Perplexed By The Deficit Scolds?

zFacts has produced an interesting graph for the perplexed (here). It shows (click graphic above to enlarge) US National Debt as a percentage of National Income by Presidential term. It shows the Supply-Side debt disaster that started in the Reagan years and continues to the present. It also shows a great counterfactual: what would have happened if Reagan and the Bushes had balanced their budgets. In the counterfactual world, debt would currently be below 30% of National Income.

There's another interesting part of the graphic. Debt during World War II reached 120% of National Income and the US economy did not seem to have been damaged by this much debt in the Post-War years. What's more, a lot of that debt went to pay for equipment and armaments that were entirely expended during WWII and never had a productive lifetime. So, is 30%, 60%, 90%, 100% (the current number) or 120% the magic "bad number" for national debt?

Nations (especially a nation that plays the role of hegemonic leader in the world system) are not households. But, many business people (for example, here) seem to argue that the household analogy is appropriate so let's see where it takes us. 

Let's say you make $100,000/year (your Personal Income) and you have a $500,000 mortgage (your only debt). You are a solid citizen with a good job, savings and a bright future. These numbers don't seem unreasonable. But, your debt to income ration would be 500%. Whoa, the deficit scolds would say. You can only have a mortgage of $120,000 to bring your debt in line with your income (that's not much of a house for a person with a six-figure income).

So, if a deficit scold was your banker, how could you have possibly obtained that kind of loan? Of course, it's not only income but also net worth that should be considered (does anyone want to guess at the net worth of the US Federal government?). Another way to look at the graph above is that Presidents from Eisenhower to Carter did not invest as much in the US as they might have and today we have an infrastructure that is crumbling due to lack of investment. And, money is basically free right now. A great time to invest.

Of course, there are good reasons why the household analogy fails. The US government can print its own money and households cannot. The US National Debt could be wiped out tomorrow by printing more money. Since we have no inflation right now, it's not really clear what the effect of such a one-time jump in the money supply might be but deficit scolds would yell "inflation"  -- I'll look at the US money supply and what the Fed is doing in a future post.

So when people circulate videos such as the one below, the purpose is to scare the perplexed with large numbers. The debt is what it is. The debt from WWII was what it was and was probably necessary to end the Great Depression and win the War. The current debt level may be what is necessary to end the Great Recession (the Financial Crisis of 2007-2008), the worst economic downturn since the Great Depression, and win the War on Terror (lest we forget, the right wing is still at war with the Islamic world). Money is cheap right now and US infrastructure needs upgrading after decades of inadequate investment. The US is a safe haven for investment. WWII did not sacrifice the "future of our children" on the altar of debt. It ushered in decades of prosperity until the Neoliberal Right-Wing Supply Siders came to power. The upcoming Fiscal Cliff experiment will show how important government expenditure is during times of crisis.

Causes of The Deficit: Republicans Acting Responsibly

I am fortunate enough to have Ron Johnson, R-WI, as my US Senator. He is one of the freshman class aligned with the Tea Party movement. I have been tweeting Senator Johnson suggesting that he seriously consider raising the US Debt Ceiling. My basic argument is that the current deficit was causally related to actions taken during the Bush II administration. Being a Republican, Senator Johnson should be willing to take responsibility for these actions.

In the event that Senator Johnson would be interested in a more detailed explication of my causal argument, I've provided the following path diagram (click to enlarge) developed from Chapter 10 of the book This Time is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff.

Reinhart and Rogoff's own explanation is pretty straight forward (p. 172-173):

When a country experiences an adverse shock--due, say, to a sudden drop in productivity, war, or political or social upheaval--naturally banks suffer. The rate of loan default goes up dramatically. Banks become vulnerable to large losses of confidence and withdrawals, and the rates of bank failure rise. Bank failures, in turn, lead to a decrease in credit creation. Healthy banks cannot easily cover the loan portfolios of failed banks, because lending, especially, to small and medium-sized businesses, often involves specialized knowledge and relationships. Bank failures and loan pullbacks, in turn, deepen the recession, causing more loan defaults and bank failures, and so on.

Earlier in Chapter 10, Reinhart and Rogoff explain that recessions, bailouts and foreign wars (Iran, Afghanistan and the War on Terror) all lead to increases in the deficit. All these causes of increasing US debt are the direct result of actions taken during the Bush II administration, to include the lax attitude toward regulation of the financial sector that led to the Subprime mortgage crisis itself (the shock in the path diagram).

Notably missing from this causal explanation are entitlement programs, Obama care, public sector unions, high taxes (taxes were cut during the Bush II administration) and other right wing fixations. Senator Johnson will certainly see the sense of my air-tight causal argument. The rational policy response, which he will also certainly appreciate, would be to end foreign wars and the war on terror in addition to increased regulation of the financial sector. And, since the wealthy do not seem to know how to spend tax reductions on anything other than speculation, a tax increase on ill-gotten gains would also help reduce the deficit.

Technical Note: The upper part of the path diagram above is a positive feedback loop (negative signs multiplied together become positive as in basic algebra). The positive feedback effect explains why financial crises last so long and are so resistant to policy interventions.

Income Inequality, Tax Cuts, Deficits and Unemployment Insurance

Al Kranken, D-MN, gave a little-noticed but insightful speech on the Senate floor in December (you can read the entire speech here or listen to the video above). His dot points were:

• One lesson of the last election was not to give tax breaks to millionaires
• Rising income inequality in the US is a very serious problem
• Republicans can't lecture anyone on deficits (compare the two Bush administrations to Clinton)
• "Small" business doesn't mean small business to Republicans
• Maintaining unemployment insurance, one of the most important automatic stabilizers in the economy, is more important than bailouts
• Giving tax breaks to billionaires is not making "tough choices"

What happened? Al Franken used to be funny on Saturday Night Live!

