Some Thoughts on the Deficit

Part I – Some Issues of Language

A lot of the disagreement and no small amount of the rancor generated around discussions of the deficit, the debt ceiling, etc., stems from sloppy, misinformed, or deliberately misleading terminology, where participants in the discussion are using different words to mean the same thing, or the same word to refer to different things. So before we discuss (or argue) policy, it would be helpful to have a common understanding of a few concepts (any and all corrections or objections to the following are welcomed).

1. What do we mean by the “deficit”?

Though we may want to redefine it for our own purposes, it would seem important to agree on the literal definition of the US deficit. First, what it is not: it is not the same as the “national debt,” though the two are frequently conflated, especially when someone is bloviating about the debt ceiling.

We intuitively understand that the national debt is the sum total of all outstanding debt obligations (Treasury bills, notes, etc.) of the US government, but the relationship between annual deficits and the gross national debt is rather complex (as indicated by the discussion of Social Security, below). The national debt is the cumulative debt outstanding (some of which was issued decades ago) that has been issued to make up for past and current shortfalls between governmental receipts and outlays. Thus, though the country was running a budget surplus as late as 2001, there was nonetheless over $6 trillion in US debt outstanding at that time. (Source: US Treasury website.)

[Footnote: As of December 2012, the total US debt held by the public (i.e., other than by other government agencies, such as Social Security) was around $11.6 trillion, or 73% of the GDP (this GDP measure, while historically on the high side, is far less than after WWII, when it hit 113% of GDP). A bit more than half of all US government debt is held by US individuals or institutions (including US agencies, such as the Social Security trust fund, which holds around $2.5 trillion), the rest by foreign investors (e.g., Japan and China, the two biggest holders, with about a $ trillion each). (Source: UST.)]

An accurate definition of the “deficit,” then, is the difference in any given period (usually the government fiscal year) between federal revenues and expenditures. Deficits (“the deficit” should really be referred to in the plural, as there is one per year these days) obviously increase the size of the national debt (which is what most discussion or complaint about the “deficit” seems to be really about), but the two are not the same. The distinction is closely analogous to the difference between the income statement and the “liabilities” side of the balance sheet in financial reporting. The 2012 federal budget, as enacted, ran a deficit of about $1.1 trillion. Federal deficits broke the trillion dollar mark starting in 2009, though they are projected at around $0.9 trillion in 2013. (Source: OMB.)

[Footnote: I love the debt “clocks,” those 14-digit gauges that look like an odometer gone wild, which abound these days on TV and the Internet. Whatever they are measuring, if they are true debt clocks, they do not measure the deficit, nor do they measure “government spending” (see below), though they are often presented that way (as in Republican attack ads last summer that used them to show what a spendthrift Obama is). They presumably measure total US debt outstanding, plus (importantly) interest accruing on that debt from moment to moment.]

2. Do deficits matter?

There is a strong economic argument that deficits — and the resulting debt — don’t matter in a world where the money owed is in a currency that the debtor (a sovereign government) can manufacture at will. The shopworn analogy to a family living outside its means is really a false one, in that a family – unlike a sovereign nation – cannot legally issue the currency it needs to meet its debt obligations. There’s a natural aversion – or revulsion — at the magical thinking suggested by the ability of the US to create money by fiat, but it’s been a fact of economic life since the US, under Richard Nixon, went off the gold standard in 1971. Ever since, there have been calls to return to “sound money” based on hoards of shiny metal (another form of magical thinking, one might argue), but such a wholesale change in how the macroeconomic world currently works seems unlikely.

Moreover, there are plausible arguments that the very last thing you want to be doing in a period of high unemployment is to curtail government spending, eliminate government jobs (including jobs in the military), etc.

So why do deficits matter if the risk of the US government becoming insolvent is actually possible only by willful policy (e.g., the imposition of debt ceilings – see below)?

