January 1, 2014

A Budget—and Debt—Primer

Given the fiscal gyrations in Washington—and the sharp political differences over the real impact of closing the government and extending the debt ceiling—it may be useful to step back and review our budgeting process and resulting financial condition a bit more objectively than our elected officials seem able to do.  

Congress and the president are supposed to sign a federal budget agreement every year, yet partisan politics have prevented such an agreement for four consecutive years. The budget document is a non-binding blueprint, but in its absence, Congress must pass a continuing resolution (CR) to continue funding government operations. Congress’ recent failure to pass a CR led to the partial government shutdown, initially furloughing 800,000 workers. With 350,000 quietly brought back after a week, and all those furloughed (less than 20% of government workers) receiving back pay, the economic impact was temporary and probably reduced gross domestic product (GDP) by 0.2% to 0.4%.   

The non-partisan Congressional Budget Office (CBO) estimated that with the government running on a CR, total spending for 2013 would be approximately $3.5 trillion, about the same as the year before. Spending can be divided into two broad categories: mandatory spending, which is 64% of the budget, and discretionary spending, which is 36%. Mandatory spending includes entitlements such as Medicare, Medicaid, Social Security, Income Security and, for our purposes, interest on the debt. Mandatory entitlement spending stays on autopilot and is not affected by the lack of a CR. Spending on all of the other federal agencies is made at congressional discretion. Entitlement spending is expected to grow more rapidly than discretionary spending, making it virtually impossible to balance the budget going forward unless entitlement programs are reformed. In addition, since Medicare will be unable to pay out all of its expected benefits by 2024 (2033 for Social Security), entitlement reform takes on additional importance. 

While 2012 spending was $3.5 trillion, the government took in only $2.5 trillion in revenues, leaving a deficit of $1 trillion. The Treasury Department reported in October that the 2013 deficit hit $680 billion. Deficits are covered by borrowing money almost daily from investors all over the world through U.S. Treasury-issued IOUs known as Treasury securities. The government has run a deficit in 45 of the past 50 years (1969, 1998, 1999, 2000 and 2001 were the exceptions), and the accumulated deficits have piled up to a public debt of $11.3 trillion in 2012. At press time, it was estimated to hit at least $12 trillion by the end of 2013. Since the Treasury issues bonds with maturities of as much as 30 years, future generations will be paying taxes to repay those debts. In that sense, the government is spending money now that our children will have to pay back later. 

Spending and revenues grow over time as the economy (the GDP) grows, so making comparisons from year to year on a dollar basis can be misleading. For example, in 1987 the deficit was $150 billion, and in 2008 it was three times as big at nearly $460 billion. But compared to the size of the economy at the time, these deficits were each 3.1% of the GDP. In 2012, the deficit was 7% of the GDP (the average since 1950 is 2.3%). In 2013, it’s estimated that the deficit will be 4% of the GDP; spending, 22% (compared to the average of 20% since 1950); revenues, 18% (the average since 1950); and debt, 73% (the average since 1950 is 42%).  

Between 2007 and 2011, U.S. debt as a percentage of the GDP nearly doubled, and it’s estimated to increase another 7 percentage points by the end of 2013. To compare debt across countries: In 2012, Chile’s debt as a percentage of GDP was 10%; Australia, 27%; China, 32%; South Korea, 34%; the United States, 75%; Germany, 82%; Greece, 161%; and Japan, 214%. The world average was 64%.   

U.S. government agencies also lend to the Treasury through their purchase of Treasury securities, bringing the gross debt to $16 trillion in 2012. About 34% of the gross debt is held overseas, with China and Japan each holding about 7%. The gross debt was projected to exceed the $16.7 trillion debt ceiling in October 2013. If the debt ceiling had not been raised (though, at press time, only until February 7), the Treasury could not have continued to borrow money. That could have provoked a default on U.S. debt payments, which would likely have sharply raised the interest rate the Treasury has to pay, thrown global financial markets into turmoil and damaged global economies. Setting a debt ceiling as a dollar value means it must be continually raised as the economy grows, causing repeated harmful political clashes. It would be more sensible for the debt ceiling to be expressed as a percentage of the GDP, a more consistent target for budget planning and negotiations. 

But in Washington, consistency and the use of numbers as most people understand them are too often elusive. For example, to better analyze the budget, the CBO makes projections assuming a baseline of no changes to current law. While baseline budgeting can be useful, it also facilitates misleading statements. Suppose a federal agency spends $10 in year one and has a baseline budget to spend $13 in year two. If Congress were to lower the year-two budget to $12, clearly spending would still be growing by $2 ($12 compared to $10). Yet in this circumstance, the president and lawmakers routinely claim that, since they lowered the original year-two budget from $13 to $12, they actually cut spending by $1. All parties use this kind of misleading accounting when referring to any budget numbers. Even though automatic budget cuts, the so-called sequester, will supposedly cut spending in 2014, the “cuts” are a reduction from a baseline budget. Total real spending compared to 2013 will actually rise. 

The lesson here: There is a lot of loose budget talk from both sides of the aisle in Washington. It takes a review of non-partisan sources to understand what’s actually going on. 

Dan North is chief economist at Euler Hermes, the world’s largest trade credit insurance company. As the company’s economist for North America, he uses macroeconomic and quantitative analyses to help manage Euler Hermes’ risk portfolio of more than $150 billion in annual trade transactions within the region.