Thursday, August 11, 2011

The Role of Growth in the Debt Crisis

For the first time since 1917, the US no longer has the highest possible credit rating, AAA. As everyone knows by now, last Friday, shortly after the stock market closed, S&P reduced its rating of US debt to AA+, its second highest ranking, based on a combination of the political wrangling involved with the way the US conducted itself during the debt/deficit deal process, the deal itself (deferred cuts + smoke and mirrors), and the economic prospects for the US moving forward.

Critical to all of this is the likely trajectory of the future debt burden on the US economy, which clearly impacts our ability to afford this debt. But how is debt burden defined? As a basic economic tenet, this is defined in relative terms -- the debt relative to our country's ability to afford it. Our ability to afford it, or ability to pay, is predicted on GDP, the value of final goods and services produced in the US. So, the focus of whether we can afford to pay our debt in the future is defined based on the Debt to GDP Ratio:

Debt to GDP Ratio = National Debt/GDP

This is not unlike what your credit worthiness is evaluated based on if (say) you apply for an auto loan: what percentage of your income (which works like GDP here) will the payments (debt) account for? Generally, if this ratio exceeds 28%, you'll be instructed not to forget to close the door on your way out -- application over! The lower is the relevant ratio, or debt relative to the ability to pay it, the more credit worthy the person or country is deemed to be.

Permit me to digress to an algebraic result at this point: through time, this ratio falls when debt grows more slowly than GDP. In other words, economic growth (the change in GDP) must outpace increases in debt for debt burden to decrease through time. So far, so good. The problem is that things get much more complicated because changes in the rate of growth themselves alter national debt by changing the federal budget.

Consider what happens when the rate of economic growth falls, either during recessions or periods of slowing growth. The way our fiscal system is designed, two critical elements automatically impact the federal budget: progressive income taxation; and entitlement spending for programs such as unemployment insurance or welfare.

  1. In a slowing economy or a recession, income tax revenue automatically falls, as there is now less income available to tax (the result of layoffs, reduced hours, etc.).
  2. At the same time, more persons qualify for entitlement programs such as unemployment insurance, automatically raising the amount spent by those programs. (FYI: the reason these are called entitlement programs is that the government only sets the criteria for entitlement, not the actual amount spent in any year. That is determined by how well or badly the economy does.)
  3. Entitlement spending is countercyclical, meaning that it rises when the level of economic activity falls (such as in recessions), and falls when economic activity improves (in recoveries).

The overall result is that the federal budget either has a smaller surplus (yeah, right!) or a larger deficit when economic activity deteriorates. More importantly, the larger deficit then adds to the national debt. The result is a greater debt to GDP ratio. As this shows, changes in the national debt are necessarily linked to changes in the rate of economic growth.

In light of this, what do governments often attempt to do? Pad the denominator -- overstate likely rates of future economic growth, making the debt appear to be less of a burden than it will actually prove to be. Actually, there is an added bonus to doing this: based on what I outlined above, if the rate of economic growth is overstated, tax revenue will also be overstated ("smoke"), while entitlement spending will be understated ("mirrors"), making the deficit, and thus the change in debt, appear to be smaller than it will eventually turn out to be!

The problem is, you can only get away with this for so long. Eventually, either voters or rating agencies will figure out what's been going on. That's when the party ends!

Of course, there are lots of other fiscal tricks that have been utilized by our government for quite some time now. I won't get into those now, but they often consist of deferring future cuts or revenue changes, assuming that these will definitely occur when assumed. This is essentially what the first round of debt reduction did.

Perhaps had the recent political process dealing with this not been such a fiasco, we might have continued to get away with these practices and gimmicks. While two of the rating agencies did not deem our debt and this process to be problematic, the S&P finally had enough, making the downgrade call. Interestingly, S&P also made mathematical errors in their determination our creditworthiness. Apparently their mind was already made up - they refused to be confused by the facts! They claimed that it was just merely a matter of different assumptions in future years. Obviously, the effects of padding exist in both directions -- symmetrical fudge factors!

Instead of arguing with S&P's decision, I prefer to view it as a very necessary wake-up call to our nation and its leaders. We have to change and to abandon the pervasive use of "smoke and mirrors." Remember, the S&P rating was not only a downgrade, it included a negative outlook as well. So, if the "committee of twelve" does what appears to be likely, more theatrics and gridlock, the US could be downgraded even further by S&P. And, I don't rule out possible downgrades by either or both of the other ratings agencies.

At the top of my holiday wish list is one very prominent wish: that members of the US House of Representatives stop acting like a bunch of spoiled three year olds, and that they finally place the good of our country ahead of their fragile egos. Unfortunately, this is not likely to be the case. As we have now begun the move toward "round two" of the debt ceiling process, the markets yesterday were rather unequivocal -- they tanked today just after hearing the list of persons who will make up the group of twelve that will potentially decide the next round of spending cuts. Unless a miracle occurs, this group will almost certainly end up deadlocked, resulting in mandatory cuts being put into place -- but they only go into effect after the election. Here we go again!

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