Why Federal Deficits, Debts and Unfunded Liabilities are a Major Problem

by Chuck Donovan

My friend and supporter Allen Buckley wrote the excellent article below.

Many think they are wasting their vote if they give it to me.  They also say they just cannot support the Libertarians on some issues other than the economic ones.  Read the below article and consider the quality of the supporters I have on my team.  Notice the level of thought that has been put into the Libertarian positions.  Then think about what America would look like with a collapsed economic system and a Bill of Rights that has been completely subverted.  Tell me, would you rather try to deal with the issues we disagree upon in an America that is properly and effectively dealing with the bills the Democratic and Republican “leadership” have handed to us, or in a society and economy that have collapsed? – CHUCK

By Allen Buckley
September 20, 2010

Intuitively, most people suspect the federal government incurring substantial amounts of debt is not a good thing. This article will try to explain why they are correct. Unfortunately, financial and economic matters cannot be explained in sound bites or a few simple sentences.

Many people, including many economists, believe (or will at least state) the tremendous amount of debt incurred in recent years is not a problem. Sometimes, people state the debt will simply be “rolled over,” making it a continuing controllable fact of life. Some economists take the position that maintaining an annual deficit of three percent (3%) of Gross Domestic Product (GDP) works on a long-term basis.

If the existing debt was frozen (and the total is now approximately $13.5 trillion, with approximately $9 trillion of this figure owed to the general public, including foreigners and foreign countries), assuming the economy retains its current size or grows (likely), these debts would not present a problem. Furthermore, making relatively small additions to the debt would not create problems. For example, if the economy will average growth of 3 percent per year, adding $100 billion of additional debt each year would not create a problem in terms of sustainability of the federal government. However, running deficits of 3 percent of GDP per year is not sustainable on a long-term basis, when any reasonable interest rate is applied. Analyzing U.S. GDP figures since 1929, I reached this conclusion. The 3 percent of GDP rule works on a short-term basis.

The annual deficit for the fiscal year ended September 30, 2009 was approximately $1.4 trillion, which amounted to approximately 10 percent of GDP, and equaled approximately 67 percent of total federal revenue (of approximately $2.1 trillion). For the fiscal year that will end on September 30, 2010, the figures will be in the same ballpark.

Several years before the “TARP” and “ARRA,” and the tremendous increase in cash outlays and spending incident thereto, the U.S. Government Accountability Office (GAO) made the following statement: “GAO’s long-term simulations continue to show ever-larger deficits resulting in a federal debt burden that ultimately spirals out of control.” Two questions are: (1) How could the nation’s auditing arm reach such a conclusion; and (2) what would our world be like if our nation’s debts spiral out of control?

First, with respect to the federal government, it is important to understand the difference between a deficit, the debt and an unfunded liability. A deficit is the excess of cash outlays over cash income for a year. A surplus is an excess of annual cash income over cash outlays. The federal debt is the sum of all annual deficits plus accrued interest due on outstanding debt. Ordinarily, interest is paid currently, meaning the sum of annual deficits generally equals the outstanding debt. An unfunded liability is a future liability for which there is no dedicated future funding source.

Ordinarily, unfunded liabilities are discussed in terms of their present value. The present value of an unfunded liability is the amount that would need to be set aside now to pay the future liability. For example, using a 5 percent interest rate compounded annually, the present value of a $105 liability due one year from today is $100. The higher the interest rate that can be earned, the lower is the amount necessary to fund the future liability. In the preceding example, if the interest rate was 8 percent, then the present value would be $97.22 (i.e. $105/1.08).

The major unfunded liabilities of the U.S. government are Medicare, Medicaid and Social Security. Because medical costs regularly increase at a greater rate than the ordinary inflation rate, Medicare and Medicaid are the greatest concerns.

In 2009, Social Security and Medicare Trustees calculated the present value of the unfunded liabilities of Medicare and Social Security (i.e. excluding Medicaid) at $106.8 trillion. As of December 31, 2009, the net worth of all Americans combined was $54.2 trillion.

The $106.8 trillion liability figure takes all sorts of reasonable actuarial and demographic figures into account, including immigration and anticipated growth of the economy.