The best answer that I’m aware of has nothing to do with fiscal solvency per se: it is that growing deficits, and the minting of money to repay the resulting debt, run a high risk of hyperinflation and increasing interest rates, which amount to an imposition of a tax burden on the populace by non-legislative means. They may also cause an eventual degradation of the value of the dollar versus other currencies, with similar results. Offsetting these tendencies might require the imposition of wage and price controls (as were instituted during WWII and again in the 1970’s, lest we forget), a far more “socialist” set of circumstances than most of us are comfortable with.

So let’s stipulate that ever larger annual deficits and a rapidly growing national debt are bad things, if only because controlling them is a hedge against the possible stupidity of future policy makers who might actually entertain sovereign default, hyperinflation, truly socialist price and wage controls, etc.

3. What do we mean when we talk about the impact of Social Security on the deficit?

Social Security, by law passed in 1990, is “off-budget” vis a vis the federal budgetary process. It is a statutory trust fund that has no access to any tax revenues other than the payroll tax. Ronald Reagan, patron saint of fiscal hawks, understood the difference between deficits and surpluses in the Social Security trust fund versus those in the general federal budget. (See http://www.youtube.com/watch?v=ihUoRD4pYzI&feature=player_embedded)

Congress and Presidential administrations of both parties nonetheless continue to present a “unified” budget that reflects Social Security receipts and disbursements, which contributes to the inaccurate notion that income taxes and other on-budget revenues are being used to support Social Security, and that therefore its disbursements are contributing to the overall deficit. This alternate presentation of budget data also enables politicians to obfuscate the size of the on-budget deficit, for reasons discussed below.

[Footnote: The benefits paid out of the Social Security trust fund (around $596 billion in 2012) are funded by two primary sources: payroll tax receipts from the currently employed (which is why it’s often, unhelpfully, called a Ponzi scheme), which in 2012 totaled $484 billion, and earnings on the assets of the trust fund (US government obligations), which in 2012 totaled $107 billion. (Source: Social Security Trustees Report, 2012.) Overall, Social Security receipts and disbursements resulted in a net surplus of $95 billion in 2012 (Ibid.). The fund has net assets (cash and US obligations) of around $2.7 trillion, though it’s fair to note that most of the US securities it holds are not marketable; they are only redeemable by the Treasury as they mature. Social Security is expected to remain in the black if no structural changes are made to it till around 2030 (give or take a few years).  A recent op-ed piece in the NY Times by seemingly disinterested quants contains an interesting discussion of when Social Security will cease to be in the black. See http://www.nytimes.com/2013/01/06/opinion/sunday/social-security-its-worse-than-you-think.html?_r=0 ]

What happened to the $95 billion surplus generated in the Social Security system for 2012? By law, it was lent back to the Treasury (or, in terms of economic substance, the Social Security fund deferred receipt of $95 billion of bond proceeds already owing to it by the Treasury). This had the effect of decreasing the deficit and increasing the gross national debt. In effect, Uncle Sam borrowed from the Social Security trust fund to pay for stuff that it would otherwise have to borrow from China to pay for. But importantly, one thing Uncle Sam is not borrowing incrementally to pay for is current Social Security benefits. Those are already funded by payroll taxes and pre-existing government obligations (hence the surplus).

Social Security impacts the size of the national debt (and, indirectly, the deficit) in two ways: first, Social Security surpluses (such as those currently being generated) are required by law to be lent to the Treasury to meet government obligations, for which the Social Security trust fund is credited with special-issue government bonds, increasing the amount of “intergovernmental” debt (as contrasted with the US debt held by the public) and, in turn, the gross national debt. Secondly, the funds needed to make good on the US government obligations the trust fund holds will have to come out of general federal revenues, which must be raised either by taxes, issuing more debt, or both.

All of this tends to get conflated into broad statements by Republicans that Social Security adds to the deficit, and by Democrats that, unless the debt ceiling is raised, Social Security won’t be able to pay benefits.

