– Winston Churchill
“Crying is all right in its way while it lasts. But you have to stop sooner or later, and then you still have to decide what to do.”
– C.S. Lewis, The Silver Chair
“I must have a prodigious amount of mind; it takes me as much as a week, sometimes, to make it up!”
– Mark Twain
No matter who won the presidency, the economic way forward was not going to be easy. The Republican team understands they must “stand and deliver.” But as we will see in today’s letter, that is not going to be easy. I’m going to depart from the normal format of my letters, where I talk about the economic realities we face and how we should invest, and instead offer my view of what I think the Trump administration and the GOP-led Congress should do.
Please note, this is not necessarily what they will do. In complete candor, what I’m proposing will be remarkably difficult for certain members of the Republican and Democratic Congress to countenance. It requires accepting some significant philosophical heresies that are anathema to all politicians (different heresies/anathemas for different politicians, according to their philosophical bent), but I see it as the only way forward if we want to dodge a deep recession and/or a greater crisis in the future.
I know for a fact that many of the people you have seen listed on the Trump economic transition team will be reading this. That is one reason I’ve been taking so long to put these thoughts to paper. And some of the ideas I’ll share are quite frankly things I have come around to in just the last week. I will readily admit to having already mentally written my post-election letter based on the assumption that Hillary Clinton was going to win; and on Wednesday morning I had to throw out everything I had thought about and start all over. And it’s not just you and I who had to shift gears quickly: I know that quite a few people on the transition team had speaking engagements and other projects arranged for later that week, and they had to scramble to redo their schedules.
I’ve done a lot of talking with a lot of people and listening and reading in the last 10 days. This letter is where I currently come out. What I’m going to propose is something that I think is politically possible (in terms of gaining bipartisan support, which will be necessary for certain portions of what I’m suggesting). I also think it has the potential to solve the deficit/debt problem and provide the funding needed for healthcare, Social Security, and the other necessary categories of government spending. It would also be a massive stimulus to the economy – boosting jobs, new business creation, and entrepreneurial activity.
Up front we must face the fact that the American people want several incompatible things at once: They want lots of expensive healthcare provisions for everyone; they want tax cuts; and they want a balanced budget. As we will see below, we can have relatively universal healthcare (no matter how it’s funded and delivered), tax cuts, or a balanced budget; but we can have only two of the three. Most Americans want all three and don’t see why they shouldn’t have them. There are some exceptions – there are, for example, some economists who don’t care about tax cuts or a balanced budget. They are working from an economic theory that says deficits and debt don’t matter; but in practice, in the observable, empirical world, they do matter. Greatly. Maybe not this year, but sooner or later the piper has to be paid.
Let’s look briefly at where we are now – at the constraining facts that any economic proposal must take into consideration.
The US federal government debt will be slightly north of $20 trillion before Obama leaves office in January. Add in local and state debt of another $3 trillion (plus), for a total of more than $23 trillion of government debt. The US economy will be a few hundred billion dollars under $19 trillion at the end of this year. That is a debt-to-GDP ratio of somewhat over 121%. For the record, when you are trying to determine the effects of total government debt on the economy, not to include state and local debt is disingenuous. The debt must all be paid by the same general taxpayers at one level or another. (Please note: I am rounding out the numbers in this letter because when you’re talking about trillions and hundreds of billions, anything to the right of the decimal point is kind of meaningless.)That debt has risen roughly $10 trillion under Obama, in just eight years. Last year the debt rose $1.3 trillion, even though we were told that the budget deficit was only around $600 billion. Lots of off-budget debt gets added every year. It greatly annoys me when spin doctors don’t include total debt when they are talking about the deficit (and they do it on both sides of the aisle). I wish I could get my banker to adopt the same enlightened view.
I know that Krugman and others call me a debt scold (scornfully, as if I am some kind of troglodyte coming out of my cave to issue unnecessary warnings), but there are 160 historical instances of major countries having to renegotiate their bonds because they had too much debt, and in the recent century some countries that did so ended up in serious financial crises. I don’t for a minute think that the US will not pay every dollar of its debt; but getting those dollars, whether through taxation or printing, will impact the economy significantly. And if we wait too long, the ensuing crisis could be ruinous to many.