It is very important to note that these two categories of entitlements are not part of what most people consider to be “government” functions. Traditional federal government functions, including the military and the interstate highway system, are not included. Excluded are Medicaid, all of the costs of every agency and the federal courts system.

How is the average citizen impacted? Comparing the net worth of all Americans combined to the present value of the unfunded liabilities of Medicare and Social Security leads to the conclusion that the people of the U.S. are insolvent on a group basis because of these future promised obligations. Assuming any reasonable rate of return, over time, the existing wealth of U.S. citizens and a substantial portion or all of future wealth would need to be consumed to pay these obligations and the other costs of the federal government. It should be apparent what type system exists when there is no or very little private wealth. Which citizens would be required to pay these amounts? Persons with assets beyond necessities would pay.

Examination of the history of the U.S. since World War II (65 years) shows the size of the federal government has only grown. With minor exceptions, entitlements have only expanded. Recently, the Democrats expanded Medicaid. In 2003, the Republicans expanded Medicare by adding Part D, covering prescription drugs.

Given the power of special interest groups to prevent spending cuts that negatively impact them (consider, for example, the medical profession’s ability to regularly force Congress to retract on statutorily-scheduled cuts to Medicare reimbursement rates) and the unwillingness of either major party to do anything with respect to entitlements except expand them, the result is annual deficits. As long as creditors allow debts to be incurred at low interest rates and the Federal Reserve Bank has the ability to create money at will, the easiest thing for members of Congress to do is what has been done—incurrence of substantial annual deficits. With the baby boomers just now starting to retire (2011 is the first year of Medicare eligibility for the first group, born in 1946), the costs of retirement entitlements will soon cascade.

The Patient Protection and Affordable Care Act (the 2010 healthcare reform law) has provisions calling for Medicare spending cuts in the future. However, as noted, in large part due to the medical profession’s ability to portray reimbursement rate cuts as reductions to health care for seniors, with little exception, cuts have not been experienced in the past even though a law necessitated them.

In a September 8, 2010 presentation to the National Center for Policy Analysis, former Comptroller General David M. Walker, stated (assuming realistic reductions to health care spending): “Without reforms, by 2022, future revenues will only cover Social Security, Medicare, Medicaid, and interest on the debt. By 2046, revenues won’t even cover interest costs.”

What if a major fiscal need exists that would best be suited for handling by the federal government when the debt load is severe? World War II would have been a much more difficult endeavor if the U.S. had entered the war heavily in debt. A major need occurring when a heavy debt burden exists could spell the end of our world as we know it.

Printing of money is an easy means of dealing with these problems. However, printing money inevitably results in inflation. If the Federal Reserve Bank does not print money to help bail out the Congress, and interest rates change to more traditional rates with the accumulated debt mounting (likely), the interest burden would become a very substantial portion of the federal tax burden. The vast majority of the burden is paid by individuals. Think big tea parties.

The laws of economics will ultimately prevail. Just as the basic rule of supply and demand has resulted in tremendous reductions in the price of real estate, the ability to incur debt at low interest rates and print money will, at some point, be constrained. Excessive cheap money, deficit spending and Fannie Mae and Freddie Mac are the main causes of the relative prosperity of 2002-2006, the real estate glut and the recession.

How would deficits spiraling out of control feel? Assuming no war, the buildings would continue to stand, as would the trees. Would people still go to high school football games on Friday nights in the fall? Probably, yes. Would there be rioting in the streets, as has been the case in Greece? Probably, yes. Would the U.S. cease to be the world’s sole super power or one of two or more super powers? Yes. Would private investments suffer, including those held in 401(k) accounts? Yes. Would life in general be enjoyable with a constant concern the federal government is in danger of collapsing with something very different taking its place? No.

Historically, empires and countries experiencing tremendous financial problems have not lasted. The collapse of the Roman Empire was in large part due to devaluation of its currency. Devaluation led to the collapse of the Weimar Republic, and the formation and eventual power of the Nazi Party in Germany. It would be pretty tough to defend a country dealing with financial insurrection and a watered down currency.

