Making Cents Of The U.S. Debt Crisis

by Hunch on July 31, 2011 · 8 comments

in Politics/Policy

With just a few short days from the looming U.S. debt cap going into effect it seems to me that the negotiations need a kick in the fourth point of contact.  This seems like an apropos time to interject my position.


The rift between our politicians, as I understand it, is basically raising revenue vs. reducing spending.  Any good negotiator will tell you the secrets to a successful outcome is to identify which party needs the other more, when concessions are made , how hard to push and willingness to walk away from a bad deal.  I for one find it inexcusable that political posturing, sound bites for re-election campaigns, and yes even ideals are careening our nation into a bite off nose to spite face scenario.  I fully understand that ideals have their place and that forcing an issue to it’s breaking point is the best way to push your agenda but this negotiating tactic is reckless in this case.  As the markets have not priced in a U.S. default and have only recently and barely moved in response to a potential U.S. downgrade, I can’t help but angrily think that if the debt ceiling was raised two or more months ago, while worsening the U.S. balance sheet, it would not have been a market event rather, simply,  Washington conducting business.    The good news is that, again as I understand it, the U.S. government can’t default on debt; the results of which would be cataclysmic (think Jaws meets Jurassic Park, meets Independence Day, meets Armageddon, meets Toba (not a movie)) and the bad news is that discretionary spending may have to be cut to the tune of 40% of the total budget.  As we’ve seen in small scale from the non-renewal of the TSA budget this will send negative ripple effects throughout the economy mostly from decreased spending from furloughed employees and private contractors who aren’t being paid for construction and other projects and, worst of all, by scaring the bejesus out of everyone.


Since political negotiations are full of nuance and intricacies let’s look at this scenario from the point of view of a five year old.  If a five year old receives $10/week for allowance and sees a toy for $50 he just can’t get it, but if he really wants that toy he can save for it prioritizing other purchases such as a weekly ice cream cone.  The five year old understands that he just can’t afford the toy and that if he truly wants that toy he must sacrifice elsewhere.  However, the industrious five year old will realize that by raking leaves he can expedite his revenue streams and accumulate the money for the toy sooner.   It seems to me that the government of the United States should take the five year-old’s position and force it’s expenditures to fall within its revenue streams by reducing or eliminating programs of lesser importance.  Since no one elected me to office I won’t offer my opinions as to what should be curtailed and by how much — though at the very bottom of my list are: defense, law and order, and smooth roads — but it is essential that we start matching expenditures with revenue streams. 


As I aforementioned there is no scenario where the U.S. balance sheet is stronger after a deal is reached, all that will be accomplished will be that the U.S. will incur more debt and continue to function unencumbered.  Some of the biggest budget items are defense, and entitlements (Medicare, Social Security, etc.) and of course the other side of the equation revenues (taxes.)  On the expenditure side of the ledger I believe in strong defense and while I generally prefer smaller government I believe that we should provide in some way for the less fortunate amongst us but when the rubber hits the road we need to radically reexamine our approaches to both.  With respect to defense I understand that it is necessary to have a large well trained standing force and that the best defense is a good offense and while I have nothing but respect, admiration, and gratitude for the courageous and honorable men and women serving in our nation’s armed services I can’t help but think that they are deployed too readily and for too long.  Aside from the toll on our troops our pockets simply don’t run deep enough to be the world’s police.  As for entitlement programs the math is simple, the baby boomers created a glut in the population distribution, which resulted in multiple boomers supporting one retiree.  As better medical care has extended life expectancies and the population distribution is normalizing these programs are underfunded.  While government should be a place for everyone to be represented, and no one discounted as too small, ideology must converge with reality.  Private corporations provide pensions and insurance to cover the same expenses as these government programs at a profit.  Corporations are able to accomplish this by charging premiums based on actuarial tables and pooling the money to invest and grow to cover future claims;  the pool operates like reserve requirements at banks under the expectation that all claims won’t be filed at once.  As GM might tell you, administering a pension is a little more difficult; mathematically it is easier because the maximum value of benefits to be paid over the course of a year is known.  Ideally the government would set up huge sovereign funds that would self fund entitlement programs by having annual expenses less than annual gains to preserve principal and limit future levies to augment the pool. 


