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The Federal Debt Freight Train Is Coming at Mr. Market


Nominal GDP has been growing at only $4 billion per month, while new Federal debt has been accumulating at around $100 billion per month.

The federal deficit is no longer an abstract long-term problem; it's a financially critical freight train coming down the track at alarming speed. Here's a dramatic way to look at it: As of last week's second-quarter report, nominal GDP was only $100 billion higher than it was back in the third quarter of 2008. So the nominal GDP has been growing at only $4 billion per month, while new Federal debt has been accumulating at around $100 billion per month. Yes, this period represents the worst of the so-called Great Recession -- but never in history has the Federal debt grown at a rate of 25x GDP for two years running!

Secondly, this time is very different in terms of the business-cycle impact on the budget. During the past three quarters of "recovery" where we've had real growth of 5.0%, 3.7%, and 2.4% respectively, nominal GDP growth has only averaged about 4%. This is steeply below the figure for past cycles when we had 7-10% nominal GDP growth due to higher real growth and also much higher inflation. Consequently, nominal GDP -- which is the true driver of Federal revenue since they tax our "money" income, not the statistical "real" income confected by the BEA/Commerce Dept -- has only grown at $50 billion per month during the last three quarters. So, the Federal debt has still grown at 2x the rate of GDP during what looks to be the strongest phase of the recovery.

Thirdly, if we're in a sustained debt deflation (below), it's extremely probable that the GDP deflator will shrink toward zero and real growth will struggle to make 2-3%. Hence, nominal GDP growth is almost certain to be even slower in the quarters ahead -- say 3% or $40 billion per month -- than it's been since last summer. This "realistic" outlook compares to the OMB forecast which assumes double this level of nominal GDP growth -- a 6% annualized rate, or about $75 billion per month. At the same time, there's virtually no chance that unemployment will drop much below 10% in the context of a deflationary "recovery" -- meaning that budget costs for unemployment, foods stamps, etc. will remain elevated, not come down by hundreds of billions as currently projected, either. Consequently, under the current policy baseline and including extension of the Bush tax cuts (at a cost of about $300 billion per year), and with even mildly deflationary economic assumptions, it's not possible for the baseline deficit to drop much below $1.5 trillion any time before 2015. So we have baked into the cake a rather frightening scenario: monthly federal debt growth of upwards of $125 billion, or 3x the likely nominal GDP growth of $40 billion -- as far as the eye can see.

Fourth, the publicly held federal debt will be about $9 trillion at the September fiscal year end, and at the built-in 3x GDP growth rate will reach $12 trillion when the next president is sworn in in January 2013. Adding in state and local debt, we'd be at $15 trillion or a Greek-scale 100% of GDP before the next president picks his or her cabinet. Every reason of prudence says not to tempt the financial gods of the global bond and currency markets with this freight-train scenario: Do something big to close the deficit, and do it now.

Fifth, there's no possibility in either this world or the next of obtaining the needed $700-$1,000 billion structural deficit reduction by spending cuts alone. We've had a rolling referendum since the first Reagan budget plan in 1981, and progressively over these three decades the Republican party has exempted every material component of the budget from cuts, including middle-class entitlements, defense, veterans, education, housing, farm subsidies, and even Amtrack! Like Casey, the GOP has been in the anti-spending batter's box for 30 years, and has never stopped whiffing the ball. The final proof is that the one GOP spending cut plan with any integrity -- the "roadmap" of Congressman Paul Ryan -- has the grand sum of 13 co-sponsors, and I dare say half would call in sick if it ever came to a vote. Therefore, tax increases are now needed because it's too late and too urgent for anything else.

Sixth, both the Keynesians and the supply-siders are wrong about the alleged detrimental impact on the business-cycle recovery of a big deficit reduction package -- including major tax increases. The reason is that both focus on GDP flows -- with Keynsians pointing to a subtraction from consumer "spending" and the supply-siders emphasizing a detriment to output and investment. But under present realities, the problem isn't the flows; it's the massive, never-before-seen stock of combined public and private debt that's depressing the economy, and which overwhelms any "flow" effects from fiscal policy. Specifically, at $52 trillion, credit market debt today is 3.6x GDP, compared to 1.6x GDP when the original supply-side versus Keynesian argument opened up back in 1980. Moreover, this 1980 total economy "leverage ratio" hadn't fluctuated appreciably for 110 years going back to 1870. So I call it the "golden constant," and note that had the total economy leverage ratio not gone parabolic after 1980, credit-market debt today would be $22 trillion at the 1.6x ratio. In short, the economy is freighted down with $30 trillion in excess debt; the process of liquidating the household and business portion of this -- about $24 trillion -- will swamp the normal cyclical recovery mechanisms for years to come. And it's insane to keep adding the mushrooming public-sector portion of the debt or order to artificially juice the GDP numbers for a few more quarters.

Finally, in the context of a secular debt deflation, the overwhelming priority is public-sector solvency, not conventional growth. So policy needs to be geared to long-term balance-sheet repair, not short-term flows.In every sector -- household, government, business -- the numbers are awful, and far worse than the bullish mainstream seems to recognize. Let me close with one example: At least once a day someone on CNBC talks about the $1.5 trillion in corporate cash on the sidelines, and how healthy the business-sector balance sheet is. Pure baloney. Consult table B 102 of the flow of funds, and you'll see that corporate-sector cash assets have indeed increased by $279 billion since the December 2007 peak, and now total $1.72 trillion. But non-financial corporate-sector debt according to the same table, has increased by $480 billion and now stands at $7.2 trillion -- so that corporate debt net of cash has actually increased by $200 billion during the Great Recession. Stated differently, corporate debt net of cash was $5.3 trillion or 36.7% of GDP at December 2007 and is now $5.5 trillion or 37.6% of GDP. There's been no deleveraging in the business sector either -- especially when its noted that tangible assets have also declined by 20% on a market basis and are flat on a book basis during the same period.

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