I start with the premise that to get the deficit and debt under control is an a priori condition for avoiding a future crisis. Avoiding that crisis – even if it is 10 years out – is important. The solution doesn’t have to be implemented all at once, but there has to be a clear trajectory along the lines of the Clinton/Gingrich budget compromises that gave us balanced budgets and even deficit reduction.
Standard Republican thought is that we have to engender enough growth to overcome the deficit. The Reagan tax cuts certainly increased the deficit, but when they were combined with the Clinton/Gingrich budget controls, we were soon paying down the debt and growing much faster. The debt became far less of a problem, at least in terms of GDP. It was when Bush II and the aggressively enabling Republican Congress basically abandoned budgetary controls (we could have used a deficit hawk like Gingrich as Speaker of the House to control the spending urges), combining tax cuts with large spending programs, that the deficit and debt once again began to get out of hand. Then along came the recession, triggered by the housing bubble brought on by interest rates held too low for too long by the Federal Reserve; and seemingly all of a sudden the deficit exploded – $10 billion in just eight years.
Sidebar: Everyone focuses on the size of the federal budget as if that is the government. The US federal spending budget is $3.88 trillion as of this year. State and local outlays are $3.3 trillion, bringing us close to $7 trillion of total government spending. Very few people realize that state and local spending is almost the same size as total federal spending.
Total US debt, including private and business debt, is $67 trillion, or just under 400% of GDP. We have 95 million people not in the labor force, 15 million of whom are not employed (twice the number officially unemployed). We have almost 2 million prison inmates, 43 million living in poverty, 43 million receiving food stamps, 57 million Medicare enrollees, and 73 million Medicaid recipients. And 31 million still remain without health insurance. (You’ll find a treasure trove of information like this at the US Debt Clock.
This US debt total does not even take into account the over $100 trillion of unfunded liabilities at local, state, and federal levels, which are going to have to be paid for out of current revenues at some point (see more below).
I bring up the size of the debt because unproductive debt is a limiting factor on growth. 10 years ago it wasn’t that big a deal. Today it is. The more we increase our debt, the more difficult it is going to be to grow our way out of our problem with the debt. That’s just an empirical fact. Both Europe and Japan have much larger debt ratios than we do, and both have much slower growth rates. Note also that the velocity of money in both those regions is much lower than ours, and the velocity of money in every developing portion of the world continues to drop. (More about that below.)Something like $5.5 trillion is “intergovernmental debt.” The theoretical Social Security trust fund is an example. We “owe it to ourselves,” and so many economists simply deduct that money when they talk about the size of the total debt. And technically it is true that we pay interest on that debt, which comes back to the government. But that doesn’t mean those debts aren’t going have to be paid.
The Social Security trust fund assumes as part of its future budgeting process that the interest will be paid. So do most other intergovernmental debtors. Think of it like borrowing against the cash value of your life insurance. You technically owe the money to yourself, and you are (typically) paying interest on the amount you borrowed, but if you die your outstanding debt reduces the amount of your life insurance. If you want the life insurance, you’re going have to pay that borrowed debt. For economists to talk about this portion of the debt as irrelevant is economic malpractice. It is smoke and mirrors economics of the worst kind. But even if we did dismiss $5.5 trillion dollars of internal debt, the government’s debt-to-GDP ratio would still be almost 100% when you include state and local debt. And that is definitely in the range where all the data and economic analysis suggests that debt is a detriment and a drag on growth.
Vice President Dick Cheney once remarked that “Deficits don’t matter” as he defended his spending on the Iraq and Afghanistan wars. And when he said it, he was more or less correct. Then, the deficit as a percentage of GDP was less than nominal GDP growth, which meant that the country was growing faster than the debt was. (Later, it turned out that deficits did matter, when the spending on everything else plus defense spun out of control.) And for those people who say that tax cuts create growth, I would suggest that 2% growth for 16 years is not exactly what we were expecting. And much of the growth we did get during the housing bubble years was clearly spurious.
