Economics and the Debt Ceiling
Lately, there has been a lot of public hand wringing about the debt ceiling, or the legal limit on how much Congress can borrow. Essentially, they’ve reached the limit and since Congress borrows about 43 cents for every dollar spent, they need to raise the ceiling in order to fund the current operations of the government. So what would happen if the debt ceiling isn’t raised?
Today, the Federal Government is on track to spend about $1.6 Trillion dollars more than it will bring in from revenues; it will spend 43 percent more than it takes in. If the debt ceiling is not raised, then spending would have to be immediately slashed by $1.6 Trillion dollars. That would be roughly equivalent to ending all spending on Social Security and Defense. It is also nearly three times the total “non-defense discretionary spending” that you hear so much talk about in Washington.
While sharply cutting government spending has a visceral appeal, we have to remember that money spent by Congress currently makes up about 25 percent of Gross Domestic Product. Cutting $1.6 Trillion dollars of spending from the Federal budget would mean immediately removing about 11 percent of wages, goods and services from the economy. To put that in perspective, the peak-to-trough decline in GDP during the recent “Great Recession” was roughly four percent. Now, it’s probable that the private sector would eventually replace that activity, but it wouldn’t happen quickly, and even the most optimistic economists agree this would cause a jarring dislocation in the middle of an already weak recovery.
While few observers believe that Congress will cut so much from the budget in a single year, what seems more likely is that the $1.6 Trillion number will be spread out across many years (10 is a frequently cited number). This would remove about $160 Billion, or about one percent of GDP, from Federal spending each year for the next ten years.
GDP was approximately $14.7 Trillion in 2010. Historically, Federal spending has averaged about 20.5 percent of GDP, but today it’s closer to 25 percent, due largely to the drop in GDP and increase in stimulus and support spending. Bringing the budget just back to this long-term average would mean cutting the budget by about four percent annually, or about $450 Billion per year. That’s about the total of 2010 spending on Medicare alone, or about 2/3 of defense spending. With the economy growing at just under a two percent pace, cutting four percent from the Federal budget would have significant near-term consequences, likely causing the economy to lapse back into recession.
From 1946 to 1980, Federal spending averaged 17.8 percent of GDP, while revenues averaged 17.2 percent. As long as the economy was growing faster than this gap, the national debt remained manageable. From 1980 to 2008, spending averaged 20.6 percent of GDP, while revenues remained at just 18.2 percent. This means that over the last 30 years, the Federal debt has been growing at a much faster pace than during the first half of the post-war period.
To quote a recent analysis from JP Morgan, “[as] a practical matter, the federal budget cannot be balanced without increasing taxes and cutting spending on Medicare, Medicaid, Social Security and Defense.” To varying degrees, this has also been the conclusion of each bipartisan panel which has examined the issue.
As the economy improves, so, too will the budget picture, though much will depend on the speed and strength of the recovery. From my perspective, what seems most likely is that government spending will be cut across the board, including Medicare, Social Security and Defense. I also expect we’ll see higher taxes soon, though probably not until after the next election. Finally, with economic growth subdued, interest rates are unlikely to rise significantly, at least not until wages pick up. Expect a slow-growth, low return investment environment for some time to come.
More on how to invest in this “new normal” next time.
Category: Business
