The White House (WH) and the Congressional Budget Office (CBO) have recently published their budgets for the next year and projections for the future. It makes for great reading, if you like fiction.
The chart to the right shows the three projected paths for the Federal Budget Deficit for the next 10 years. One is from the White House and two are from the CBO – a Baseline and an Alternative (worst case scenario).
In our opinion, both are based on spurious if not completely fictitious numbers. They have expectations of high revenues and economic growth and low expenses. From a financial planning perspective, this is not proper. Expenses should be estimated high and income should be estimated low.
We have no reason to believe any of the budget deficit estimates from the WH, since they have already proven themselves to have a poor grasp of the numbers. Below is a comparison of their 2010 budget deficit estimates and the actual deficits. (trillions of dollars)
The difference is a cool $728 billion total in just 3 years. How much will their current estimates be off? What difference could it make to your investment strategy?
This report will look at some key estimates from both the CBO and WH Budgets. They will include interest expense, revenue and outlays.
According to CBO estimates, debt should start to decline relative to the GDP under their baseline scenario. If the Alternative happens, which is their worst case, debt grows relative to GDP. These debt numbers are relative to GDP, it does not mean that the Federal debt will decline in real terms, which in fact their estimates show. They expect the national debt to continue to grow, even under the Baseline scenario. (Example: if the GDP were to grow at 5% annually, and the National Debt were to grow at 4% annually, the debt to GDP is declining. If however, the GDP grows at 3% annually and the National Debt grows at 4% annually, the Debt to GDP grows.)
The variables that have to be looked at include the components of the deficit, (revenues and outlays) and the estimates for GDP growth.
Mandatory Spending is made up of Social Security, Medicaid and Medicare and other social programs. After a sharp increase in 2007/2008, there was a slight pullback, but not to pre-2008 levels. The projections for the next 10 years is for Mandatory spending to increase relative to GDP.
Discretionary Spending is made up of military spending, the Justice Department, government operations and the Executive Branch, among other non-social programs.
It reasonable to assume that with the end of the recession, spending on social programs would have reverted back to their previous levels of about 10% of GDP. But this wasn’t the case. The CBO estimates that most of the recent increases will continue and even grow. This shows a lack of discipline in Washington and a willingness to pander to the voters. Instead of doing what is right and cutting all spending, they are leaving social programs alone and letting them get bigger.
The one outlay they can’t control is interest expense. Later we will show just how dangerous this expense is and how it can cause outlays to climb much higher than they project.
The Revenue side of the deficit equation is where they expect to make up the most gains in reducing the deficit.
Under the CBO’s Baseline projection, Revenues to the Government will be about 20% of GDP in just a few years, and then continue higher from there.
Since 1972, Revenues averaged about 18% of GDP. 18% of GDP is the CBO’s worst case scenario under the Alternative Projection.
Since Revenues only hit 20% of GDP for a limited time in the late 1990’s, a period of high economic growth, it seems like a stretch to expect that under current circumstances, Revenues could climb to 20% of GDP again and then go higher from there.
Without the increased revenue stream, the budget deficit reduction plans fail. The Congress would have to start cutting Mandatory Spending and the chances of that are very low.
This means that deficits will continue to get larger and the Treasury will have to issue more bonds to finance the debt. The Federal Reserve will likely continue their QE strategy of monetizing the debt, which is inflationary.
In order to get the increases in Revenues, the CBO expects large increases in Individual Tax Receipts. Surprisingly, Corporate Tax Receipts go up, but not to their previous highs, and after a couple of years, they decline. Meanwhile, Individual Tax Receipts continue higher, to highs not seen in the past 40 years.
Since 1972, Individual Tax Receipts averaged about 8% of GDP. The CBO anticipates Tax Receipts to rise to over 10% of GDP in just a few years and climb even further. Individual Tax Receipts only hit 10% during the economic boom of the late 1990’s. It is hard to believe that under the current slow growth economic environment they could grow beyond their historic average of about 8% of GDP.
