Sunday, August 7, 2011

The downgrade: let the elections begin!

S&P's downgrade of U.S. government debt was without doubt an historic event, and for all the obvious reasons, not least of which is that this was unprecedented, and it throws a wrench into every theory of efficient markets. If U.S. debt is not without risk, then where in the world can highly liquid and risk-free investments be found?

Of course, markets knew even before the downgrade that U.S. fiscal policy was on an unsustainable course. The downgrade added nothing to the world's understanding of the increasingly fragile outlook for U.S. finances. It was clear long ago that something had to change, but for years the majority of the politicians of both parties had steadfastly refused to acknowledge the problem.

The greatest impact of the downgrade will be on the future course of U.S. politics, because the downgrade sets the ground rules for next year's elections. The question around which all political discussions will revolve for the next 15 months is this: is the U.S. government's fiscal problem one of too much spending, or insufficient taxation? This election will be about the proper role of government, and that is an issue that is long overdue to take center stage.


To properly set the stage, I offer the chart above. Importantly, I would note that spending as a % of GDP is set to increase significantly absent any attempts to reform entitlement programs, most notably ObamaCare and Social Security. Meanwhile, revenues have been increasing at a 10% annual rate for over a year even as the economy posts only meager growth and tax rates have not risen at all. In my view, the problem is clearly one of too much spending, but this is an issue which needs to be decided by the electorate next year.


If there is any obvious cause of the revenue shortfall that we are experiencing, the above chart points the finger to the weak recovery. Income taxes have fallen more than anything, and this is a direct function of the fact that total employment has fallen by more than 6 million in the past three years, and the unemployment rate is over 9%. Get the economy on a faster growth track, with more people working and paying taxes, and federal revenues will almost certainly boom. The revenue side of our fiscal problem has its roots firmly planted in an anemic recovery.

The solution to our fiscal problem has its roots firmly planted in partisan politics. What is the best way to boost growth and thus solve the revenue side of our fiscal problem? Spend more or tax more? Should spending as a % of GDP increase, or should it decrease? Should government do more or do less?

As a supply sider, I believe that there is no reason to raise tax rates. In fact, I would argue strongly that tax rates should be held steady or reduced, especially corporate taxes. As a student of how the world works, I believe that more government is not the solution to our problems, since government can never be as efficient as the private sector. Less government, especially considering how much it has grown in the past few years, and how much the economy has struggled, is the solution.

But I'm not in charge, and the people will have to decide in November 2012 which direction we should take. The next year or so will be one of the most exciting and eventful times in decades. Let the elections begin!

14 comments:

Kurt said...

I notice in the language of Capitol Hill, at least as I read or hear it in the media, the term "revenue increase" or "revenue enhancement" invariably is a euphemism for tax increases. I wonder whether the supply-siders should fight this language, by saying loudly, clearly, and repeatedly, something along the lines of "Yes, we believe in revenue enhancement -- via lower tax rates!"

Stone Glasgow said...

Thank you for including the war in this graph. Most leave it out, and insist that the US will soon be broke. The S&P downgrade is a politically motivated action. Millions of people loaning their money to Uncle Sam at 4% over 30 years are not worried about default.

Lower gov spending is good, but the focus on gov debt is not. It moves attn away from the benefits of free trade, and ironically focuses on markets that can't be trusted, and must be "set straight" if the world as we know it is to continue.

Jeff said...

Treasuries have always been considered the closest thing to "risk free".

During this whole debate the risk of "default" has never been the issue. As Greenspan said yesterday on Meet The Press, the US can always "print more money".

But THAT is the real risk. You'll get your principle and interest back...it's just worth less than your investment.

The government is clipping coins. They are eating away at every dollar in your pocket. And nobody seems to care. Some on this board actually think it is good.

And the only grown ups in the room--those calling for spending CUTS and lower taxes and less government--are blamed for CAUSING this downgrade.

'If we just let those damn Bush tax cuts expire all would be right with the world'. Kerry called it a 'tea party downgrade'.

I have delt with people with addictions. The left in this country acts exactly like addicts...blaming others, denial, and destructive behavior.

Mike Eliason said...

I can think of no worse investment strategy than to take present trends and extrapolate them into the future. Imagine if you did that in 2000 or 1979.

This situation is going to get fixed. Everyone is waking up. Even Democrats are begrudingly admitting there is a problem.

I'd look at the dips as a buying opportunity. We're going to get a new President and this is going to be fixed.

Public Library said...

For those of you demagoguing the left, I offer up the NY Times study of how the current deficit came to be.

http://www.nytimes.com/interactive/2011/07/28/us/charting-the-american-debt-crisis.html#panel/how-the-debt-accumulated

Over 50% or $7.6T of the 14.3 came from none other than Bush Sr. and Jr. Lets get realistic here.

Although I do not advocate Obama policy, an honest man would conclude he inherited a lot of his deficit term-to-date. Doesn't mean he won't keep adding to it but people need to get realistic.

