Why Federal Debt Matters

Homeless man turns $500 into $978,750 in just five weeks

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The Congressional Budget Office (CBO) recently lowered its estimate of the projected budget deficit for fiscal year 2016, which runs through September. The deficit is estimated to be $10 billion lower.

That is the good news.

Unfortunately, that is the small picture. The big picture is that the deficit is estimated to come in at $534 billion for fiscal 2016. That is about $100 billion more than last year.

This is in a time where we are supposedly in a recovery and unemployment rates have dropped back down to normal levels. Yet the deficit is still over half a trillion dollars.

There is sometimes confusion between debt and deficits. Perhaps this confusion is deliberate on the part of politicians and media.

Whenever you hear a politician talk about cutting the deficit, be sure to look at the details. You can cut a deficit, but it doesn’t mean the debt isn’t continuing to increase.

Obama, congressional Republicans, or whoever can claim to have cut the deficit in half since 2008 or 2010. But that is just a cut in the rate at which the government is racking up the debt.

As an analogy, think of a family with $50,000 in credit card debt. They are adding $10,000 every year in new debt without paying anything down. The following year, the family adds “only” $5,000 in new debt. The family proclaims success in cutting their deficit in half. But now their total debt is $55,000 instead of $50,000. Is this really an improvement?

When you have a debt crisis, you can’t claim any victories when the debt continues to get larger. You have to at least balance the budget in order to stop the bleeding.

But Congress is nowhere close to getting a balanced budget. They haven't passed a budget in years. It isn’t even on the radar. In fact, the CBO stated that if current laws don’t change, the deficit will only grow over the next decade.

The national debt is over $19 trillion. It will be over $20 trillion not long after Obama leaves office. It will continue to grow when he leaves office.

Meanwhile, the unfunded liabilities are estimated to be as high as $200 trillion or more. This number is an impossibility. The government simply will not be able to keep all of its promises.

Don’t Mention Recessions

The deficit is over half a trillion dollars in an economy where people are working and paying taxes. The jobs and wages may not be as good as what people would like, but at least there are jobs.

When the CBO projects increasing deficits, this is under an assumption that there will continue to be moderate growth. But what if there is a recession? What if there is a recession similar to 2008?

If the U.S. economy falls into recession and unemployment rises again, then the government is all of a sudden faced with declining tax collections and increased welfare. The deficit is going to quickly balloon to well over $1 trillion.

This is the crazy thing about government budgeting and projections. They are always under the assumption that the economy will just keep humming along at a decent pace. But how often do we go a decade or more without seeing an economic recession?

Cut the Deficit But Keep Spending

While we can safely blame the politicians and bureaucrats for the mess we are in, the American public is not blameless.

If you survey Americans, they will say that the government should cut the deficit. They will even say that they favor a balanced budget amendment.

The problem is that you have to cut spending somewhere, which means that at least some people will have to give up their favorite government goodies.

It is easy to say that you favor less spending until you find out the specifics of it. Many Americans probably would favor some spending cuts, but it would have to be in areas that would not have a significant and immediate impact on them.

When you add up Social Security, Medicare, Medicaid, military spending, and the interest on the debt, that is about 80% of the entire federal budget. You could cut every last penny of every other department and program and you would still barely arrive at a balanced budget.

Do you see the problem here?

The military spending and the so-called entitlement spending is unsustainable. It will be impossible to maintain over the long run with the current trajectory.

And as the debt gets larger, the payments on that debt will continue to grow, consuming a larger portion of the federal budget.

The government is getting away with it right now because rates are so low. But just as they never project a recession, they also don’t project significantly higher rates.

If rates normalize just to historical levels, we could be staring at interest payments of close to $1 trillion per year in the not-too-distant future.

Funding the Deficit

Most Americans do not favor higher taxes as a remedy to the situation. That is the good news.

Some do favor higher taxes on the rich — meaning those with higher incomes — but that won’t even put a dent in the problem. There aren’t enough rich people to make that big of a difference.

In addition, there is something to the Laffer curve. If you raise tax rates high enough, it just ends up discouraging work and investment and leading to less economic growth. Higher taxes probably won’t lead to more tax collections for the government. If they do, it won’t be much.

The obvious solution for the federal government is to have the central bank — the Federal Reserve — fund the deficits through money creation. This is why the federal government can run up such huge amounts of debt with seemingly little consequence.

State and local governments are essentially forced to balance their budget, or at least come somewhat close. They do not have a printing press. They actually depend on investors to fund their debt.

In the short run, Fed inflation really will be the solution in desperate times. But it will just cause more distortions in resource allocation. It will hurt productivity and economic growth.

And even with Fed inflation, there is a limit.

Faith in the Currency

Earlier this week, Fed chair Janet Yellen gave a speech that sent signals of a “dovish” policy by the Fed. The Fed is now talking about hiking rates at an even slower pace.

After Yellen’s speech, the U.S. dollar quickly fell. This is in context with other currencies. Over the last several years, the dollar has been strong compared to the other major currencies of the world, but that is not saying much.

Japan has an even bigger national debt than the U.S. in terms of the size of its economy. The Japanese central bank continues to create money out of thin air with little restraint. And interest rates are now negative, with even the 10-year yield going into negative territory.

This is all supposed to be stimulus, yet Japan’s economy is a total mess. It is stagnant. The continued money printing and negative interest rates just cause greater fear and an increased demand for cash.

The one good thing about Japan is that it may give us some indication of what to expect in the U.S. If we are lucky, maybe some people will see it as an indication of what not to do.

When rates and consumer price inflation are relatively low, the Fed (and other central banks) can get away with a lot. Monetary inflation is distorting the economy and hurting productive activity, but it isn’t as obvious.

But does anyone think that interest rates and price inflation will remain really low for another decade? It is possible, but is it likely?

As the deficit continues to grow and the debt gets ever larger, the Fed is going to create more money to help fund these massive deficits. At some point, people are going to realize that it isn’t going to end.

When there is a loss of faith in the currency, things can change quickly. People start to spend their money to get rid of it because they know it will continue to depreciate. Price inflation rates and interest rates can jump quickly.

This is the ultimate limit on the Fed and every central bank. At some point, the central bank has to cut back or else risk hyperinflation. We are nowhere close to this point now, but the situation can come about rather quickly when there is a loss of faith in the currency.

When the central bank is forced to cut back on its monetary inflation and interest rates rise, then Congress will be forced to cut back. This is what we need. We need a correction in Washington, D.C.

Washington, D.C. needs to go through a recession just as everyone else did eight years ago. The spending is strangling our economy and will continue to do so.

Eventually, the federal government will be forced to cut back. But until that time, the Fed will be a main source of funds for the deficit. This means you should plan accordingly with hard assets to protect yourself for when there is a loss of faith in the currency.

Until next time,

Geoffrey Pike for Wealth Daily