December 3, 2012

Barone: Spending: the nation’s real fiscal cliff issue

Posted in Economy, government, recession, taxes, Uncategorized tagged , , , , at 11:51 PM by Robert Barone

The business media is fixated on the “fiscal cliff” issue, not because its avoidance will spur economic growth, but because failure to avert it likely would mean another severe contraction in an already underperforming economy.

The most likely short-run outcome is for Congress and President Barack Obama to reach a “compromise,” which “kicks the can down the road” and gives these institutions additional time to resolve the issues. “Kicking the can” is a skill that has been mastered by politicians throughout the world, especially over the past five years.

The most significant and serious issue of the fiscal cliff, one that has been discussed but poorly analyzed, is the “spending” issue. Most Americans who pay some attention to the federal budget issues believe that the deficits have been $1.1 trillion to $1.5 trillion in the Obama era, and about half of that level when George W. Bush was president. The reality is that the federal budget deficit is grossly understated. It is calculated on a “cash” basis, meaning that only current cash-in and cash-out is counted. Future promises are completely ignored in calculating this deficit.

Think about this: Every single day for the next decade or so, 10,000 Americans will become eligible for Medicare and Social Security. These programs have no real assets of their own and must be financed out of current tax revenue. Today, 86 perrcent of all federal revenue collected already is committed as “transfer” payments (Social Security, Medicare/Medicaid, income security and federal pensions) (USDebtClock.org). Just think of how much federal revenue will have to rise just to take care of these newly eligible benefit recipients. If interest on the debt (at historically low interest rates) is added, 97 percent of federal revenues are already accounted for. That leaves precious little for all of the rest of the federal functions, including defense, education, environment, homeland security, immigration, agriculture, foreign policy, etc.

Every publicly traded company in America is required to report their financials on a Generally Accepted Accounting Principles (GAAP) basis. GAAP reporting includes, via a present value process, taking into account the cost of future promised payments. The underfunding of public pensions has become a big issue in America today.

But, even a pension that is 40 percent underfunded still has 60 percent of the assets that it needs. The promises made for all of the social programs of the federal government have 0 percent of the assets needed to meet the required payments. All must come from current tax collections and borrowing. You can see how the problem is exploding, given the current demographics of the population and those rapidly becoming eligible for such transfer payments.

Once each year, by statute, and to little fanfare, the U.S. Treasury reports (Dec. 15) what GAAP accounting would be for the federal budget. In 2004, under Bush, the headline federal cash-based deficit was $412 billion, but, because of changes to Medicare that year (prescription drugs), the GAAP-based deficit exploded to $11 trillion. For the first three years of the Obama era, the GAAP-based deficit exceeded $5 trillion each year.

The Treasury recently has postponed release of the 2012 fiscal year (ended Sept. 30) GAAP deficit until Jan. 17 so as not to inflame the fiscal cliff negotiations. I’ve seen an estimate from John Williams, a noted economist (shadowstats.com), that puts the 2012 GAAP deficit at $7 trillion, or about 44 percent of the entire output (GDP) of the country. Worse, while the official U.S. debt is approaching $15.2 trillion, the actual amount of promises already made for Social Security, Medicare and prescription drugs is more than $121.6 trillion, according to USDebtClock.org (and about $88 trillion using official U.S. Treasury estimates, according to Williams). Using the USDebtClock.org data, which appears to be more comprehensive, that amounts to $386,000 in unfunded promises for every U.S. citizen and $1,059,000 for each U.S. taxpayer.

Just to put this in perspective, the estimated value of all U.S. business, corporate and household assets is only $87.4 trillion. Now, do you see the magnitude of the spending issue?

No amount of spending cuts outside the social and entitlement programs and no amount of tax increases can bring the real GAAP budget deficits into balance. This fiscal cliff appears to be the last real opportunity to address the deteriorating spending issue.

Unfortunately, unless the social programs are addressed, the overspending issue isn’t going to be touched.

No doubt, a successful fiscal cliff can-kicking will encourage equity investors and most likely propel stocks upward, at least for the short term. But, if the social program and entitlement issues are not addressed, then all of us should worry about the future value of the dollar and future interest rates. The current situation in Greece will be just a microcosm of what could happen here.

Given the recent track record of Congress and the president on spending issues, you should begin to prepare your portfolio now.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs. Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

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