Neither of these statements is very nuanced or illuminating. Because that $95 billion in surplus that rightfully belongs to the Social Security trust fund has of course already been spent for other stuff (under law and appropriations passed by Congress), unless the debt ceiling is raised to allow it to be returned as needed, there will be insufficient money in the Social Security trust fund to close the gap between payroll tax revenue and benefits due. And while the US Treasury obligations held by the Social Security trust fund, placed there by law in exchange for FICA taxes withdrawn from it and spent elsewhere, do represent a lien on future revenues (and to that extent “contribute to the deficit”), that is equally true of every dollar of US debt outstanding, regardless of whether held by the Social Security fund, the Chinese government, or Aunt Polly.

The point is that, until 2010, payroll taxes and other “non-interest income” (i.e., excluding interest owed by the Treasury) exceeded Social Security payouts. (Source: Social Security Trustees Report, 2012.) That excess, by law, is swept out of the Social Security account and loaned to the Treasury, which must eventually be returned by the Treasury out of its general funds. But it’s a bit disingenuous – or at least woefully glib — to say that Social Security is contributing to the deficit.

None of this diminishes the fact that, due primarily to demographic changes, Social Security surpluses will one day disappear, creating a huge unfunded liability in the out years and the need to at least push back this insolvency horizon, and preferably to make Social Security (or some form of it) permanently self-supporting (the latter, given the unavoidable increase in the weighted average age of the populace, may be infeasible). For what it’s worth, I would favor raising the retirement age to 70 and introducing a “needs” cap on disbursements to the wealthy.

Medicare/Medicaid is a different matter, as it is funded out of general federal revenue and contributes massively to the deficit. There is no question that Medicare/aid outlays will need to be curtailed in order to reduce the size of future deficits and the rate of increase in the national debt.

4. What do we mean by “government spending”?

Much finger-pointing could be avoided (or redirected more truthfully) if we could all agree on what we mean by “government spending.”

In practical terms, government spending is the total amount in a given period that the federal government is either compelled to pay out due to past legislation, or decides to pay under newly enacted legislation or appropriations. Currently, about 63% of the federal budget is paid out to meet the obligations of standing legislation and previously issued debt. (All of the info in this paragraph is derived from an excellent article in the WSJ, “Everything You Ever Wanted to Know About the Budget But Were Afraid to Ask,” David Wessel, 7/20/12.) One in every five dollars the government spent in 2011 was for defense, and 20% of that was for the wars in Afghanistan and Iraq. Medicare and Medicaid take up another 25% of the year’s budget. About 6% of the budget was paid out for interest on already outstanding debt (and funded in part out of the issuance of new debt, creating more interest payments, in the proverbial vicious cycle).

Who is responsible for government spending? Much of the effort to unseat Obama last year was devoted to claims that he was responsible for the deficit and/or the national debt, and that Romney, contrarily, would reduce government spending and/or eliminate the deficit. However, we know from our high school civics classes that we elect Presidents, not kings. The President proposes budgets, but Congress enacts them (having inevitably changed them). Then the President is bound by oath to carry out the spending reflected in that budget, and in appropriations enacted outside the budgetary process (such as the recent $50 billion appropriated by the Republican-controlled House of Representatives for Hurricane Sandy victims).

The biggest spending programs signed into law by Obama are TARP and the “stimulus” package, both of which had their genesis before he took office. TARP authorized spending of as much as $700 billion to deal with “troubled assets” (which mainly troubled the private companies that held them), but which, per current GAO estimates, cost (net of recoveries from securities sold back to their issuers and into the open market) a total of around $34 billion. The stimulus program authorizes spending of as much as $770 billion in the aggregate through 2019.

“Obamacare” has been thoroughly tarred with the deficit brush by Tea Party-ers and their ilk, but in fact its net contribution to federal expenditures over the next 10 years (as projected by the Congressional Budget Office) is $109 billion, less than a tenth of the cost of the wars in Afghanistan and Iraq over the past ten.