As spending decisions are being considered capital structure must too be considered.  Generally funding should match duration.  That is to say taking on a loan to finance the purchase of a home that you plan to live in indefinitely is okay while taking on a loan to finance the purchase of weekly groceries will lead to unsustainable debt levels.  There are circumstances where this highly levered capital structure might be permissible, if there are sufficient funds to cover the expense and a reasonably safe investment that will yield a greater return than the interest expense and transactions costs, but at the government level this risk should be adverted.  There is an effort to pass a balanced budget amendment in Congress but a better budget would borrow for long-term projects preventing the financing term exceeding the reasonably expected useful life of the purchases while funding all recurring or short term expenditures from general revenue.  Once these conditions are satisfied, I can’t believe I’m saying this, dedicated taxes should be levied only during the deleveraging period to quickly strengthen the balance sheet .  While it is unavoidable to curtail spending increasing revenue runs the risk of a negative income effect.  Income effect is the impact on consumption as a result of an increase in income; as income rises so does consumption.  The income effect calculation for specific goods and services involves elasticity of demand, availability of supply, savings rate and other considerations.  At the macro level the calculation simplifies to account for the consumption and investment multipliers of GDP minus the savings rate.  The formula to calculate GDP is C+I+G+Nx.  C (consumption) is usually the largest portion of economic activity and increasing taxes will almost assuredly shrink C.  I (investment) are corporate expenditures which are unlikely in the face of a shrinking C.  G (government spending) will also shrink but this is essential to shift from an unsustainable debt level to a sustainable one.  Nx (net exports) may pick up some as the dollar is likely to decline against currencies of nations likely to import from the U.S. but not nearly enough to compensate for I let alone C or G.  It is essential to shrink G and taking a risk in raising taxes to deleverage will likely shrink C; coupling these actions will provide a strong foundation for foreign direct investment and a more stable economy in the medium to long term leading to increased hiring, disposable income and consumption.  I should also note that there is a small but improbable chance that C won’t shrink under this plan.  The only forced decline in C due to the new levy would be households that have no savings and live paycheck to paycheck while C is driven by households with an abundance of cash.  Financial reforms should increase consumer’s outlook and therefore their propensity to spend though in the short term a reserved posture would be expected to be maintained to see if the financial reforms are implemented as expected.


By definition a recession has to be spent out of; it is the only way to correct an economic contraction.  Unfortunately, the employment level is too low for consumers to drive a recovery and the government is too over leveraged to provide the huge sums necessary to countermand the current negative sentiment .  That leaves the exact opposite, extreme fiscal conservatism as outlined above, as the best chance to stabilize the economy.  Businesses react to three primary factors revenue/margins, risk, and uncertainty.  There is virtually no way to drive revenue or margins higher, there just isn’t the capital available in any of the main GDP drivers but a strong balance sheet will remove a lot of risk and uncertainty.  The problem is that this creates a prisoner’s dilemma between the public interest and corporations.  Hopefully CEOs have studied non-competitive game theory and realize that the Pareto optimal situation requires them to ignore short-term instability and maintain headcount paving the way for a prosperous mid and long term rather than hoarding cash and reducing head count forcing a negative spiral or tailspin.


The problem now is that while a few months ago the increase to the debt ceiling would have been written off as regular legislative business and, while increasing leverage ratio, would have had a minimal impact on the market.  Now as virtually nothing has been priced in, the market can only drop regardless of the outcome due to the increased political risk stemming from both the lateness of a solution and the wet tissue paper weak balance sheet.  These negotiations can only yield a bad outcome: increased leverage  or worse, an initial capital crunch preceding increased leverage.  Absent good news or abating of fear to lift markets, the only rational direction for markets to head is downward.    


 As I fully expect markets to retreat it is sensible to move to cash or metals.  The problem with moving to cash is that if any investments are short term in nature this would result in a substantial income tax charge.  Since this is an unintended consequence of the government’s stalemate I’d like to know if these taxes will be waived? 


