Government Finance 101: Welcome to Alice in Wonderland

 

 

Fiscal Policy

 

Some basic definitions:

 

Deficit.   The difference between the federal government’s spending and its revenue in one fiscal year.   The fiscal year starts on October 1.  So fiscal year 2024 started on October 1, 2023. You know right away this is going to be confusing.

Yearly deficits before the coronavirus were around $1 trillion per year. For fiscal year 2021, the deficit was $2.8 trillion. Total stimulus spending and tax cuts were around $4 trillion. The Congressional Budget Office’s latest projection is an average yearly deficit of $1.5 trillion for the next 10 years. This should be viewed as a minimum.

 

Social Security and Medicare are funded by their own taxes and working down their trust funds (selling government bonds). Subtracting Social Security and Medicare taxes from the Federal budget, other revenue covers about 50-60% of all other government spending; the other 40-50% is the deficit and financed by borrowing.

 

Debt.  Short for national debt.  The sum total of all past yearly deficits minus yearly surpluses.  By the end of fiscal 2020, the national debt would have been over $23 trillion. With virus-related spending, the national debt will be over $30 trillion by the end of 2022.  The national debt is projected to be over $40 trillion by 2030. The national debt is larger than the whole American economy.

The Federal government also has off-balance-sheet liabilities like your student loan and probably your mortgage. Net increases to these obligations are added to the national debt but are not included in the yearly deficit. They average around $250 billion a year. The increases in off-balance-sheet liabilities are added to the national debt; that is why it goes up more than the yearly deficit.  

There is also something called "unfunded liabilities."  This is mostly future government obligations like Social Security, Medicare, and federal employee retirement benefits that are not covered by projections of future payroll tax and trust fund revenue. Even the most conservative projections are scary as Americans get older and the health care industry is doing a really good job of keeping us baby boomers alive longer (mostly paid for with government funds).

But wait, there's more! State and local governments had a total debt of over $3 trillion before the virus. Their unfunded pension liabilities are even larger and scarier than those of the Federal government. And, if that weren't enough, the Federal government has guaranteed about $400 billion in private pension plans. 

State and local governments were running large deficits. But they received so much stimulus money from the federal government that they were running large surpluses. Most states are again running deficits

 

Commentators often say we shouldn't worry about the national debt because we owe it to ourselves. Well, sort of. About 30% (pre-virus) of the national debt is owned by…the U.S. government!  Mostly Social Security and other trust funds and federal employees' retirement funds. Of the other 70%, about half is owed to foreigners, the largest being the Chinese government. About a quarter is this is owed to...other American government agencies such as the Fed (Federal Reserve System, (America's central bank), state, and local governments. Americans households own about 10% of the total. But with the Social Security and Medicare Trust Funds selling government bonds and China not buying, more will have to be sold to the Fed (indirectly) and "private" buyers. But while there are high inflation rates, the Fed intends to continue selling off the government debt it accumulated to finance the stimulus programs.

A little history. If you don’t care how we got so deeply in debt, even before Covid, skip the next three paragraphs. Just blame whoever is currently in office and forget about who you voted for in the past.

American politicians reacted to the end of the Cold War with the Soviet Union not with a “peace dividend” but with profligate spending and yearly deficits. In 1990, just before the Cold War ended, the U.S. national debt was $3.2 trillion. On the eve of the 2008 financial crisis, it had risen to $9 trillion. By the end of 2019, it was approximately $22.5 trillion, seven times what it was just 30 years earlier. This large increase in debt was created by both Republican and Democratic administrations during a period of economic growth.  

Why is the national debt so large?   When Ronald Reagan became president in 1981, the national debt was about $1 trillion.  Most of the increase occurred when conservative Republicans were president!  Massive tax cuts by Presidents Ronald Reagan ("Deficits don't matter."), George W. Bush (reversing the tax increases on the rich by his father and Bill Clinton) and Donald Trump, combined with big increases in defense spending and national security, are two of the major reasons. In the last two years of Clinton's administration, the government actually ran a small surplus and the national debt went down. 

The Bush tax cuts have added about $4 trillion to the national debt. The wars in Iraq and Afghanistan have added at least $1 trillion ($4 trillion in the long run). The housing bubble recession of 2007-2009 added another $3 trillion through reduced tax revenues and increased safety net expenditures such as unemployment benefits (not including the $700 billion stimulus program).  These large deficits run under Obama were caused by the financial consequences of the disastrous deregulation and absence of oversight of the financial and housing markets advocated by Ronald Reagan, George W. Bush and Alan Greenspan. The recent tax cuts and increased defense spending of President Trump will add an additional $1.5-$2.0 trillion to the national debt over the next ten years, over and above the projected $5 trillion in deficits before the tax cuts. More if a recession or two occurs in addition to the costs of the virus pandemic.