Interest Expense is not controlled by the Congress or the Budget. Whatever the market rate is will be the interest expense that the Government has to pay on its debt. Since 1980, the cost to the government has been about 4.28% of the previous year’s debt. Since 1940 it has averaged about 3.47%. These numbers are important because when doing any long term calculations, one should always expect that the average will prevail. A regression to the mean or average is the norm.
In the White House projections, they estimate the total expense to be less than 1.50% for a few years and climb to only 3.27% by 2022. Even under their very low rates, the total debt climbs to over $25 trillion by 2022.
We estimated that the cost to the government would revert back to its average. We used both 4.28% and 3.47%. Under these scenarios, the interest expense adds an additional $4 to $7 trillion dollars to the national debt over the next 10 years. This is completely unproductive debt used only to pay off the interest on previous debt.
This is one of the main reasons we believe that the Fed will continue to print Dollars, monetizing the debt. We also believe that there is a chance the Treasury will eventually default on debt held by the Fed in a strategic, targeted default. This will in effect lower the debt to GDP ratio and give the government room to borrow more.
Much of what the White House and CBO forecast depends greatly on the growth of the economy. If the economy grows substantially, then the odds increase that they can attain their revenue goals. If the economy doesn’t, then their projections won’t be worth the paper they were written on.
The chart above shows the GDP growth projections from the CBO and WH, along with several “impartial” sources. As you can see, the CBO and WH projections are much more optimistic than the impartial global organisations, and even more optimistic than the Optimistic projections from the Conference Board.
A cynic might say this is because the Congress and White House have voters that they have to appeal to, so they are putting everything into the best light possible. The Conference Board, the International Monetary Fund (IMF) and the organisation of Economic Development (OECD) on the other hand, do not have voters to pander to. Call me a cynic.
But there is a rabbit that Washington could pull out of the hat that could produce strong growth. The chart to the right shows the 5 year GDP growth rates, including the White House Projections.
There was a period of continually strengthening GDP growth – during the inflationary period of the 1970’s. That’s right, a time when most people thought the economy was doing poorly, the GDP was growing, thanks in large part to the impact of inflation.
This, we believe, is the magic the Fed will rely upon. Inflation can cure a lot of economic ills. It can make a slow growth economy perk up, it can bury a debt problem and it can make a budget deficit disappear.
We believe that the estimates in both the White House Budget and the CBO’s budget are too optimistic. By missing the budget deficit projections by almost three quarters of a trillion dollars, the White House budget projections from 2010 confirm our opinion.
We believe that the revenue estimates are too high, the interest rate assumptions are too low and that not enough has been cut from spending.
It appears to us, that the only way they can hit their targets is to let inflation gain momentum. Higher inflation can push up the GDP, income and thereby tax revenue and reduce the impact of the deficits on the economy.
We are by no means advocates of this strategy. We believe that the natural course of economic cycles should be allowed to be fulfilled without interruption. This means allowing the Creative Destruction part of capitalism to do the work it has done in the past – Cleaning out the weak companies, and setting the stage for new, more flexible companies based on sound fundamentals instead of pumped up by debt and liquidity driven markets. It would eliminate the Moral Hazard that the Fed has created in the banking an finance industries.
It would also be a deflationary time, with GDP declines and high un-employment. If allowed to work naturally, this period of time, while painful, would be short lived and result in a stronger, leaner country with much less debt.
Instead, the monetarists at the Fed will lean on their Keynesian ways and keep printing Dollars until they run out of ink. We will be told that the economy is fine, as we have been for the past couple of years, even though we all know it isn’t. The strategy of kick the can down the road will keep the economy limping along and if they let inflation run high enough, might give the illusion of higher growth and smaller deficits.
They will continue to run deficits, piling on more and more debt. Eventually, (sooner, rather than later) as it does with all countries that live beyond their means, the markets will say “No Más!” Interest rates will head higher and Washington will be forced into doing what they should have done in the first place, but now thanks to the trillions of piled on debt, it is even harder.
Unless there are drastic changes in the Administration, Congress and the Federal Reserve, inflation seems to be the cure they will rely on instead of real spending cuts, fiscal discipline, real tax increases for everyone and real economic development and growth.
Wise investors would position themselves accordingly, because the Fed won’t be making any announcements that they are letting inflation solve their problems – they will just let it happen.
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