Meanwhile, Dept. of Defense spending (including for war theaters) in the 2012 budget alone is $688 billion. (Source: OMB.)

G.W. Bush and Congresses during his administration chose to embark on two wars and increased Medicare spending without seeking to raise the revenue to even partially pay for them (rather, they famously reduced taxes to levels that Republicans have been fighting hard to preserve). With Congress’s help, war costs entirely escaped the budgetary process through the wonders of “supplemental appropriations,” and by the end of 2011 amounted to around $1.4 trillion in deficit spending. (Source: Congressional Budget Office.) Remember that there are 1,000 billion in a trillion; so the net $34 billion for TARP, net $109 billion for Obamacare, and $770 billion for the stimulus are collectively smaller than the deficit spending on the wars. We might argue the need for those wars or debate the prudence or economy with which they have been pursued, but there really can be no debate that they were and are being financed by massive deficits, contributing significantly to the very debt burden now decried as a threat to the well-being of our grandchildren.

5. What about that pesky “debt ceiling”?

Most of us know that the debt ceiling is a statutory limit on the amount of debt that the US government can carry on its books. The law imposing a debt ceiling has been in effect since 1917 and Congress has voted to increase the ceiling 91 times since 1940, for the very sensible reason that only by doing so could the US meet its contractual and statutory obligations (including payment of interest on already-outstanding debt). It should likewise be clear that the debt ceiling does not limit government spending per se, except of course indirectly, and does not prevent Congress from passing legislation or making appropriations that will inevitably require the issuance of new debt (as past Congresses did, resulting in the need to raise the debt ceiling).

To me, the recent use of the debt ceiling as a weapon in the war against big government is the height of bad faith and worse statesmanship. I’ve heard it defended as throwing a monkey wrench into the machinery of government spending where all else has failed to slow it, but in essence it’s nothing less than breach of contract, and anyone espousing it should defend it on that basis. Corporations and individuals avoid their contractual obligations all the time through a statutory process called bankruptcy, but there is no such statutory framework available to the US government, nor, presumably, would we want there to be. Not raising the debt ceiling is a de facto declaration of bankruptcy of the US government on the part of our elected representatives. Not what you’d call good governance, let alone stewardship. Fortunately, Republicans seem to have recently realized that this is not the smartest tactic, and are retreating from it at least temporarily.

Advocates of using the debt ceiling as bargaining chip in deficit-reduction negotiations also need to justify its effect on the credit rating of US debt (which, recall, applies to all US debt no matter when issued or for what reasons). While I’ve heard it said that the credit downgrade of 2011 obviously didn’t matter, since the US still has no trouble selling securities at historically low rates, the downgrade may well come back to bite us in the form of higher interest rates when the current flight to safety eases and triple-A credits are competing in the debt markets with double-A Treasuries.

6. What do we mean by “tax reform”?

The shibboleth of “tax reform” has been bandied about for my entire adult life. To some, it simply means tax rate reduction (any diminution in the demands of the government being by definition a “reform”). To others, it means rebalancing the tax burden across income tax brackets and categories of taxpayers. To still others, it means chucking the progressive income tax regime altogether and moving to a flat tax or a national sales tax (which is, for the well-off, another form of rate reduction, and for the less well-off, a tax increase).

Several obvious points: working significant change upon the Internal Revenue Code is hugely difficult, not only because it is mind-bogglingly complex to begin with, but because every deduction, exclusion, and credit in it is there because of the hard work of one entrenched interest group or another, and essentially none of them have gone away or become less well-funded or passionate.

Flat taxes and sales taxes are terribly regressive — that is, they tax lower-income earners proportionally more than higher income earners. Just sayin’.

For what it’s worth, I think tax rates will have to be materially increased — across more or less their current pattern of progressivity – in combination with spending reductions in order to reverse the current trend of increasingly large deficits.