To make you feel better, you should know that the national debt to nominal GDP ratio has been rising in almost all industrialized and modernizing economies. The champion here is Japan; their national debt is more than twice the size of their national economy. They can do this because they pay virtually zero interest on the debt - so the total doesn't matter - and almost all of it is owed to Japanese. Over half of the national debt is owned by the Japanese central bank. No worry about attracting pesky foreign investors. 

The debt/GDP ratio is now rising rapidly in Japan and most other countries. Interest on national debts is rising rapidly because of the current global inflation. For the U.S., even at relatively low interest rates on the national debt, the increase in total interest payments will eat up most of the projected increase in tax revenue over the next 10 years.

 
Total interest on our national debt is low, only about $450 billion in 2022. The government has benefitted from the very low interest rates engineered by the Fed over the last twenty years. But interest rates beg to rise as the Fed quickly raised the Fed funds rate to bring down aggregate demand and the inflation rate. Of course this had no effect on government spending. Every one percent increase in the interest rate on the national debt will add at least $180 billion a year to expenditures and the deficit. Another way to look at it is that the interest expense in this fiscal year (2024) was more than half of the deficit. Interest expense is about equal to the cost of national defense At current interest rates, total interest expense will be about equal to the current deficit in about two years (as the debt is rolled over). The government is borrowing more money each year to pay interest on past borrowing.

A combination of rising national debt of over $1 trillion a year (if economic growth) to as much as $2 trillion a year (if a recession) combined with rising interest rates would push politicians and us voters even further into denial. So far, everyone wins. We get corporate and household tax cuts, we spend more money on defense and national security than the next nine countries combined, and we have generous social welfare, health and retirement benefits. After paying for Social Security and Medicare with dedicated taxes, we borrow about one-fourth of the total cost of the rest of the budget every year. Even the most optimistic projection indicates that by 2030 all of the income the Federal government takes in will only cover “mandatory” programs (mostly Social Security, Medicare, and Medicaid) and defense. Maybe a part of national debt interest, depending on future interest rates. All of the rest of the budget, all the subsidies and tax loopholes, are funded through borrowing. Who says there's no such thing as a free lunch program? Party on!

What is the point of this discussion? Fiscal policy - the size and changes in the size of yearly deficits and government debt - has nothing to do with political philosophy or promoting economic growth and stability. It has to do with lowering tax rates and no one paying the full cost of received benefits and services.

 

Tax Rates

 

The size of the deficit can also be affected by changes in the income tax rates but only to a limited extent. About 45% of all households pay no federal income tax. Of all the households that file an income tax, about 80% pay more in “payroll taxes” (Social Security and Medicare taxes) than income taxes. The Federal government collects more revenue from payroll taxes (Social Security and Medicare) than from personal income taxes.

 

A high percent of personal income taxes is paid by high income households; they receive most of any personal income tax cut.

 

Studies by the IRS show that small businesses and high-income households substantially underreport their income. Large corporations pay substantially less than the statutory rates; some large companies including GE pay none at all. Many industries have special tax reduction rules. Property developers and commercial property owners are notorious for not paying income taxes. 

 

Comments on Fiscal Policy

 

The federal budget and its deficits do not exist in a vacuum.  They are part of the overall economy. Budget deficits are not inherently good or bad. When they occur and the trend over the growth cycle are important. So is what they buy or finance. 

Government spending is all lumped together in macroeconomics. Yet what governments spend their money on is important. A lot of it is "income transfers," taking tax money from one group and distributing it to others. Much of it goes to people who are old or sick or poor but also some goes to less deserving folks. Some of the spending should be considered consumption. Another part is public investment. This part is vital to economic growth and the development of new technology. Government pays for basic research, public health, infrastructure, education and training, financing and subsidizing private investment, and paying for some of the social costs (such as cleaning up toxic waste dumps) of past private investment and production. This does not include the future costs of fighting the effects of global warming; preliminary estimates are very scary.

There is nothing inherently bad or immoral about government debt. But some consideration should be made about the future size relative to GDP and future cost. There is a danger that the increase in the future cost of the national debt will be about equal to the increase in tax revenue. All new or expanded programs – national defense, fighting emissions and the past costs of pollution, infrastructure, and others - will all be paid for by more borrowing and increasing debt.