The slow growth of the problems is, in itself, a problem. There is no punch in the stomach that wakens people to the magnitude of the problems. Our nation’s financial problems are a slow growing cancer. Contrast the attack on Pearl Harbor. By the end of December 7, 1941, virtually every citizen understood the gravity of the situation.

Could our nation’s problems be solved if our nation went “cold turkey,” and balanced the budget every year? The answer now is: Absolutely, yes. Further, the budget would not need to be balanced every year. For example, annual balanced budgets coupled with reasonable deficits during times of recession (or worse) could work indefinitely. However, such a proposal is not on the radar screen of either major political party. Furthermore, once talk of the ability to run limited annual deficits begins, the run on the bank is on. As time goes by, the ability to fix the problem diminishes.

The ability to stop the insanity at any time allows the insanity to continue. The federal government has become a feeding trough for the two major parties to buy votes, repay political debts and satisfy the needs of special interest groups.

Greece (perhaps ironically, allegedly the first democracy) could, and should, save us. Before things get really bad here, things will get really bad elsewhere. Greece is the tip of the western European iceberg in terms of entitlements and debts going awry. The U.S. is behind countries such as Greece and Spain with respect to its financial problems. Modern communications mechanisms will allow our people to see where we are headed unless we act. It should save us in the long term.

There’s something else the GAO has told us: State and local governments are facing very substantial financial challenges as well. Their pension and post-retiree medical plans are exempt from federal funding laws, leaving many systems subject to funding as needs arise. For example, the pension plan for the State of Illinois is less than 39 percent funded.

The course of action the Democrats have taken so far in dealing with the recession and its aftermath (if that is what we are now experiencing) has been a Keynesian approach. Economist Paul Krugman has been a major advocate of tremendous deficit spending since the recession began. He would apparently spend much more (and borrow much more) than Congress and the Obama Administration have spent and borrowed. The apparent hope is that bridge building, etc. will prop up the economy and simultaneously fulfill public needs while demand in the private sector recoups sufficiently to support itself and grow the economy, thus creating private sector work. Government growth would then be reversed. History shows that once government grows, it does not recede. The Democrats know their history in this regard.

John Maynard Keynes was a British economist. Ironically, the British are now in the process of trying to cut spending by 25 percent to fix the U.K.’s financial problems. Time should tell which approach works best for long-term sustainability.

The inability of historically low interest rates for an extended period of time to turn things around shows the economy was well overcooked in most of the industrialized world for too long, leaving a glut of real estate that cannot be “worked off” in a few years. Add global competition from low labor cost countries that did not exist in most past recessions and you have a difficult mix.

What would Republicans do differently? They have complained about Democrats’ spending and debt habits, even though they grew government approximately 7 percent per year and increased the debt by approximately 50 percent while the economy grew at less than 3 percent during the 2001-2006 time frame when they controlled the federal government. They have argued to make the 2001 and 2003 tax changes permanent. What would doing so look like when coupled with Republicans’ spending ways? The chart at the end of this article was created by the GAO in its 2010 Update titled “The Federal Government’s Long-Term Fiscal Outlook, January 2010 Update.” It supplies an approximate financial synopsis of what things would look like if the Republicans took control and continued their recent past ways.

Our system does not work on a long-term basis. In fact, it does not come close to working on a long-term basis. The sooner we realize it and make necessary changes, the better off we’ll all be. The longer we wait to fix our system, the more painful the situation will become in the long run.

In our Alternative simulation, which assumes expiring tax provisions are extended through 2020 and then revenue is held constant at the 40-year historical average, roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020. By 2030, net interest payments on the federal government’s accumulating federal debt exceed 8 percent of GDP—making it the largest single expenditure in the federal budget.

Figure 4: Potential Fiscal Outcomes under the Alternative Simulation: Revenues and Composition of Spending Percentage of GDPFiscal yearAll other spending Medicare and MedicaidSocial Security Net interest Source: GAO.Revenue01020304050204020302020201001020304050 Note: Data are from GAO’s January 2010 analysis based on the Trustees’ assumptions for Social Security and Medicare. GAO-10-468SP Long-Term Fiscal Outlook January 2010