to which government bureaus confessed. “[F]or fiscal year 2014,” the GAO relates, “two federal agencies did not report improper payment estimates for four risk-susceptible programs and five programs with improper payment estimates greater than $1 billion were noncompliant with federal requirements for three consecutive years.” It seems fair to conclude that more than $125 will go missing in fiscal 2016.

Add the misdirected $125 billion to the unpaid $500 billion, and you arrive at a sum of money that far exceeds the projected fiscal 2016 deficit of $534 billion.

Which brings us to intergenerational self-deception. The fiscal outlook would remain troubled even if the taxpayers paid in full and the bureaucrats stopped wiring income-tax refunds to phishers from Nigeria. Not even a step-up in the current trudging pace of economic growth would put right the long-term fiscal imbalance. So-called non-discretionary spending, chiefly on Medicare, Medicaid and the Affordable Care Act, is the beating heart of the public debt. It puts even the well-advertised problems of Social Security in the shade.

James Grant - Federal Debt

Fiscal balance is the 3D approach to public-finance accounting. It compares the net present value of what the government expects to spend versus the net present value of what the government expects to take in. It’s a measure of today’s debt plus the present value of the debt that will pile up if federal policies remain the same. To come up with an estimate of balance or-as is relevant today, imbalance-you make lots of assumptions about life in America over the next 75 years. Critical, especially, is the interest rate at which you discount future streams of outlay and intake. Jeffrey Miron has performed these fascinating calculations over the span from 1965 to 2014.

The director of economic studies at the Cato Institute and the director of undergraduate studies in the Harvard University economics department, Miron has projected that, over the next 75 years, the government will take in $152.5 trillion and pay out $252.7 trillion —each discounted by an assumed 3.22% average real rate of interest. Add the gross federal debt outstanding in 2014, and—voila!—he has his figure: a fiscal imbalance on the order of $120 trillion. Compare and contrast today’s net debt of $13.9 trillion, GDP of $18.2 trillion, gross debt of $19.2 trillion and household net worth of $86.8 trillion. Compare and contrast, too, the estimated present value of 75 years’ worth of American GDP. Miron ventures that $120 trillion  represents something more than 5% of that gargantuan concept.

There’s nothing so exotic about the idea of fiscal balance. In calculating the familiar-looking projection of debt relative to GDP, the Congressional Budget Office uses assumed rates of growth in spending and revenue, which it also discounts by an assumed rate of interest. It’s fiscal-balance calculus by another name, as Miron notes.

Nor is the fiscal-balance idea very new. Laurence J. Kotlikoff, now a chaired professor of economics at Boston University, has been writing about it at least since 1986, when he shocked the then deficit-obsessed American intelligentsia with the contention that the federal deficit is a semantic construct, not an economic one. This is so, said he, because the size of the deficit is a function of the labels which the government arbitrarily attaches to such everyday concepts as receipts and outlays. Thus, the receipts called “taxes” lower the deficit, whereas receipts called “borrowing” raise it. The dollars are the same; only the classification is different.

James Grant - Federal Debt

James Grant – Federal Debt

Be that as it may, Miron observes that the deficit and the debt tell nothing about the fiscal future. Each is backward-looking. “The debt,” he points out, “. . . takes no account of what current policy implies for future expenditures or revenue. Any surplus reduces the debt, and any deficit increases the debt, regardless of whether that deficit or surplus consists of high expenditure and high revenues or low expenditure and low revenues. Similarly, whether a given ratio of debt to output is problematic depends on an economy’s growth prospects.”

Step back in time to 2007, Miron beckons. In that year before the flood, European ratios of debt to GDP varied widely, even among the soon-to-be crisis-ridden PIIGS. Greece’s ratio stood at 112.8% and Italy’s at 110.6%, though Ireland’s weighed in at just 27.5%, Spain’s at 41.7% and Portugal’s at 78.1% (not very different from America’s 75.7%). “These examples do not mean that debt plays no role in fiscal imbalance,” Miron says, “but they illustrate that debt is only one component of the complete picture and therefore a noisy predictor of fiscal difficulties.”

So promises to pay, rather than previously incurred indebtedness, tell the tale. Social Security, a creation of the New Deal, did no irretrievable damage to the intergenerational balance sheet. It was the Great Society that turned the black ink red. Prior to 1965, the United States, while it had run up plenty of debts related to war or-in the 1930s-depression, never veered far from fiscal balance. Then came the Johnson administration with its guns and butter and Medicare and Medicaid. From a fiscal balance of $6.9 trillion in 1965, this country has arrived at the previously cited $120 trillion imbalance recorded in 2014. And there are “few signs of improvement,” Miron adds, “even if GDP growth accelerates or tax revenues increase relative to historic norms. Thus, the only viable way to restore fiscal balance is to scale back mandatory spending policies, particularly on large health-care programs such as Medicare, Medicaid and the Affordable Care Act.”

We asked Miron about the predictive value of these data. Could you tell that Greece was on the verge by examining its fiscal imbalance? And might not Japan be the tripwire to any future developed-country debt crisis, since Japan—surely—has the most adverse debt, demographic and entitlementspending profile? Miron replied that comparative statistics on fiscal imbalance among the various OECD countries don’t exist. And even if they did, it’s not clear that they would tell when a certain country would lose the confidence of its possibly inattentive creditors. The important thing to bear in mind, he winds up, is that the imbalances- not just in America or Japan or Greece but throughout the developed world-are “very big and very bad.”

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