On March 30, 2017, the Congressional Budget Office (CBO) issued its latest “Long Term Budget Outlook” (LTBO) report. The LTBO forecasted “unsustainable” deficits, which would cause federal debt held by the public to rise from 77 percent of GDP in 2017 to 150 percent of GDP in 2047.
The CBO’s latest debt projections called to mind Naegleria fowleri. Perhaps you are more familiar with its common name, “the brain-eating amoeba.”
Just as exposure to N. fowleri can bring on mental confusion followed by death, exposure to the CBO’s debt forecasts seems to rob conservatives of their analytical abilities, and causes them to call for “austerity.” This will lead to political death for Republicans, if it translates into attempts to cut Social Security and Medicare.
Here is the chart that seems to have infected the minds of otherwise sane conservatives:
A typical conservative response to the CBO projections was Six Sobering Charts about America’s Grim Future from CBO’s New Report on the Long-Run Fiscal Outlook by Daniel J. Mitchell of the CATO Institute. Mitchell declares that, “more than 100 percent of our long-run fiscal mess is due to higher levels of government spending,” and that, “the spending burden is rising because of Social Security and the health entitlements.” These conclusions were echoed in an analysis published by the Committee for a Responsible Federal Budget and in the “Blueprint for Balance” published by the Heritage Foundation.
These analyses and prescriptions are wrong. Not only are they wrong, they also amount to a call for Republicans to commit political suicide.
A cursory look at the CBO numbers shows that the problem isn’t excessive spending but anemic economic growth. The LTBO basically assumes a permanent economic depression.
The CBO forecasts that, over the next 30 years, real GDP (RGDP) growth will average 1.95 percent and that there will not be a single year where RGDP growth exceeds 3 percent. In the 226 years of U.S. economic history, the only 30-year periods where RGDP growth rates averaged less than 2 percent ended in the pit of the Great Depression.
Prior to the Great Recession that began in late 2007, the longest that America had ever gone without a year with 3 percent RGDP growth was four years. The CBO assumes that by 2047, America will have endured 42 such years in a row.
The following chart puts the RGDP growth forecast in the LTBO in perspective:
Here is the strategic “bottom line” for conservatives: the GOP is either the party of economic growth, or it is nothing. For Republicans, growth plans win elections, and austerity programs lose them. Donald Trump seems to understand this, having been the Republican primary candidate that consistently advocated big tax cuts and rebuffed calls for “reform” of Social Security and Medicare.
Voters will not elect Republicans to help them cope with permanent depression. Depressions drive income redistribution, a favorite tactic of the Democrats. So the only logical thing for Republicans to do is to toss the LTBO report in the wastebasket and put forward a program for accelerated economic growth.
Math is on the side of pro-growth conservatives. An RGDP growth rate of 3.5 percent — the U.S. historical norm — would solve all of our deficit and debt problems, even if big tax cuts were required to achieve it. This is shown in the chart below:
The CBO expects the corporate income tax to capture about 1.6 percent of GDP, so there would be room within a tax cut of 2 percent of GDP to eliminate the corporate income tax entirely. The death tax, which brings in an insignificant 0.1 percent of GDP but is extremely economically damaging, could also be eliminated. These two tax cuts, totaling 1.7 percent of GDP, would have an enormous positive impact upon RGDP growth.
Just as infection with N. fowleri destroys a victim’s sense of balance, contemplation of federal debt seems to impair conservatives’ ability to think.
For example, government debt is “bad,” right? So, if the owners of the $12 trillion in federal debt held by entities other than the Federal Reserve were to mail their bonds back to the Treasury marked “Debt Forgiven,” that would be “good,” right?
Wrong. The economy would plunge into a deflationary spiral, and implode. This is because the financial markets cannot do without the dollar liquidity that those $12 trillion in Treasury securities provide.
Government spending, especially on things outside of the powers explicitly granted to Congress by the Constitution, does waste capital and distort the economy. However, as they pursue spending cuts, conservatives need to understand two things.
First, the world economy needs a certain amount of dollar-denominated liquid assets to function, and those assets have to come from somewhere. As of this writing, low general commodity prices and other indicators are saying that the markets need more dollar liquidity, not less. It would be foolhardy to cut the deficit until after Congress (or the president) forces the Federal Reserve to stabilize the real value of the dollar at an appropriate level.
Second, the real issue is not deficits but the level and composition of federal spending. A balanced federal budget is not even desirable. If we had a balanced budget today, the right thing to do would be implement pro-growth tax cuts until the deficit (as a percent of GDP) were equal to the growth rate of nominal GDP (which would move higher, of course).
So conservatives don’t seem to understand the role of Treasury securities in the world monetary system, and they don’t appreciate that deficits can be a good thing. Unfortunately, their conceptual blindness does not stop there.
The same “experts” who are certain that the federal government will go bankrupt by 2047 don’t seem to wonder why the financial markets are clamoring to buy 30-year Treasury bonds at a real interest rate of less than 1 percent.
Prices are information. Low bond yields equate to high bond prices. The markets are trying to communicate through high prices that they want more. Why would investors be screaming to buy more bonds from an entity racing toward financial disaster?
Obviously, the markets don’t believe that the U.S. government is headed for bankruptcy. They also don’t expect that the government will try to inflate its debt away. As of the end of March 2017, the 30-year Breakeven Inflation Rate (which is based upon the spread between 30-year Treasuries and 30-year TIPS) was 2.09 percent. This suggests that the markets expect the Fed to hit its announced 2 percent inflation target indefinitely.
Here is what the conservative analysts are missing. Investors are not concerned with the size of the federal debt relative to GDP; they focus on the ratio of the debt to the present value of future GDP (PVGDP). This is because PVGDP is the true measure of a nation’s ability to meet its obligations.