 

A second consideration is what the spending financed by debt is used for. A major use in the past has been to finance tax cuts. Almost all of the stimulus money went to all American families in the form of higher income. The idea was that a big rise in total income would lead to a big increase in total spending. Not as much as expected. There was a big increase in total saving; many American families didn’t need the extra income. This is one reason the prices of stocks and houses went up.

 

What the stimulus money was not used for was investment to increase future economic growth. Some of the money in the bills passed by the Biden administration starts to address increased infrastructure needs and the cost of combating the effects of global warming. President Trump, like earlier presidents, wanted Congress to cut back on some of the government's basic research. It is almost impossible to think of any new technology developed after WWII that the federal government did not help finance and develop, including computers, microchips, jet aircraft, the Internet, GPS, digital photography, biotechnology, and autonomous driving. Especially in the early stages of basic research and applied research and development. Developing new technology is the main source of economic growth and thus increases in tax revenue. 

 

Some commentators believe the "debt overhang" (higher debt partly from stimulus and other programs) plus higher interest rates caused by inflation, will be the cause of our next economic crisis.

 Monetary Policy

 

Two Definitions:

 

Fed funds rate. The most watched interest rate in the United States and probably the world. Not set by supply and demand in financial markets. Set (fixed) by the Federal Reserve Bank (the Fed), America’s central bank. Determines or heavily influences almost all other short-term interest rates in financial markets. Also indirectly influences many other longer term interest rates. For details, see the Investopedia website.

 

The fed funds rate is the interest rate banks charge other banks that borrow their excess reserves. It is a very short-term (overnight) rate. An increase in the fed funds rate increases the cost of capital of large banks (net borrowers) and puts pressure on these banks to raise their lending rates. A change in the rate also changes the rate charged by other sources of short-term funds.

 

Nominal vs. real interest rates. Nominal rates are the reported interest rates, also called current interest rates. Real interest rates are nominal rates minus some measure of inflation. Both nominal and real rates can be negative. For many years recently, nominal interest rates on many countries’ national debt have been negative. No longer; only Japan has negative rates on its national debt. Although almost all countries are currently raising central bank rates, the inflation rate in the United States and many other countries is above almost all nominal interest rates, making real rates negative.

 

The Fed’s mandate is to make monetary policy. The objectives of monetary policy and the tools the Fed uses to implement policy have changed in the past.  

 

In the past, the Fed’s main functions were to fight inflation (raise interest rates and slow down the growth rate of the money supply) and fight recessions (lower interest rates). The Fed could also be the “lender of last resort” if the banking system got into serious trouble. Most of the time, however, the economy grew and the Fed had little to do.

 

With the deregulation and globalization of the banking system and the explosion of nonbank financing, the Fed has less control of the finance sector than in the past. 

 

The recent history of Fed policy has been unusual. The Fed under Ben Bernanke and Tim Geithner and the Treasury under Henry Paulson were extremely aggressive during the 2008-2009 financial crisis in containing the real threat of a total meltdown of the national and global financial system. They extended loans to and guaranteed debt of non-bank corporations.  But their policies of historically low interest rates and purchasing of public debt continued long after the economy resumed growing. From 2008 to early 2022, the fed funds rate has been below 1% in 12 out of the 14 years. This is extraordinary; the last time the fed funds rate was below 1% was for a short time in 1958. And, during this recent past period, real interest rates were negative.

  

Again, a major beneficiary of low interest rates has been the federal government. The government has been able to greatly increase the national debt with little increase in interest expense. Interest rates on government debt before the 2022 inflation, less than 1% on ten-year government bonds, were the lowest they've been since the end of World War II.

Extremely low interest rates do not seem to have much of an impact on economic growth rates. But a combination of low interest rates and corporate tax cuts have helped to increase after-tax corporate profits. They have grown much faster than the economy and total income, reaching a record high as a percent of GDP. Over the last 40 years, stock prices have increased at a higher rate than wage income. No wonder families with financial assets have seen their incomes grow faster than families without financial assets.

 

While the Fed has greatly increased the number of tools it is willing to use, it usually cannot prevent accelerating inflation or a recession. These are often caused by exogenous (outside) events the Fed has no control of. OPEC raising oil prices, Asian and Russian debt crises, Covid, Chinese lockdown policies and supply-chain problems, war in Ukraine and Russia shutting off oil and gas supply to Europe, disruptions caused by climate change. The Fed is judged on how quickly and effectively it reacts.  