In any event, shedding political rhetoric and re-election considerations to deliberately and thoughtfully re-structure government revenue, expenditures, and capital structure is essential for the continued prosperity our country has enjoyed these many years.  Just like the little boy had to forgo ice cream for a time and miss playing with his friends to rake leafs, the smile on his face carrying home the new toy and satisfaction from working hard and being rewarded are well worth the sacrifice.


The long and short of it are these salient details:


√  The government delayed in raising the debt cap causing a routine event to transform into a market event and in so doing brought enough attention to the topic to give it the best chance possible to correct the underlying deficiencies before it’s too late.


√  Short term market turmoil is to be expected.


√  The government has to fundamentally shift its approach to budgeting.  Long term corrections should be set by ideologically driven policy blended with business acumen to design a sustainable budget and framework.  Serious consideration must be given to capital structure particularly long term financing versus revolving credit and matching expenses to revenue balanced against GDP drivers and income effect.


√  The word of the day in Washington should be sustainable.


√  The word of the day in the boardroom should be circumspect; there is a lot of money to be made by business that can successfully tack through this restructuring to a more prosperous time.

{ 8 comments… read them below or add one }

Aaron_Williams 08.01.11 at 12:21

I violently disagree with this sentence “By definition a recession has to be spent out of; it is the only way to correct an economic contraction.”

Hunch Hunch 08.01.11 at 13:12

Mr. Williams: Firstly, I’d like to thank you for taking the time to post your thoughts and raise the level of debate. While I’m not sure that you can violently disagree with my statement, unelss you plan to express your disagreement by punching me in the face, I am interested in your position. Secondly, you do make an interesing point that it might be possible to have private economic output increase offsetting a consumption decline. For example home gardens grow and produce more vegtables causing Dole’s reveunes to decline but the increase in private vegtables offsets the Dole losses. For our purposes if recession is defined as a prolonged contraction in economic output as expressed by expenditures I don’t see how you can grow without spending. Please let me know your thoughts and expand on your original comment. – Hunch

Aaron_Williams 08.01.11 at 13:41

Hunch, Being an Austrian economist I am of the opinion that recessions are a cyclical event and a necessary mechanism of the business cycle. This current recession is due to the distortion and malinvestment of capital. The capital structure was and is distorted by the lending practices of the Fed. The economy will only recover once the malinvestments have been cleared from the market and capital is again directed toward its more efficient uses. I am trying to think of an example of a country that has successfully spent its way out of a recession… Nothing comes to mind except for the excuse “we didn’t spend enough”. Can you provide of any examples?

Hunch Hunch 08.01.11 at 14:15

Dr. Williams: I agree that recessions are an essential component of the ecnomy; you need an oil change from time to time. I and while they are cyclical the length (lost decade) can be quite prolonged. I’m affraid that your argument is specious as I never said it had to be government spending that increased economic output. The simple fact is that GDP will not grow if aggregate consumption from all sources does not increase. Also the U.S. government spent its way out of the Great Depression on World War Two. You make very interesting points particularly to missallocated funds and capital structure disfunction; whith which, I fully agree. To end a recession GDP must expand I don’t know how that happens without increased spending from one of the contributors; staying flat and contraction are just that. I hope you’ll continue to keep me honest this was quite interesting for my part. – Hunch

Aaron_Williams 08.01.11 at 15:03

I may have preemptively jumped down your throat when you said that a recession must be “spent out of”. I have these horrible flashbacks of politicians using that very line to put me in the shackles of debt. How much money was recently spent in order to “spend our way out” of the current recession to no avail? Demand must increase which in turn increases spending and income. Increased demand for war goods caused the increase in government spending. The spending that was done by FDR before the war did little or nothing to actually increase demand and spur economic growth.

Turc1656 Turc1656 08.24.11 at 13:28

Dammit Aaron, you stole the words right out of my mouth.

