As long as I can remember we've heard talk of the risks of deficit spending and the resulting national debt. In fact, a youthful memory which may have helped lead me to the work I do now features a family friend complaining that as much as he admired President Eisenhower, he couldn't forgive Ike’s failure to consistently balance the federal budget. Now, the deepest deficit during the Eisenhower administration, some $12.8 million ($101.8 million in today’s inflation-adjusted dollars), seems like a venial sin compared to the $1.3 trillion estimated for fiscal 2012, but the issue of what government should spend, with whose money, and on what remains one of the most contentious issues facing the American public. And the way that issue is or is not addressed has important implications for us as investors.
Budgetary issues dominated the recent presidential election campaign, overshadowing major concerns including foreign policy, immigration reform, and education. Even the highly contentious debate over health care seemed to revolve more around how it would be financed rather than what it would provide. Both candidates seemed to agree that the current budgetary path is unsustainable, but with the electorate having collectively decided to maintain the status-quo balance of power in Washington, I cannot say that the election has clarified how we can expect to move forward. In fact, the constellation of forces doesn't seem that different from the one that has brought us to our current situation.
What is a better path? Most of us have interests and principles that inform our opinions about who should pay more and who should benefit less as the federal government seeks to rein in its deficits, but we can all usefully step back and try to see how past efforts have or have not put the ballooning debt genie back into the bottle. The International Monetary Fund (IMF) recently devoted a chapter of its World Economic Outlook to a six-country comparison (including our own, following World War II) of experiences with controlling sovereign debt that had reached troubling levels. Not every case has been successful, and you can’t just assume you’ll grow out of it.
The authors do, however, identify a few criteria for successful debt reduction. First, a growing economy is the best way to ease a debt burden. Note that even with continuing deficits, the ratio U.S. federal debt to GDP fell from over 10 percent in fiscal 2009 to an estimated 8.5 percent for the fiscal year that ended September 2012 just because of modest growth the economy enjoyed. One advantage the IMF authors note for the U.S.: in contrast to the debt-ridden countries in peripheral Europe, America still maintains a fairly sound financial system, the absence of which impedes economic growth. They also point to accommodative monetary policy as a positive in the U.S. because it reduces the government’s borrowing costs and reduces the threat of deflation. Countries that have attempted to reduce their debt burden in the face of tight monetary policy have largely failed.
With a sound financial system and easy monetary policy, the authors consider the U.S. as ready for the hard part: fiscal consolidation, or economist-speak for cutting the deficit. While they don’t prescribe detailed budgetary formulae, they do insist that “permanent or structural” reforms will be effective while temporary fixes will not. Tax holidays, temporary benefit packages, or expiring tax packages of the sort that successive administrations have used to produce acceptable budget projections will only extend the problem. Deficit reduction takes time; it requires commitment to a plan that stays in place for (my numbers) five to eight years without slippage.
Deficit reduction is the hard part and it lays bare a serious concern with the state of our political process. Political scientist Francis Fukuyama writes pessimistically, “The United States seems increasingly caught in a dysfunctional political equilibrium, wherein everyone agrees on the necessity of addressing long-term fiscal issues, but powerful interest groups can block the spending cuts or tax increases necessary to close the gap.” And while we have images of the slick lobbyists when we read “powerful interest groups,” we might want to look in the mirror. Superstorm Sandy severely damaged my house, and although I’m distraught over my losses, I take some comfort that my federally-subsidized flood insurance policy will defray a portion of the costs. Are you reading this essay via the internet? This vehicle for 21st Century commerce owes a significant portion of its original funding to federal grants.
We will all have adjustments to make. We and subsequent generations will increasingly bear our own burdens especially for healthcare and retirement. And I expect the cost of those burdens and of our daily needs and comforts will rise—note that a bit of inflation has an effective element in shrinking government debt burdens, including our own. I don’t share Professor Fukuyama’s pessimism, but I do want to start making those adjustments.
Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.