The Reds ran this country into the ground and the Dems obliged by getting what they wanted while the whip was sinking.

Benjamin said...
This comment has been removed by the author.
Benjamin said...

Absolutely concur that federal spending must be scaled back--tell that to Representatives and Senators who sit on the House or Senate Armed Services Committees. They come from districts deeply dependent on federal spending, defense and otherwise. You think they will want spending cuts?

Rural states and districts are huge beneficiaries of federal spending--states such as New Mexico, Alaska, Kentucky or North Dakota get back $5000 per capita net or more in federal spending ever year (federal outlays minus federal taxes, per capita by state, see the conservative Tax Foundation).

For Kentucky (R-Mitch McConnell) to vote for balanced federal budgets is to vote for an economic depression in Kentucky.

This reality makes mud of partisan politics--you think you can vote for a party that want to reduce the size of government? Most rural districts are GOP, now. Everything in rural America is subsidized by the federal government: The roads, the water systems, the power systems, the telephone systems, the crops, the airports, the post office.

This is one reason why the GOP rants about entitlements, but mysteriously quiet about federal agency spending.

I do favor a law or amendment limiting federal outlays to 18 percent of GDP, scaling down to 16 percent in 20 years.

Entitlements are largely financed by payroll taxes, and they have become onerous Trims needed there.

Defense must be cut in half (back to real levels of 10 years ago) and then we should examine ways to reduce defense pending to 1 percent of GDP. Surely with new technologies this can be done. A few hundred terrorists do not pose a serious military threat to the independence of the United States.

Lastly, we need to refrain from monetary fetishism. A robust economy is more important than reducing inflation to minute levels. Read George Gilder on this.

The cost in lost production for the last couple points of inflation is not worth it. Japan has proven that, for two decades.

The need for growth trumps everything else, at least for the next five years.

Zhang Fei said...

Entitlements are largely financed by payroll taxes, and they have become onerous Trims needed there.

Defense must be cut in half (back to real levels of 10 years ago) and then we should examine ways to reduce defense pending to 1 percent of GDP. Surely with new technologies this can be done. A few hundred terrorists do not pose a serious military threat to the independence of the United States.


Defense - the only traditional function of government - should be cut in half, but entitlements should be "trimmed"? Ideally, entitlements should be zeroed out.

Benjamin said...

Zhang-

Gigantic defense spending is a modern tradition, at least in US history.

So are payroll-tax financed entitlements.

I am happy to reduce both.

However, people have made retirement plans etc. based on Social Security. Such programs need to be phased out slowly.

In contrast, every dollar that does not go into defense spending is freed up to go into the jobs- and wealth-creating private sector. The sooner the better.

Zhang Fei said...

However, people have made retirement plans etc. based on Social Security. Such programs need to be phased out slowly.

In contrast, every dollar that does not go into defense spending is freed up to go into the jobs- and wealth-creating private sector. The sooner the better.


The savings from cutting defense spending are illusory. The US cut defense spending to the bone in the run-up to WWII, thereby failing to deter Nazi Germany and Japan. The fruits of that failure to deter? War spending of 2x GDP during WWII and 400,000 dead GI's. The failure of deterrence in the nuclear age may well extend to millions of dead Americans in the continental USA.

Benjamin said...

Zhang Fei-

The USA was late to mobilize for WWII. In the American tradition, we had de-mobilized after WWI. We had always detested and loathed standing militaries, especially our right-wing.

Dos that mean we would be late to mobilize for the next war, if there is one?

Who would profit from nuking the USA? Who would invade the USA?

Spending $1 trillion a year (Defense, Homeland Security and VA) must be balanced against reasonable risks and the need to avoid USA bankruptcy.

There are always risks. For example, I think we can eliminate the USDA, and the food stamp program. There is a risk some people will starve to death, or even a risk of urban riots. I think the risk are low enough to take a chance at the gains.

I see no reasonable chance anyone will invade the USA, or launch a nuclear strike.

We have a terrific opportunity to cut federal outlays, and we should go for it.

It is only our corrupt Congress that prevents cutbacks.

Vasco said...

If private industry is always more efficient than government, then why are the health insurance companies so scared of competing with a government option?

Zhang Fei said...

Spending $1 trillion a year (Defense, Homeland Security and VA) must be balanced against reasonable risks and the need to avoid USA bankruptcy.
...
I see no reasonable chance anyone will invade the USA, or launch a nuclear strike.


We have a large defense establishment not to fend off the predictable, but to guard against the unpredictable. Who could have foreseen that Germany would make an even more ambitious foray across the European continent, after their staggering human losses during their first attempt in WWI? Students at Oxford pledged to renounce war, no matter what happened. Who predicted that the Japanese would create out of whole cloth the idea of a Pax Japonica - with IJA and IJN boots on the ground - that covered the entire East Asian mainland, all the way from Siberia to Oceania?

TradingStrategyLetter - Weekly Summary said...

Forget elections ... bring on the executions!