Yes, the US economy has grown at something like an average 2% for the last 16 years. Inflation was higher in the early years, but now it is about 1.5%, which gives us nominal GDP growth of about 3.5%. Total debt this year rose by 6.8%, or almost double our growth rate. Not the right direction. After eight years of the slowest economic recovery in history, we are growing our debt dramatically faster than we are growing our country – even when we include inflation.
Remember that seemingly innocuous “velocity of money” bit of detail that I threw in earlier? You need the velocity of money to begin to increase so that you can actually get inflation. Ask Japan about how much money you can print without getting inflation. That also suggests it is going to be harder to create inflation than many economists would like. I know that many establishment economists would like to see inflation closer to 4%, with GDP growth of 3%, so that we could begin to quote “grow our way” out of the debt. That’s not impossible, but it’s highly unlikely. Frankly, we will be lucky to get 2% growth and 1.5% total inflation for the next four years.
Republicans want to cut corporate and individual taxes to help stimulate growth. That is a necessary but not sufficient condition to stimulate growth. Significant regulatory rollback will help. It is also necessary but not sufficient. Fixing the Affordable Care Act and bringing costs and benefits into alignment is another necessary but not sufficient condition for growth.
There is a major lag time for any economic programs that are enacted. Even if they are enacted in the first 100 days of the Trump administration, it will be months if not years before we see actual results. A $19 trillion economy does not turn on a dime.
The central advantage of the entirety of my proposals is that they offer a path to a finance the needs of the country and at the same time allow a balanced budget. The actual increase in the total tax revenue needed will be a function of the degree to which Congress can get the various budgetary items under control, especially healthcare and Social Security. I know a lot of conservatives would like to see no increase in total tax revenue to the federal government, and if we can do that and balance the budget, I am all for it. I am decidedly in the camp that government is too large and would be more than happy to eliminate a few departments here and there.
But voters clearly want healthcare and Social Security benefits to be paid for, along with other government services that are actually necessary (especially defense). Therefore, we must figure out how to pay for those services. Simply holding government expenditures flat for four years would go a long way to solving the problem, but it won’t get us all the way there.
Boosting growth is going to be difficult. This is not the 1980s and the environment that Reagan encountered. Stock markets are at highs, not lows, as they were in his term. Today, the market capitalization is 196% of GDP, versus 40% when Reagan took office (hat tip Stephanie Pomboy). Reagan also had a falling-interest-rate environment. Plus he had a huge demographic shift to work with, from Baby Boomers coming of age. Reagan also had his recession at the beginning of his term, so the economy was coming off its lows. There was a great deal of pent-up demand, which is not presently the case. All of these factors were a great help in spurring the economy when combined with tax cuts. Those conditions all tended to boost growth, yet they don’t exist today.
We can have growth and create good jobs, but it’s not going to look like the ’80s and ’90s. Our rebuilding of the economy will have to take a different path, and a more challenging one in many respects.
Let me be very clear. If we don’t get the debt and deficit under control – and by that I mean that at a minimum we bring the annual increase in the national debt to below the level of nominal GDP growth – we will simply postpone an inevitable crisis. We have $100 trillion of unfunded liabilities that are going to come due in the next few decades. We have to get the entitlement problem figured out. And we have to do it without blowing out the debt. If we don’t, we will have a financial crisis that will rival the Great Depression. Not this year or next year, and probably not in Trump’s first term, but within 10 years? Very possibly, if we stay on our present trajectory.
For investors, navigating the next few years is going to be tricky. We already have multiple markets with valuations at the upper end of their historical trading ranges. Interest rates are likely to rise, although by less than most people now assume.
OK, I’m going to close now, and perhaps in the future letter I can answer questions and criticisms I’ve provoked here. As always, I look forward to your comments.