By Van R. Hoisington and Lacy H. Hunt, Ph.D.
High Debt Leads to RecessionAs the U.S. economy enters 2012, the gross government debt to GDP ratio stands near 100% (Chart 1). Nominal GDP in the fourth quarter was an estimated $15.3 trillion, approximately equal to debt outstanding by the federal government. In an exhaustive historical study of high debt level economies around the world, (National Bureau of Economic Research Working Paper No. 15639 of January 2010, Growth in the Time of Debt), Professors Kenneth Rogoff and Carmen Reinhart econometrically demonstrated that when a country's gross government debt rises above 90% of GDP, "the median growth rates fall by one percent, and average growth falls considerably more." This study sheds considerable light on recent developments in the United States. After suffering the most serious recession since the 1930s, the U.S. has recorded an economic growth rate of only 2.4%. Subtracting 1% from this meager expansion suggests that the economy should expand no faster than 1.4% in real terms on a trend basis going forward, which is virtually identical with the economy's expansion in the past twelve months.
In highly indebted countries, governments have expansively taken resources from the private sector through taxing and borrowing. This leaves the private sector with less vigor to produce jobs and increase productivity, and subsequently wealth for its fellow citizens. This theory, which dates back to David Hume's essay, Of Public Credit published in 1752, is now being played out in real time in the United States. We judge that when an economy is expanding in such a meager fashion it is exposed to an increasing frequency of recessions. We expect such a recessionary event to emerge in 2012.
Contractionary Fiscal PolicyIt would be difficult to devise a more horrendous set of fiscal policy parameters to spur economic growth than currently exist. Real federal government purchases of goods and services, which comprise 8% of real GDP, will decline by about 1% if the impartial projection of the Congressional Budget Office (CBO) for a fiscal 2012 deficit of about $1.3 trillion is in the ballpark. Defense spending will bear most of the decline in federal expenditures, but non-defense spending will, at best, be flat. In spite of record deficits since the spring quarter of 2009, real federal government purchases of goods and services have risen at an anemic 1.5% annual rate, confirmation that only a small amount of exploding expenditures went for infrastructure projects. The scant growth rate in the economy suggests a negative outlay multiplier.
Contrary to common belief, the massive deficits of recent years will actually reduce economic growth in 2012 through a subtle, but nevertheless credible channel consistent with the preponderance of economic research. Studies suggest the government expenditure multiplier is zero to slightly negative. Increased deficit spending does appear to provide a modest lift to GDP for three to five quarters, depending upon the initial conditions of the economy. However, following this small, transitory gain, deficit spending actually retards GDP growth and the economy returns to its starting point at the end of about twelve quarters. Based on our interpretation of these studies, the U.S. economy is now on the backside of the string of record deficits, and this will be a drag in 2012. Despite the massive spending, all that is left is an economy saddled with a higher level of debt, with more of its productive resources diverted to paying the non-productive elevated level of interest payments. According to the CBO, gross federal debt will rise to at least 103% by the end of 2013. However, if the FICA tax reduction is extended for the full year, and/or a recession ensues, as we expect, revenues and expenditure estimates by the CBO will prove to be too optimistic. Under current circumstances, no viable way exists to remove the increasing federal debt burden from the economy's growth trajectory. As such, the federal fiscal constraint is operative for the foreseeable future.
In the past three fiscal years, the budget deficit averaged 9.3% of GDP (Chart 2), the highest since 1943-45. Federal outlays were almost 25% of GDP (Chart 3), and also the highest since the final three years of WWII. Dr. Barry Eichengreen of the University of California at Berkeley, author of Exorbitant Privilage,estimates that after 2015 this outlay figure is headed to 40% over the next quarter century without major structural reforms in Social Security and Medicare. For Dr. Eichengreen this means that the current law cannot remain unchanged in spite of the lack of political will to deal with the issue. Dr. Eichengreen states: "The United States will suffer the kind of crisis that Europe experienced in 2010, but magnified. These events will not happen tomorrow. But Europe's experience reminds us that we probably have less time than commonly supposed to take the steps needed to avert them. Doing so will require a combination of tax increases and expenditure cuts." He goes on to point out that, "At 19 percent of GDP, federal revenues are far below those raised by central governments in other advanced economies with spending on items other than health care, Social Security, and defense and interest on the debt having shrunk from 14 percent of GDP in the 1970s to 10 percent today, there is essentially no non-defense discretionary spending left to cut. One can imagine finding small savings within that 10 percent, but not cutting it by half or more in order to close the fiscal gap."
Consistent with this analysis, the Trustees of Social Security and Medicare have calculated that the present value of unfunded liabilities of these two programs totals $59.1 trillion. Additionally, there have been tabulations that all federal government liabilities, including those of Medicaid, veterans and other defense obligations, pension liabilities of government employees, and additional federal programs total $200 trillion at present cost.
These massive unfunded liabilities, when coupled with our present trillion dollar deficit, point to the stark reality that significant revenue increases and serious cuts in all programs will be shortly forthcoming. If these readjustments take advantage of current knowledge regarding tax and spending multipliers, the economic implications should not be severe. Clearly the only solution for our present predicament is to have a vigorous and rapidly expanding private sector and a shrinking public sector. As an investor concentrated solely in Treasury securities, our maturity structure will depend greatly upon the timely resolution of the country's present deficits.
State and local purchases of goods and services (10.9% of real GDP) has fallen at a 2.1% annual rate since mid 2009, and is poised to decline further in 2012. The fiscal condition of these levels of government has improved due to rising tax revenues and expenditure cuts. However, about one half of the states still face deficits in the final half of the current fiscal year and/or in the new fiscal year that begins in July 2012. Also, these budgets do not reflect the unfunded liabilities of their pension funds that are experiencing another year of investment returns that are considerably less than their actuarial assumptions. Further, a number of states enacted temporary tax increases that expire. Thus, state and local governments must continue to either cut spending or renew the taxes that politicians promised were temporary. The seeming improvement in state and local finance is an illusion, and this drag on economic activity will continue.