The Coronavirus and Government Finance

The Federal government has spent trillions of dollars to maintain total income, keep companies and state and local governments from going bankrupt, and paying for emergency services.

The government's financial response to the coronavirus is unprecedented. Starting with the 2008-2010 playbook, the Fed and the Treasury, working together, came up with massive new programs to keep the economy from falling into a prolonged depression, buy time until the virus abated, and guaranteed virtually all debt in the country. In the first round, over $3 trillion will be spent on income maintenance. Congress added another $1.9 trillion in the first months of President Biden’s administration.

All of the government income maintenance programs cost at least $300 billion a month, about equal to the fall in total income. This was extraordinary – a deep recession (fall in total output) without a decrease in total income. The economy recovered quickly. There were falling levels of unemployment in 2021 and near record lows in the first half of 2022. 

 

The lagged effect of earlier income maintenance programs plus the 2021 “stimulus” expenditures pushed total income above the long-term trend line, resulting in increases in total spending and falling unemployment rates. The inflation rate rose through 2021, reaching levels far above 2% before the Russian invasion of Ukraine and the resulting huge increase in energy prices.

The national debt in April 2020, when Covid became an epidemic, was around $24 trillion. By the end of 2022, the national debt will be over $30 trillion. By the end of the decade, the national debt will climb to about $40 trillion, according to the latest projections by the Congressional Budget Office. Assuming a 4% interest rate on the national debt, which is below the post-war average, all of the increase in tax revenue will go towards paying increased interest expense. For the details behind this projection, see The Congressional Budget Office Projects the Future. 

 

This projection is very likely to be too optimistic. Among other questionable assumptions, the CBO assumes there will be no recessions or virus outbreaks in the next 10 years. More realistically, the national debt could be as high as $50 trillion by 2030, about 150% of nominal GDP.

 

How is the government paying for all this? Borrowing. Selling new debt. Much of the new debt has been bought directly or indirectly by the Fed. The Fed is also underwrote the risks of virtually the entire debt market, even announcing it is willing to buy junk bonds. Much of the junk bond market consists of bonds issued by frackers who were in danger of going bankrupt because of low oil prices. The government would loan money and provide assistance (guarantee corporate debt) to companies in danger of going bankrupt.

2022 and 2023:  FIGHTING INFLATION

All U.S. government fiscal and monetary programs in 2020 and 2021 were aimed at countering the sudden recession and economic dislocations caused by the Covid epidemic. But throughout 2021, the Fed was ignoring the financial effects of the stimulus programs financed by Fed’s buying of the rising national debt and massive expansion of the money supply.

The Fed has stated for a long time that it will tolerate an inflation rate of 2% but will be concerned if the inflation rate goes above 2%. The inflation rate started to go above 2% in March, 2021. It rose steadily to 7% by the end of 2021. The unemployment rate fell rapidly, reaching 4% by the end of the year. The unemployment rate has been below 4% in 2022. This is close to what economists consider full employment. Until March, 2022, the Fed continued to purchase large amounts of U.S. government debt.

The $1.9 trillion stimulus program of March, 2021 was “a bridge too far.” A smaller program was probably needed to continue the recovery. The problem was the size. If you (or Fed economists) added the creation of new income to the trend in total income, the total was greater than the amount of total income leading to full employment. That suggested that sometime in the foreseeable future (the Fed’s planning horizon), the inflation rate would go up, well past 2%.

Even with the inflation rate around 7% at the end of 2021, the Fed didn’t react. The fed funds rate was still around zero.  The inflation situation was made marginally worse by Russia’s invasion of Ukraine in March and the rise in energy prices (since reversed, at least the U.S. price of crude oil). Not until May, 2022, did the Fed start getting serious about raising the fed funds rate and stop increasing its holdings of government debt.

The current fed funds rate after Thursday’s 75 basis points (3/4 of one percent) is the range 3.0-3.25%, well below the current inflation rate of 6.5-8.3%, depending on which measurement of inflation you use. The Fed made it clear they would continue to raise the fed funds rate until the inflation rate would show a substantial downward trend. They are hoping that sometime in 2023 the inflation rate and the fed funds rate will meet at somewhere around 4.5%. They would keep the rate at this level as long as the inflation rate was above 2%. Back to the old-time religion – fight inflation come hell or high water! Don’t support any aggressive fiscal policy to fight a possible recession that might result from rising interest rates. In fact, the Fed, to support higher fed funds rates, must reduce its holdings of government securities to reduce the money supply.

The U.S. economy stopped growing in the first half of 2022. Partly because of its delay in raising rates, it now finds itself quickly raising rates while, at the same time, the U.S. economy (and the global economy) may be entering a recession.

