An Endless Fiscal Crisis Looms

Back then, there was really no choice.

You couldn’t have found a single dyed-in-the wool Keynesian or even Marxist economist who would have embraced the path of massive, permanent government borrowing and debt monetization by the central bank which actually ensued over the next three decades.

So Washington stumbled forward at the $1 trillion mark. By October 1981, with the U.S. economy sliding back into a double-dip recession, the fiscal math of Reaganomics was already beginning to burst at all the budgetary seams. The “Reagan tax cut” had triggered a monumental bidding war on Capitol Hill among special interest lobbies, and had ended up reducing the permanent out-year revenue base by about 6.2% of GDP — compared to the original pure supply side rate cut of less than 3% of GDP.

“You couldn’t have found a single dyed-in-the wool Keynesian or even Marxist economist who would have embraced the path…”

Likewise, the defense budget was supposed to have grown at about 5% in real terms for a few years, but the Pentagon had spooked the new President into authorizing a decade long spending spree that would have tripled defense outlays by the mid-1980s (the neocons told him the Evil Empire was flexing for military victory when it was actually tumbling into economic collapse). Needless to say, the modest domestic cuts enacted during the Reagan Administration’s initial honeymoon did not even make a dent in these monumental excesses on the tax and defense fronts.

So in the fall of 1981 it was not merely the symbolic ignominy of crossing the trillion-dollar national debt threshold for the first time that weighed on the White House. It was actually driven by fear that acquiescence in giant, permanent deficits would lead to a fiscal crisis and economic ruin.

And by the standards of the past, where even Johnson’s infamous “guns and butter” deficit of 1968 had only amounted to 2.5% of GDP, the outlook was dire. As I put it at the time, the nation faced 6% of GDP deficits “as far as the eye can see.”

And there’s one more salient point. The nation’s central bank was then being run by the great Paul Volcker who was determined to break the back of the double digit inflation that his predecessors, William Miller and Arthur Burns, had foisted on the nation during the 1970s. It goes without saying, therefore, that no one thought Volcker was about to monetize the Federal debt in order to let spendthrift politicians at either end of Pennsylvania Avenue off-the-hook.

So for nearly the last time in history, Washington reluctantly repaired to the “takeaway” mode.

During the next three years, by hook and crook, about 40% of the giant Reagan tax cut was recouped. Likewise, the bountiful flow of the defense pork barrel was stretched out and tamped down. And, crucially for all that was to follow, they payroll tax was jacked up by about 20% in the guise of rescuing the Social Security trust fund from insolvency in 1983.

Taken together, these measure of fiscal restraint did no inconsiderable amount of good. They put a cap on the runaway deficits that would have otherwise occurred owing to the frenzy of tax-cutting and defense spending in 1981 and the drastic recessionary shock to the economy that had resulted from Volcker’s unavoidable monetary medicine. Still, for the period 1982-86, the Federal deficit averaged 5% of GDP.

Nothing like that had ever been imagined before outside of world war — not even by professors Samuelson, Heller, Tobin and the other leading Keynesian lights of the day. During the peacetime period from 1954-64, for example, the Federal deficit had averaged less than 1% of GDP and Eisenhower had actually achieved several modest surpluses during the period.

Indeed, the deficit breakout that ensued notwithstanding the take-back efforts of 1982-84 was not even embraced by assistant professor Paul Krugman. Back then he was on economics staff of the Reagan White House. Never once did he aver that the national debt at only 33% of GDP was way too small, and that open-ended “stimulus” was in order.

But then came Volcker’s victory over inflation, a strong economic rebound and the “morning in America” campaign of 1984. For all practical purposes, the job of fully restoring fiscal rectitude was left unfinished; and permanently so, as it turned out.

What happened was that the structural deficit begin to shrink modestly. This was in part owing to the strong economic recovery of 1983-85 when GDP growth averaged 5% per year, and also due to the delayed revenues gains from three tax increase bills signed by Reagan during 1982-84 and the massive payroll tax increase that was buried In the so-called bipartisan social security rescue (1983).

And that was the historical inflection point. Thereafter, Social security and Medicare entitlement reform was off the table due to the trick of the front-loaded payroll tax increase. This caused cash surpluses in the trust funds and the accumulation of intra-governmental accounting IOUs for the next two decades. At the same time, these front-end surpluses functioned to bury the long range fiscal disaster these intergenerational “social insurance” entitlements embody in 75-year projections that are always way too optimistic.

Likewise, the White House took any further tax increases or defense cuts off the table in January 1985. The spending cut weary politicians of both party, in turn, were more than happy to oblige by shelving any further meaningful domestic spending reductions, as well.

In 1985, fiscal policy went on automatic pilot

So in 1985, fiscal policy went on automatic pilot — where it has more or less languished ever since. Even before the fiscal madness of George W. Bush broke out in 2001, the handwriting was on the wall. By the time the 12 years of the Reagan-Bush administrations has elapsed, the national debt had reached $4.3 trillion, and was now 4 times the size of national debt that Jimmy Carter had left behind.

Ironically, the scourge of deficit spending and his 1980 primary opponent, who had noisily campaigned against “voodoo economics,” had teamed up to generate deficits that averaged 4.1% of GDP. That initial 12-year plunge into permanent deficit finance was not owing to a weak economy or insufficiently robust read GDP growth, as Reagan revisionists have argued ever since. In fact, between 1982-93, GDP growth averaged 3.6% annually and was at the top of the historic range.

No, it was a political choice that changed the policy landscape forever. The Reagan-Bush deficits amounted to 3 times the average deficit that had been accrued during peacetime by FDR, Truman, Kennedy-Johnson and Jimmy Carter, combined. Accordingly, the Democrats would never again face Tip O’Neill’s great fear — that they would be someday flushed out of their congressional majority owing to a 1946 style GOP attack on their proclivity for deficit spending.

