Thursday, November 22, 2012

"The U.S. Deficit/Debt Problem: A Longer-Run Perspective"

For the last 40 years we have been told over and over and over again that the Federal debt and deficits are proof government spending is excessive. They are not proof.

Daniel Thornton
Vice president and economic adviser
Federal Reserve Bank of St. Louis
The Economic Research division of the St. Louis Fed offers an intro page on Daniel L. Thornton's The U.S. Deficit/Debt Problem: A Longer-Run Perspective (PDF). The intro page presents the abstract of the paper:

The U.S. national debt now exceeds 100 percent of gross domestic product. Given that a significant amount of this debt is the result of governmental efforts to mitigate the effects of the financial crisis, the recession, and the anemic recovery, it is tempting to think that the debt problem is a recent phenomenon. This article shows that the United States was on a collision course with a major debt problem for nearly four decades before the financial crisis.

Oh, I agree! I think it is a great insight... Well no, not really. I think it is painfully obvious that the Federal debt was growing long before the crisis. Really, Perot was talking about Federal debt in 1992, and before him Reagan was talking about Federal debt in 1980. So nobody -- nobody at the Fed, and nobody outside the Fed, either -- should be thinking that the Federal debt suddenly became a problem at the time of the financial crisis. Oh, well. The abstract continues:

In particular, the debt problem began around 1970 when the government decided to significantly increase spending without a corresponding increase in revenue.

Yeah yeah, the problem began long ago.

But wait a minute. What does Thornton say? "The debt problem began around 1970 when the government decided to significantly increase spending without a corresponding increase in revenue." The Federal debt problem arose right around the end of the Golden Age, when the government decided to increase its spending. Really?

Quick look:

Graph #1: Federal Government Total Expenditures  (Log Scale)

... I dunno. I see a slow-down from 1980 to 2000 all right, but before 1980 looks to me like a straight line. Wiggly, sure, but straight. And a straight line on a log-scale graph means a constant rate of growth. Means there was no decision to "significantly increase spending". Quick look, mind you.

What I think, it wasn't that there was a decision to "increase" Federal spending. I think things were growing, population, GDP, Federal spending all were growing. And there was a presumption that a straight-line increase (like the 1960-1980 trend on Graph #1) was a baseline that did not count as an "increase". And I think that was a perfectly reasonable thing to think.

And then what happened was, the Golden Age ended, and GDP started falling behind its baseline trend. Unemployment started going up:

Graph #2: Unemployment hits bottom, 1968-1970

Federal revenues (red) started falling off, ever so slightly at first:

Graph #3: Federal Government Total Expenditures (blue)
Federal Government Current Receipts (red)
1960-1990, Log Scale

Okay. Granted, it's hard to see clearly whether Federal spending increased or Federal revenues fell off. Gimmie a break, I'm telling ya what I think. I think revenues started falling off. I think the source of the Federal deficits was that revenues started falling off. Not that "the government decided to significantly increase spending" relative to trend.

These are small changes, subtle differences. If I have sufficiently motivated myself, then soon I will take a closer look at the growth patterns of Federal revenue and spending, and come up with something more definitive. But I shouldn't have to do that. Daniel Thornton should have done it already.

Hey, here is one more look at Federal spending (blue) and Federal revenue (red) on a log chart, this time with nominal GDP shown as well (green, right scale):

Graph #4: Federal revenues (red) lag GDP (green) more than Federal spending (blue) leads GDP.
In this conceptual view we see Federal revenues falling off, and not Federal spending growth, as the chief contributor to the deficits.

NOTE: It may well be that the Federal deficits increasingly fail to have the intended (Keynesian) effect. In other words, stimulus spending does not work as well as expected. The value of the fiscal multiplier has fallen. This is a view more often expressed by "conservative" economists (I think) than by "liberal" ones. But I think there is something to it. Nevertheless, it remains wrong to say that "the government decided to significantly increase spending".

From Thornton's PDF:

The analysis here shows that the U.S. deficit/debt problem began during the early 1970s when the government started to increase spending significantly without a corresponding increase in tax revenue. This article also analyzes various aspects of government revenues and expenditures to better understand the different elements of the debate...

(Page 441.) Thornton continues:
The conclusion that the United States was on a collision course with a debt problem is supported by a simple analysis of government revenues and expenditures as a percent of GDP. Figure 3 presents government spending and revenue as a percent of GDP from 1950 through 2010. The black and blue dashed lines denote the average federal government revenue and expenditures, respectively, as a percent of GDP from 1950 through 1969. The figure shows that after 1970 both revenues and expenditures increased on average relative to the previous two decades; however, revenue increased marginally, while expenditures increased significantly...