The Fed could get lucky. Many commodity prices are falling, which might counter some of the increased wage and salary costs. Almost all large corporations are saying they are “increasing free cash flow,” a nice way of saying they are slashing costs. A recession might lead to a moderate increase in measured unemployment because the labor force is growing at a much slower rate than in the past. Fewer than expected new entrants. So an increase to 4 1/2 to 5% brings the rate up to near the long-term average, far below the 10% unemployment rates of the last serious recessions of 2007-2009 and the Covid recession of 2020. A recession or no growth, reducing supply chain disruptions, no new Covid outbreak, and European adjustment to higher energy prices would bring down the inflation rate. 

If the price index as measured by some version of the CPI stops going up but stabilizes at the current high levels, the year over year inflation rate will go down. Why? Because the price level – the inflation rate – rose rapidly in the second half of 2021. The same current price level will be divided by increasingly higher past price levels, resulting in a lower yearly inflation rate.

Leads and lags again. Don’t “follow the data,” which is past news. Anticipate the future and build in lags in the impact of policy changes. Like everyone else making financial decisions, the Fed should forecast the future and place its bets. As my old econ prof used to say – you puts down your money and you takes your chances. 

The Fed should have anticipated that an aggressive monetary policy supporting massive fiscal stimulus to fight the disruptive recession caused by Covid could led to higher inflation rates if taken too far. As it did, the Fed should have started fighting the resulting inflation earlier, before it accelerated and raised inflation expectations. Large, delayed increases in the fed funds rate chasing higher inflation rates now runs the risk of impacting the future economy as it enters a recession. To continue with cliches – the Fed gets the devil and the deep blue sea at the same time. 

Concluding Remarks

 

There are indirect effects of the Fed’s monetary policies. Very low interest rates, money creation, bailouts to avoid company bankruptcies, and massive bond buying to avoid debt defaults all directly or indirectly helped stock prices. This continued asset price rises while the real economy has little or no inflation. But the 2022 inflation and rise in interest rates is reversing asset price increases, especially stock prices.

In short, the Fed bought massive amounts of private and public debt and paid for it by creating money.

This is short-run Keynesian economic policy on meth. Massive income maintenance through deficit spending. This is unlike government spending in the Great Depression, when some of the government spending led to public investment and new jobs - WPA, PWA, CCC, TVA, dams, rural electrification. The recent infrastructure bill provides potential tax subsidies to private investment in designated industries, particularly computer. Even before passage of the bill, large, global chip designers and manufacturers announced investment in new plants in the United States.

This is also Modern Monetary Theory - run large fiscal deficits and have the central bank (the Fed) create electronic money to buy the new government debt - on steroids. Keep interest rates low, preferably near zero, so the federal government can continue to run larger and larger deficits with small increases in the total interest expense on the national debt. The government has been doing this for years; only the very high inflation rates is forcing the Fed (and financial markets) to increase interest rates.

There is research done by Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff that when government debt rises above 90% of GDP, economic growth slows down. We are already above this ratio. What if the causality is the other way? What if slowing economic growth means a slowing growth rate in taxable income? In the "everybody wins" reality of democratic politics, it is difficult to control total spending or to refuse tax cuts or tax breaks. Rapidly rises expenditures for Social Security and Medicare because of an aging society is increasingly paid for out of general tax revenue. Payroll tax rates for Social Security and Medicare will rise but when the Social Security Trust Fund goes to zero in the mid-2030s about 30% of Social Security expenditures will come out of the general budget. 

Total tax revenue for the rest of the decade will only cover Social Security, Medicare, government pensions and social welfare programs like Medicaid and food stamps. The rest of the budget - defense, interest on the national debt, discretionary spending - will be paid for out of borrowing. Borrowing more money at low interest rates is politically easier than "fiscal discipline."

All of these fiscal and monetary trends can go on for a long time but not forever. Japan has been doing this since the early 1990s, soaking up most of the country's savings to fight off a stagnant economy, deflationary pressures, an aging population, and lack of any structural reform. But Japan has had very low rates of economic growth over the last 30 years; I doubt if the U.S. economy and society could tolerate very low growth rates over a long period of time.

The U.S. can continue running large budget deficits as long as the dollar is the international reserve currency, interest rates remain low, and U.S. government debt is considered risk-free. It is likely, however, that future interest rates on the national debt will be higher to roll over the existing debt and attract buyers of the large amounts of new debt. 

 

Updated April 5,2024