Part II – What to do?

Given the foregoing, what is to be done about federal deficits and the ballooning of the national debt?

Much of the disgust over the size of current and projected deficits is really an expression of a more philosophical discomfort with the size of government, its reach into public life, and its impacts on private enterprise. Some people want a smaller, more constrained federal government, with fewer functions and more limited power, regardless of whether a government of its current size could be made to operate at break-even or (as it briefly did) at a surplus. I think that philosophical (or aesthetic) preference needs to be explicitly stated and separated out from the discussion of deficit reduction, because it not only affects the definition of goals but also the means employed to achieve them. Too often, the core goal of government-shrinking comes cloaked in deficit-reduction garb, when it is really an independent agenda.

For instance, if your goal is to reduce the size of government regardless of whether it can be made to operate at break-even, you will likely oppose measures, such as increasing income taxes, that might achieve the break-even goal but not result in shrinking government. Rather, you might argue openly that the way to kill the beast is to starve it, and argue for tax reductions as a way to force government to shrink (though this may entail some severe dislocations, such as inducing recession or impairing the credit rating of US debt). Shrinking the federal (and, presumably, state) government is the apparent goal of at least a significant faction of the Republican Party. It is a much bigger and different task than mere budget-balancing.

If your goal is merely to balance the budget, your tools will be different. You will do pretty much what the Obama administration and most Democrats have espoused – cut expenditures where you reasonably can and increase taxes on whom you reasonably can. You can differ with your counterparties over the balance between and itemization, size, and timing of those cuts and increases, but it’s at least plausible that the negotiation can result in achieving the goal. Some of the cuts may result in shrinkage of the federal footprint, but that’s a by-product. [Footnote: I realize that many Republicans believe that Democrats (and Obama in particular) have a much more pernicious goal, namely to turn the US into a socialist state on the European or even Marxist model, but for the sake of reasoned discussion let’s assume that’s not the case.]

However, if one side is negotiating with the goal of balancing the budget (or at least shrinking the deficit), and the other side is negotiating with the goal of shrinking the size of government regardless of whether its deficits are reduced, you can see how negotiations might not go well. That is where I think we are.

I am negotiating with the goal of shrinking deficits. If a by-product of that goal is that the government shrinks, fine, but that’s not my primary goal. I don’t find the federal government overly intrusive into my life, I don’t think it overburdens business, and I think the amount of taxes I pay (or will pay under the recent tax increases) is reasonable given what the federal government does. I think we are better off with the SEC, FDA, EPA, ATF, and most other government agencies (including the Dept. of Defense) than without them or with vastly attenuated versions of them. I don’t think any of my Constitutional rights are being materially infringed upon, and I’d even give up some of them (mainly, my right to bear military-style assault weapons, as I don’t see any armed insurrections against the government in my future). I think there have been some horrible recent decisions by the Supreme Court, but I think those errors will eventually be reversed and that in the main the Court (and the federal court system in general) does a good job of adjudicating difficult issues.

I know many of you feel differently, and strongly so. You feel that the federal government is hugely intrusive, unduly constrains free enterprise, costs more than we can ever afford, inculcates dependency in an otherwise free people, and on balance degrades the quality of life of the body politic.  You think the federal judicial system is full of politically motivated, activist judges who put their own social agendas ahead of the Constitution. I get it, and respect your right not only to feel that way, but to seek to change it by reducing the role of government. But for purposes of our discussions, I hope we can limit ourselves to the goal of shrinking the deficit, and how that might actually be achieved.

Look at the 2012 federal budget in terms of total expenditures by agency (I’m referring to the presentation on Wikipedia under “2012 United States Federal Budget”). What leaps out at you is that two line items utterly dwarf all the others: the amount allocated to the Dept. of Defense ($688 billion) and to the Dept. of Health and Human Services, including Medicare and Medicaid (around $880 billion). These are on the order of 10 times larger than the amount of the next-largest allocation, to the Dept. of Education. These figures are for a single year. If we have any hope of reducing future deficits, something dramatic needs to be done to curtail both defense spending and the public cost of health care.