Jack Lew on the Deficit and the 2012 Fed Budget Overview

President Obama is about to deliver his budget proposal to Congress and Jack Lew, OMB Director, appears in the video above to explain how the administration plans to get the deficit under control. In a prior post (here), I looked specifically at the deficit (the topic of Jack Lew's first white-board presentation) and deficit dynamics.

Mr. Lew goes on, in the second white-board exercise, to talk about the debt/GDP ratio. When the Obama administration took office, it was high (approaching ten percent). The intention of the budget that is about to be unveiled is to bring it down to around two percent of GDP.

Looking at the US budget deficit as a percent of GDP from 1900 to the present (above) it's clear that the major World Wars created deficits far larger than either the Great Depression, the Vietnam War period or the current Great Recession. In any event. Mr. Lew expects the deficit to decline to historically sustainable levels in the future.

Essentially, Mr. Lew has a business-as-usual (BAU) model in mind when making his deficit forecasts. The BAU forecast above suggests that a more reasonable GDP percentage for the deficit might be around three percent (somewhere between two and four percent). Mr Lew's forecast is at the lower end based on historical data and political calculation.

What's also somewhat interesting about the graph above is the comparisons of actual deficits (the black line) with the dynamic attractor (red dashed line) and the 98% prediction intervals. The period from 1950-1975 had improbably low deficits (if deficit hawks want to point back to this period, they'd be cherry-picking the data). Also, the Clinton surplus period around 2000 (Jack Lew was director of OMB in 2001!) was an improbable surplus given historical experience (Democrats would be cherry-picking the data to point to this period in defense of their ability to generate surpluses or control expenditures). The current deficit is quite improbable given experience since 1950 but not, as we saw above, given the entire Long Twentieth Century.

Mr. Lew's BAU model, however, might not be the best way to actually forecast the deficit. The forecast above predicts the US deficit as a percentage of GDP using trends in the state of the U.S. Economy. The forecast uses the USL20 model. The model predicts that as a result of economic performance (particularly the effects of globalization), deficits will increase in the future regardless of what Democratic or Republican administrations might attempt to do about it.

For me, these forecasts provide a counter point to Mr. Lew's optimistic, business-as-usual scenarios.

IN THEORY, you might expect the US Federal deficit to be a random walk, D(t+1) = D(t) + V, where this years deficit depends on last year's deficit and any economic shocks that might necessitate deficit spending or debt retirement. Or, a business as usual model for the deficit might be D(t+1) = a + b D(t) + V where the coefficient b captures some inertia in retiring debt and a=0 meaning that the average debt should be zero in the long-run. One last idea would be that the deficit should related to the state of the US economy, D(t) = a + b D(t-1) + cS(t-1) + V. That is, the deficit should respond to secular and cyclical trends in the economy.

The Drunkard's Walk and the Moment of Truth

The National Commission on Fiscal Responsibility and Reform has finally issued their report on the U.S. Deficit, "The Moment of Truth". They are not the only ones trying to seize the moment. The Economic Policy Institute has issued its report "Investing in America's Economy: A Budget Blueprint for Economic Recovery and Fiscal Responsibility." And, the Bipartisan Policy Center has released its report "Restoring America's Future." There are enough recommendations in and questions raised by these reports to keep many policy analysts busy blogging for many years in the future. Before jumping into the issues, I'd like to put a stake in the ground.

What do we expect to see when we look at a historical time plot of the U.S. Deficit? If the deficit hawks are right, we should see the deficit increasing uncontrollably over time when, in fact, the deficit should always be zero. The Keynesian viewpoint is that we should see periods of deficits during recessions followed by periods of surplus during recoveries. In other words the deficit should be a drunkard's walk, randomly moving from surplus to deficit based on shocks to the economy. The only issue is the range of movement: conservatives think there should be very little, if not zero movement and liberals say it depends on economic conditions.

The first figure above, using data from the CBO, fits a random walk model to the U.S. deficit. Although the fit is not bad, it looks like the model is always "catching up" and missing the turning points. What is striking about the graphic is that the deficit "excursions" are increasing in amplitude: economic shocks getting worse, spending responses ("bailouts") and attempts to "stabilize an unstable economy" getting more desperate.

Both the conservative and Keynesian views miss seeing that the U.S. deficit is part of a system. During an economic downturn, there is a flight to quality. Investors want to unload their higher-risk investments for the safety of U.S. debt which is covered by the "full faith and credit" of the U.S. government. During normal times, purchasing U.S. debt allows country's with trade imbalances (e.g. China) to do something safe with their dollars.

When we add debt held by the public into the random walk model, the predicted fit is much better (second graphic above). For the U.S. deficit to exist, there has to be a counter-cyclical market for U.S. debt. The market is somewhat self-correcting. If investors don't want to purchase U.S. debt, the only other way to create a deficit (as is the case in many "debt crisis" countries) is to print money.

What does this all have to do with the common explanations for the U.S. deficit being repeated in the policy echo chamber? Is it those mandatory entitlement expenditures such as Social Security, Medicare and Medicaid that must be eliminated to eliminate the deficit? Is this a reasonable conclusion from the graphics and discussion above? Is it the entitlement programs or the shocks to an "unstable economy" that are driving the deficit? It all depends on the time path of the entitlement programs compared to the time path of the deficit, a topic I'l talk about in future posts.