Lenders always lend against the present value of a borrower’s expected future income, so the markets are not singling the U.S. government out for special treatment. However, the markets assume that United States government is effectively immortal, so they calculate the present value of GDP (and therefore of federal revenue) “to the infinite horizon.” (This also happens to be the methodology that the Social Security Trustees use to assess the ultimate solvency of Social Security and Medicare—see Appendix F in their 2016 report.)
Even under the dismal LTBO assumptions (long-term RGDP growth rate of 1.9 percent and real interest rate of 2 percent), 2017 federal debt of 77 percent of GDP amounts to only 0.12 percent of PVGDP. The CBO’s forecasted 2047 debt of 150 percent of GDP would equate to 0.24 percent of 2047’s PVGDP.
Conservative analysts, fixating on the debt-to-GDP ratio, are ignoring an important fact: PVGDP is exquisitely sensitive to economic growth.
For example, if the markets believed that the U.S. economy was going to be completely stagnant (RGDP growth = 0 percent) the U.S. would instantly become Greece. (This is how Greece became Greece — its economy stopped growing.)
This is because 2017’s debt of 77 percent of 2017 GDP would be 1.54 percent of PVGDP. Servicing this debt would require a “primary surplus” (revenues less non-interest expenditures) of 1.54 percent of GDP, which would be impossible to achieve in a no-growth economy.
Also, with zero economic growth, federal deficits and debt would skyrocket. Assuming that the Treasury could (somehow) finance the resulting deficits for the next 30 years, the 2047 deficit would be almost 42 percent of GDP. Debt held by the public at that point would be 505 percent of GDP (and 10.1 percent of 2047 PVGDP).
The good news is — and this is the most important thing for conservatives to understand — when it comes to the sustainability of federal debt, economic growth cuts both ways.
Increasing expected RGDP growth from 1.9 percent to 3.5 percent would shrink our projected 2017 federal debt from 0.12 percent of PVGDP to 0.0000005 percent of PVGDP. That’s 5 parts per billion. In other words, with 3.5 percent growth, even if debt were cyanide and GDP were water, the mixture would be safe to drink.
The public does not want cuts to our major entitlement programs, and it doesn’t want tax hikes. Many conservatives seem to believe that the voters are being unrealistic. They’re not. It’s the CBO’s 1.9 percent long-term economic growth assumption that is unrealistic.
The electorate knows that, with the right government policies, America is capable of much faster economic growth. By strongly opposing both entitlement “reform” and tax increases, the voters are doing their best to press politicians for an economic growth solution.
But the CBO believes 3.5 percent economic growth is impossible, and many conservative analysts have bought into this notion. Once again, they are wrong.
The CBO based its dismal economic growth assumptions on the following equation:
GDP Growth = Growth in Hours Worked + Productivity Growth
This equation is true. But it is also misleading. The reason is that the government measures GDP and hours worked, and then divides the two quantities to get productivity. In other words, the equation is true by definition.
But the equation is misleading because it doesn’t describe what causes GDP growth, although it pretends to do so. As a matter of fact, it is capital investment that drives all three of the variables in the above equation.
The following “Woodhill Equation” describes how the economy actually works:
GDP = (0.082 x residential assets) + (0.438 x nonresidential assets)
The Woodhill equation suggests that all we would have do to increase RGDP growth by 1.6 percentage points (i.e., from 1.9 percent to 3.5 percent) would be to increase investment in nonresidential assets by 3.65 percent of GDP, which would be equivalent to about $700 billion for 2017.
Such an increase would amount to only about 0.91 percent of world GDP. What is more, the capital is available, especially since nonresidential assets produce a 43.8 percent GDP return on investment, and the U.S. government can borrow at a 2. percent real interest rate to fund pro-growth tax cuts.
For the period from 2003 to 2015 (the last year for which “produced assets” data is available), real GDP growth averaged 1.97 percent and “total gross investment” (TGI) averaged 20.6 percent of GDP.
Increasing average TGI during this period by 3.65 percent of GDP would have brought it up to 24.25 percent of GDP. We know this would have been possible because TGI averaged 24.3 percent of GDP from 1984 to 1986 (and those were good years for the economy).
Would 3.5 percent RGDP growth require rates of productivity growth that have never been seen before? Probably not.
If U.S. RGDP were to grow at 3.5 percent for the next 30 years, measured productivity growth would likely not exceed the 2.4 percent annual rate seen during the 1960s. This is because the surge in capital investment would produce a surge in demand for labor. This would bid up real wages, and higher wages would bring forth increased supply of labor. (Remember, the LTBO assumes a permanent economic depression, and no changes to the social programs that pay people not to work.)
If the brains of conservative analysts had not been infected by the CBO’s dire debt projections, they would be calling for the following policies:
1. Leave Social Security and Medicare alone.
2. Eliminate all taxes on savings and investment (this includes the corporate income tax, personal income taxes on the profits of businesses other than C corporations, the capital gains tax, and the death tax).
3. Rein in the regulatory state.
4. Force the Federal Reserve to fix the real value of the dollar at an appropriate level.
If lawmakers do these four things, the U.S. economy will blast forward at a rate that would make federal deficits and debt melt away, just as they did in the late 1990s. The CBO would be caught by surprise by the speed of the fiscal turnaround (just as they were in the 1990s). But their projections would catch up eventually.
Conservative analysts should ignore CBO graphs projecting skyrocketing federal debt and get to work on developing ideas for faster economic growth.
Louis R. Woodhill is a software venture capitalist. He has had articles on economics published in Forbes magazine and The Wall Street Journal.