Figure 3 shows, however, that tax revenue as a percent of GDP increased from 17.5 percent of GDP to 20.6 percent of GDP from 1993 to 2000. This increase is associated with the tax increases introduced in 1993. Revenue subsequently decreased following passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; a.k.a. the George W. Bush tax cuts). The decline in tax revenue relative to GDP between 2000 and 2003 was likely due in part to the 2001 recession; 2007 tax revenue as a percent of GDP was at or above the 1950-69 average level during the 2006-08 period. The marked decline in revenue as a percent of GDP during the 2009-11 period is likely due to the financial crisis and the accompanying recession. Hence, while the Bush tax cuts may have been a contributing factor to the deficit after 2001, this analysis suggests that the average deficit from 1970 to 2007 was largely due to a marked increase in expenditures relative to GDP: The ratio of debt to GDP was 57 percent in 2000 and increased to only 64 percent by 2007. Hence, most of the increase in the debt over the entire 1970-2007 period occurred because the government spent much more than it collected in taxes—about $6 trillion more.

I quoted quite a lot here, because Thornton's conclusion is important. That conclusion again: "Hence, most of the increase in the debt over the entire 1970-2007 period occurred because the government spent much more than it collected in taxes."

Okay. It is true that if you spend more than you receive, you increase your debt. If A is less than B, then A minus B is less than zero. It is a mathematical fact, yes. But it is not a "because". It is not an explanation. And it is not "proof".

Why was A less than B? Why did the Federal government spend more than it received? What happened? These are the important questions.

Thornton says there was "a marked increase in expenditures relative to GDP" beginning in the early 1970s. Fine. But economic performance dropped in the early 1970s. The marked increase in expenditures relative to GDP was a result of the decline in GDP growth. Meanwhile, the accepted view at the time called for increased government spending when GDP growth slows, as a way to boost economic growth.

The proper question is not Why did the government choose to spend "much more than it collected in taxes"? The proper question is Why did GDP growth falter?

The rising cost of interest, a result of our ever-increasing reliance on credit, drove up the financial cost of production. This cost drew income away from labor, causing a subtle decrease in the growth of demand. That same cost drew profit away from productive ("nonfinancial") enterprise, undermining the incentive for productive sector growth. And that same cost boosted the profit of the financial sector, enhancing the incentive for financial sector growth. Policy encouraged all of this, on the grounds that credit use is always good for growth.

GDP faltered because of our excessive reliance on credit. Federal spending increased when GDP faltered, and Federal revenue declined. Thus, the Federal debt and deficits.

I find it most disturbing that the people who should be looking into such things, people like Daniel Thornton, are instead busy overlooking them.


jim said...

Hi Art,

I like how Harry Dent explains the financial crises.

I don't agree with all his conclusions, but he does present the basic facts well.

The Arthurian said...

Dent: debt, and demographics. Interesting link. I read The Great Boom Ahead by Harry Debt back in the '90s. That 1993 book predicted the end of inflation and a boom beginning in 1995. Right on both counts.

Happy Thanksgiving.

Gene Hayward said...

Loved this posting, Art. So clear even I could understand it. Have a great holiday with your family. :)

The Arthurian said...

Oh, thank you, Gene! Happy Thanksgiving to you and yours.

netbacker said...

So no mention of we going off the gold standard in 1971 which meant the govt is no longer revenue constrained. A fiat currency issuer like the US doesn't need revenues for its spending. It spends the currency into existence.

The imperative behind federal borrowing is to drain excess reserves from the banking system, to support the overnight interest rate. It is not to fund untaxed spending. Untaxed government spending (deficit spending) as a matter of course creates an equal amount of excess reserves in the banking system. Government borrowing is a reserve drain, which functions to support the fed funds rate mandated by the Federal Reserve Board of Governors.
The federal debt is actually an interest rate maintenance account (IRMA).
Fiscal policy determines the amount of new money directly created by the federal government. Briefly, deficit spending is the direct creation of new money. When the federal government spends and then borrows, a deposit in the form of a treasury security is created. The national debt is essentially equal to all of the new money directly created by fiscal policy.

netbacker said...

Look up soft currency economics by Mosler.

The Arthurian said...


From Daniel Thornton's point of view, my analysis is far more relevant than yours. Remember on Seinfeld, Jerry and Elaine would be talking about something, and George would keep talking about something completely different?

I think, if you want to convince someone that they are wrong about something, you have to participate in their conversation. Not like George Costanza.

"Government borrowing is a reserve drain, which functions to support the fed funds rate mandated by the Federal Reserve Board of Governors."

So the Fed's interest rate target is a "mandate" that forces Congress to spend more than it taxes? That doesn't strike you as silly?

Cinthia Mull said...

Indeed, there are struggles that a lot of people tend to overlook and the result is oftentimes devastating. We have to make people aware that spending heaps of money every day will not contribute to improving the overall status of the country. It would only lead to more debts, which makes financial management impossible.

Cinthia Mull