September 13, 2011

The “New Normal” May Trump Political Courage

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 10:23 PM by Robert Barone

There are two huge issues facing the American economy today.  The first is a government that doesn’t understand why the economy isn’t growing, and, in fact, promotes policies that inhibit such growth, such as overregulation, interference, and the deployment of more debt as the answer.  The second issue is that inability to grow.  The two issues are closely related.

Despite Promises, Federal Spending is Out of Control

In looking at the trends in the Federal budgets, especially over the last decade, one word comes to mind – gold!  Despite all of the hand wringing and promises about spending cuts, it just doesn’t happen.  According to the Wall Street Journal (August 24), CBO projects that total Federal spending for fiscal year 2011 (which ends at the end of this month), will be $141 billion higher than 2010, and even higher than that of 2009 which was supposed to be the temporary spending peak.  The growth in Federal spending just for 2011 will be 4% higher than that of 2010.  Furthermore, exactly one month after the brouhaha over the debt ceiling in which a “temporary” debt ceiling cap some $400 billion higher was enacted, we find that the total debt has again exceeded the ceiling (Zerohedge, Déjà vu All Over Again…, 9/2/11).  Growth in Federal spending over the 50 years ending in 2010 has been at a compounded annual rate (CAGR) of 6.5%, while the growth rate of GDP during that same span was 5.7%.  Everyone knows that continual growth in Federal spending that exceeds the growth in the economy is simply unsustainable.  This, of course, has all come to a head because in the last 10 years, Federal spending grew at a CAGR of 7.1% compared to a CAGR of GDP of 3.9%.

Growth Rate of Entitlements

It isn’t a secret that the biggest issue in Federal spending is the so-called “entitlement” issue (although some object to the characterization of some aspects of “entitlements”, having contributed to Social Security and Medicare for all of their working lives).  Defining “entitlements” as “transfer payments” from the government to individuals, and going back to 1960, we find that such “transfers” were 26% of Federal tax collections.  Since then, those “transfers” have grown at a CAGR of 7.8%, while tax receipts and the economy have grown substantially more slowly, 5.6% and 5.7% respectively.  Thus, in 2010, “entitlement” payments were over 92% of Federal tax receipts.  That percentage was 64% as late as 2007, and has grown because of the demographics of Social Security and Medicare, but more so because of a massive jump in “Income Security” payments (defined by USDebtClock.org as Supplemental Security Income, Earned Income Credits, Unemployment Compensation, Nutrition Assistance, Family Support, Child Nutrition, Foster Care, and Making Work Pay).

Current Trends Mean Exploding Debt Ratios

Table 1 extrapolates current budget, tax and demographic trends using the underlying assumptions shown, most of which are drawn from CBO estimates for 2015 and then extrapolated further.

Table 1: GDP Growth = 3% CAGR

Entitlements/

GDP

Entitlements/

Fed Budget

Entitlements/

Tax Receipts

Deficit/GDP

Debt/GDP

2011

14.4%

60.7%

95.3%

8.6%

97.9%

2015

14.1%

54.4%

78.3%

7.9%

118.2%

2025

15.9%

61.5%

88.6%

7.9%

157.4%

2035

17.6%

68.1%

97.9%

7.9%

186.6%

Assumptions:
1) Social Security and Medicare expenditures per capita are from CBO 2015 estimates of approximately 1.6%.  The same CBO expenditures per capita are extrapolated to 2035.
2) CBO estimates that the 65+ age cohorts, as a percentage of total population, will increase from 21% in 2011 to 36% in 2035.
3) Population growth extrapolates the .94% CAGR for the decade ending in 2010 throughout the forecast period.
4) “Entitlements” in the model are defined as Medicare/Medicaid, Social Security, Income Security, and Federal Pensions per the definitions found at USDebtClock.org.
5) Federal Pensions are projected by CBO to grow at a CAGR of 2.5% through 2015.  The table above extrapolates that CAGR throughout the forecast period.
6) Taxes/GDP rise from 15.1% in 2011 to 18.0% (near the 50 year mean of 18.3%) and remain at 18% for the forecast period.
7) The Federal budget grows at a 5.3% CAGR (per CBO) to 2015 after which its level is fixed as a percentage of GDP at that 2015 level.
8) The “Income Security” portion of “entitlements” shrink under CBO assumptions as “Unemployment Compensation” is assumed to fall.  After 2015, the Table assumes this category to grow at a CAGR of 1%.
9) Defense budget growth is 1.7% annually.