That we need to reduce the cost of health care is a truism in this country, but so much piety (much of it opportunistic) surrounds statements about the military these days that there is less attention paid to its excesses than there needs to be.

Drilling down a bit into the DOD figure, the single largest line item in the 2011 military budget was $283 billion for “operations and maintenance.” (By way of contrast, all of Homeland Security gets only $47 billion.) I have no idea what O&M really means in this context but I think we can safely stipulate that it is rife with what would classically constitute “government waste.”

The next biggest DOD line item for that single year is $154 billion for “Military Personnel,” presumably what it costs to clothe, feed, house, and pay salary to the 1.5 million or so active personnel in the various armed services. This line item for this one year is greater than the net cost of Obamacare (as projected by the OMB) for the next 10 years. Do we actually need this many people in the military? To what extent has the volunteer military become a de facto welfare program that needs to be pruned just as other “nanny state” programs will inevitably have to be if we are to balance the budget, let alone reduce the national debt? Winding down the US presence in Afghanistan and Iraq is a drop in the bucket. As ever, the question comes down to what price we want to pay for what level of security.

On the DOH side, Medicare accounts for over half of its $870 billion in spending for the fiscal year, with Medicaid requiring another 30% of that figure. And of course, like the cost of Social Security, these figures are only expected to rise as the population ages. These mind-numbing costs present the same dilemma as military spending — the fact that not incurring them means that they may be replaced by other costs: the economic cost of threats or damage to US lives and assets if the military is weakened; and the economic (not to mention the human) cost of disease, disability, and indigence if decent health care becomes unavailable to more of the population.

But without question, medical care in the US is grossly inefficient and its skyrocketing costs are a product of that inefficiency. For a country that reviles the idea of government involvement in the delivery of medical care, we’re awfully tolerant of the private sector’s failure to bring the costs of that care under better control. This is at least partly because those costs are being subsidized by the taxpaying population as a whole, but it is also because of the inherent asymmetry of power between patient and caregiver, and the knee-jerk tendency of medical practitioners to throw technology at every problem. Much can be done at the local level to redress that imbalance of power through patient advocacy and self-education (including via the Internet), and tort reform might mitigate not only the cost of medical insurance (which gets passed on to the patient and in turn to the taxpayer), but the defensive instinct of doctors to over-test and over-prescribe.

Of course, the DOH and the DOD are only two of the 21 federal agencies whose expenditures contribute to the federal deficit. No one or two or group of them can be cut enough to make up for a $1.3 trillion deficit. They all must contribute to the solution, as must increases in tax revenue. And even in the happy if unlikely event that a balanced budget can be achieved, the mountain of government debt outstanding at that point will still loom before us. The temptation is not so much to kick the can down the road as it is to turn and run away from it.  Kicking the can down the road is sometimes called “debt management.”

I’ve recently been reading Nate Silver’s “The Signal and the Noise,” and one of the lessons of that excellent book is how profoundly bad we are, despite access to ever-increasing amounts of data, at making accurate predictions about the consequences of our decisions and policies, especially in the realm of economics. We live in a time when it is increasingly easy to create our own little hermetically-sealed bubbles of self-affirming data and filter out information that conflicts with our preconceptions. We need to approach decisions about the deficit with the humility that comes from that realization, rather than with the ideological arrogance that characterizes current public discourse about the deficit. We believe we know what we need to do, but we can’t be sure of all the ramifications of our doing it, assuming we can succeed at all. We also need to recognize that we may be drastically underestimating the upside possibilities: that government spending actually succeeds in stimulating the economy to a greater degree than expected, and the resulting cyclical upswing dramatically reduces the budget deficit.

Or we can move to Chile, which I hear is really nice, and hope they don’t screw up too.

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