But there was something more. The economic ruin that was supposed to flow from large chronic fiscal deficits did not happen — at least in the time frame that had been traditionally imagined. Accordingly, the GOP gradually embraced a militant anti-tax doctrine which simply ignored the ballooning levels of national debt.

Meanwhile, bourbon democrats and the fading ranks of orthodox Republicans made one last run at restoring fiscal rectitude during the early Clinton days. And on paper they made considerable progress. Indeed, the Federal budget registered surpluses during the last three years of the 1990s, albeit unsustainable ones owing to the massive one-time tax windfalls from Greenspan’s dotcom bubble.

But the structural fiscal problem was not solved; it was merely temporarily buried beneath three illusions.

The first was that the giant Reagan defense buildup — which was actually a vast armada of conventional land, sea and air forces ideally suited to wars of invasion and occupation — would go quietly in the night when the cold war ended and the Evil Empire was no more. It didn’t.

Instead, the military-industrial complex and its neocon propagandists panicked the nation into a pointless “war on terrorism” after the fluke tragedy of Sept. 11. Soon the defense budget had doubled, rising from under 3.0% of GDP during the early post-cold war to nearly 6.0% of GDP after Bush’s war campaigns reached full intensity by 2007.

Likewise, the front-loaded payroll tax hike eventually exhausted its capacity to deceive. Accordingly, by fiscal 2013 the OASI fund (retirement) ran a $95 billion cash deficit and the DI fund (disability) generated an additional $45 billion cash deficit. This means that on a combined basis, the cash deficit was nearly $140 billion annually and growing rapidly into the future.

In effect, the so-called social security surplus, which had financed the general fund deficit for more than two decades, had not only disappeared, but had now entered the liquidation phase of Washington’s phony trust fund accounting scheme. Stated differently, the $3 trillion of paper IOUs which had been issued to the trust funds over the prior decades were no longer building up due to the receipt of real cash income from employers and employees.

Instead, the trust funds were booking just enough phony intra-governmental “interest” income on the prior balances to give the appearance of solvency. But even by the lights of OMB’s rosy scenario economic projections, in which full employment is attained in 2017 and remains there for time immemorial, the trust fund cash deficit is projected to reach $190 billion annually by 2019.

By then, however, the trust fund accounting game will have been long exposed. In fact, the OMB projections show only $95 billion of phony intergovernmental “interest receipts” by 2019, meaning that trust fund “assets” will be liquidated by $100 billion that year alone, and then disappear entirely over the following decade.

What this means is that the $18 trillion of public debt outstanding today is the real debt — not the convenient illusion peddled by Washington and Keynesian economists that the “publicly held” debt is only $13 trillion and therefore a “manageable” 75% of GDP.

Nope, the nation’s true leverage ratio today is 106% of GDP. Thirty-three years on from the first trillion dollar crossing, the public debt burden on national income has tripled. And when you add the $3 trillion of state and local debt, the total public sector debt ratio is nearly 120% of GDP.

Debt to GDP: 106%

And that gets to the final question. How did we get away with this vast fiscal debauch? The short answer is that we didn’t.

Crowding out and high consumer price inflation never occurred because the Greenspan Fed launched the entire world economy down a path of massive credit expansion and financialization — an insidious process engineered by the concerted action of all the major central banks. That convoy of money printers generated large but dangerous central bank “vaults” where Uncle Sam’s debt has been temporarily sequestered.

It was the equivalent of a monetary roach motel: The bonds went in, but they never came out. What happened in practical economic terms is that central bank fiat credit was substituted for real savings from privately earned incomes in the financing of public debt.

Indeed, owing to currency pegging by the mercantilist export economies of Asia and the oil exporters nearly $5 trillion of the U.S. public debt has been absorbed by foreign central banks and sovereign wealth funds. Another $3 trillion is owned by the Fed. And still another $5 trillion, as indicated above, had been temporarily funded by intergovernmental trust funds that are now about to plunge into an irreversible liquidation mode.

Two things are therefore evident. The first is that massive monetization of the public debt cannot go on much longer or the monetary system will be destroyed. That’s what being stuck on the so-called zero-bound really means. And that’s why the lunatic money printing in Japan is a sign that the end of the monetization era is at hand.

In the case of Japan, the largest debtor government in the world has already destroyed its own bond market — the BOJ is the only bid left at 0.4% on the 10-year JGB. And the BOJ is now fast deep-sixing the yen, as well.

Secondly, the U.S. nominal GDP has been growing at less than 4% annually for the last decade, and, in a deflationary world, it has no chance of breaking away from that constraint. Accordingly, the ridiculously optimistic rosy scenario currently projected by CBO does not have a snowball’s chance of materializing over the next decade. Rather than $8 trillion of cumulative baseline deficits of the next 10 years as projected by CBO, the current policy stalemate in Washington — that has been running for 30 years now — will generate at least $15 trillion of new public debt in the decade ahead.

Yes, add that to the nation’s current mountain of public debt and you get to $33 trillion by 2024 or so. And then also recognize that the giant financial bubble and vast malinvestments generated by the world’s central banks over the last two decades now guarantee a long spell of global deflation.

Accordingly, U.S. nominal GDP will be lucky to reach $24 trillion by that same year. The math computes out to a public debt equal to 140% of GDP. For all practical purposes, it means an endless fiscal crisis lurks in the nation’s future.

That’s the real end game of a lamentable path of unprecedented fiscal profligacy embarked upon 33 years ago today.


David Stockman

for The Daily Reckoning

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