Because CBO assumed that the spike in “Income Security” that has occurred since ’07 would largely dissipate by 2015, the “entitlement” ratios shown in Table 1 all shrink until 2015.  However, despite the low (optimistic) 1.6% growth in per capital Social Security and Medicare expenditures of CBO, the “entitlement” ratios rise rapidly after 2015.  Worse, even under this extremely rosy set of assumptions, including the return of the tax take to 18% of GDP by 2015, the deficit as a percentage of GDP remains unsustainable, and the Debt/GDP ratio rises inexorably.

What Political Courage Means

Given this base case scenario, what do the Washington politicians have to do to fix the situation.  Table 2 uses the same model as Table 1 with the following changes:

  • The Social Security and Medicare growth rates are reduced from 1.6% to 1.0% over the forecast horizon;
  • The CAGR of the “Income Security” category is reduced from 1.0% after 2015 to 0.5%;
  • The CAGR of Defense spending is reduced from 1.7% to 1.0%;
  • The CAGR of Federal Pensions is reduced from 2.5% to 0.5%;
  • Total Federal spending only grows at a CAGR of 0.5% over the forecast horizon;
  • The tax take as a percent of GDP rises to 19%;
  • GDP growth remains at a CAGR of 3% over the forecast horizon.

Table 2: GDP Growth = 3% CAGR

Entitlements/

GDP

Entitlements/

Fed Budget

Entitlements/

Tax Receipts

Deficit/GDP

Debt/GDP

2011

14.4%

60.7%

95.3%

8.6%

97.9%

2015

13.7%

63.6%

72.0%

2.5%

105.1%

2025

14.5%

67.3%

76.2%

2.5%

100.4%

2035

15.0%

69.9%

79.2%

2.5%

96.8%

As is evident from the table, if the Washington politicians can find the courage to make hard decisions around the growth rate of “entitlements” and put itself on a no growth (0.5% – likely less than the rate of inflation) budget (still giving Washington 21.5% of America’s GDP, an historically high number), all of the critical ratios either slow their climb or reverse course.  Yet, even under such a politically unlikely scenario, many would say that even the outcome shown in Table 2 is not acceptable.

The “New Normal” May Trump Political Courage

Critical to this analysis is the growth rate of the GDP.  Clearly, a faster rate than the 3% shown above would have better results.  But a faster growth of GDP implies higher rates of inflation, and it is unlikely that the spending assumptions for Table 2 could be accomplished in an environment with significant inflation.  In real terms, the CAGR of GDP has been 3.1% over the 50 year period ended in 2010, but only 1.6% since 2000.  Recently, PIMCO’s Bill Gross stated that he believes that the U.S. has structurally changed such that nominal GDP growth will average between 0% and 2%.  Literally, this is more of the same anemic growth that we have seen in the U.S. since ’07.

Table 3 embodies the same assumptions as Table 2 except the CAGR of the GDP is reduced to 1%, per PIMCO’s view.

Table 3: GDP Growth = 1% CAGR

Entitlements/

GDP

Entitlements/

Fed Budget

Entitlements/

Tax Receipts

Deficit/GDP

Debt/GDP

2011

14.7%

60.7%

95.3%

8.8%

99.9%

2015

15.1%

63.6%

79.4%

4.7%

121.0%

2025

19.4%

81.9%

102.3%

4.7%

154.9%

2035

24.6%

103.4%

129.2%

4.7%

185.5%

Thus, even if the Washington politicians can summon the courage to do what they have never been able to accomplish in the past and slow the growth of “entitlements” and its own profligate spending, the debt and deficit levels remain unacceptable if the economy grows in nominal terms at PIMCO’s “new normal.”  This threatens the U.S.’s status in the world, and certainly the dollar’s role as the world’s reserve currency.

Conclusion

It is imperative that U.S. economic growth return to its historic path of 3%.  And even then, the economic results depend on the level of political courage from the Washington pols.  To accomplish a return to economic health, fiscal and monetary policies must first return to balance.  Fiscal policy must refrain from the gimmicks used in the recent past, like cash for clunkers or homeowner tax credits, which have simply pulled demand forward, and monetary policy must stop monetizing the deficit.  Rather, the encouragement of investment through a rational and sane tax policy (e.g. flat tax or national sales tax), a reduction in government interference in the private sector (e.g., Dodd-Frank, the EPA, and Obamacare), and the use of policy to encourage the development of the nation’s natural resources (e.g., cheap energy) would be a good start to revive the nation’s economy.  But, as an election year approaches, doesn’t the word “gold” ring true?

Robert Barone, Ph.D.

Matt Marcewicz

September 6, 2011

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

 

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