I was going to make the important distinction between spending our way out of a recession and demand increasing which thus leads to increase spending, production, investment, etc. the FDR policies are a perfect example and they were also exactly what I was going to use. The US went into debt from 1 billion to 27 billion leading into WWII and it did nothing because people were still understandably skittish about the economy so those that had any extra money sure as hell didn’t spend it on anything but the essentials.

otherwise, everyone ends up hoarding whatever it is they have. Demand is always the key factor because supply will always adjust to meet it, provided there are no physical limitations like the inability to produce a desired good because there simply isn’t enough of the materials that go into it. Outside of that, supply always adjusts, as do prices.

Turc1656 Turc1656 08.24.11 at 13:32

also, i completely agree again with Aaron that the bad debt needs to be cleared. the longer we push it out, the longer we put a serious damper on economic growth. bad debt needs to go. the problem is no one is willing to take a loss. so instead we get bailout plans and other crap ideas that stave off failure in certain areas.

we are being Japan’ed, slowly and surely. and i don’t like it one bit.

Hunch Hunch 08.24.11 at 21:12

You’re correct in thinking that a robust economy is based on a strong and broad demand base; however, as you pointed out, people won’t spend if they are concerned about losing their jobs. Just like Aaron, you seem to wrongly presume that the spending has to be government driven and are missing the simple fact that for economic growth to occur spending has to increase. Increased spending is the same as increased demand but for it to be effective there needs to be the reasonable presumption that it can be sustained. I’d also argue that there is no bad source of spending, in fact your demand, which I take to mean consumption, is in some ways the worst component of GDP. Positive net exports are really good because they grow the domestic economy providing jobs and job security with external capital allowing greater growth than could occur in a closed economy. Strong net exports provide tax revenues and investment opportunities that aren’t correlated to the domestic economy i.e. consumption. This allows the two dependant contributors to GDP (government spending and investments) to offset weakness in either independent contributor (consumption and net exports).

Fundamentally, as I’ve stated before, spending must increase for a recession to end. Would GM prefer to sell 5,000 Suburbans to soccer moms rather than the FBI as part of a stimulus program? Yes because the soccer moms represent “real” demand while the directed government expenditure is “fake” as it is designed to prop up the economy. However, selling 5,000 Suburbans allows GM to hit its sales target, keep head count, which will lead to stronger consumer confidence and the beginning of the consumer rally. I also agree that government doesn’t distribute funds as effectively as direct consumption and that most of their initiatives are more technical in nature such as easing credit that consumers and businesses don’t avail themselves of due to their defensive posture. Absent robust demand any demand available is better than none. One contributor to GDP has to increase spending to lead the broader demand rally, very much like priming a pump with water.

Let me make clear in no uncertain terms that spending does not necessarily mean government; it just means that there needs to be an increase in the consumption of and demand for goods and services. It is more efficient and effective if spending comes from private markets; not the government. The cycle is usually this: consumers buy less prompting firms to reduce costs (usually the easiest way is via headcount) leading to a further reduction of spending and further declines of revenue resulting in more cost reductions and cash hoarding limiting investments. Government spending should drop due to less income tax revenue unless borrowing increases to offset the decline. An increase in net exports can also offset tax declines sustaining or increasing government spending; they can also provide strong enough demand to offset domestic consumption weakness prompting increased investments. To grow the economy spending must increase. Typically consumers lead the contraction and take a bath in savings and jobs during a recession. This means consumers don’t have the wherewithal to lead the rebound. Therefore net exports, government spending, or investments must lead the growth, which in turn will increase taxes and government spending , investments, hiring, consumer confidence, and finally consumer spending.

Supply adjusts to match demand only to the extent that products can be produced with profitability. The cost of production, which is itself costly to change, serves as a hard floor for pricing below which a price can’t sustainably drop. An example is the HP TouchPad, currently being sold for $150 with a production cost of $305. This extreme pricing is not to match demand, it is to liquify capital from a product that couldn’t support its supply driven price of $500 and redeploy it to a profitable business line.

I’d also like to note that for your second comment, about bad debt, it seems that you disagree with my position but I clearly recommended aggressive action to strengthen the balance sheet or clear the bad debt as you put it. I think your second comment is perfectly on point and agree with it completely.

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