Weak Deal is No Solution

with 5 Comments

Scarecrow on Money Pointing UpwardsStandard & Poor’s (S&P) downgraded U.S. debt, and the administration and others pushed the idea that most of the blame was due to the intransigence of the Tea Party. Calling this a “Tea Party downgrade” might be true in one sense. There weren’t enough members of the Tea Party to overcome the stubbornness of those refusing to make real spending cuts.

First the Tea Party was going to be blamed if a deal wasn’t made and the debt ceiling wasn’t raised. We were told the United States would default. We were warned the world would end. In response, I explained how the federal government could pay interest, Social Security and the active duty military with the cash coming in. I may be the only person to have made the nightly news for predicting the world would go on.

Then a relatively weak deal was made and the stock markets dropped anyway. When the S&P downgraded the U.S. credit rating, the markets dropped again.

S&P said they would downgrade the United States unless $4 trillion was cut from the deficit. Members of Congress only cut $900 billion and then seemed shocked when S&P followed through. S&P even explicitly spelled out the possibility in what they called scenario 2:

“The White House and Congress agree to raise the debt ceiling to avoid potential default but are not able to formulate what we consider to be a realistic and credible fiscal consolidation plan.

“Such a partial solution would essentially put before American voters in the 2012 presidential and congressional election the spending vs. revenue debate. Meanwhile, debt would continue to mount and the results of the election might not, in any event, resolve the issue. Under this scenario, we might lower the U.S. sovereign rating to ‘AA+/A-1+’ with a negative outlook within three months and potentially as soon as early August.”

Unlike Congress, S&P follows through on its promises.

One of the positive aspects of our country’s financial debacle has been to show our financial health more clearly as a house of cards. Intransigence in Congress, we were told, imperiled everything from Social Security to defaulting on our interest payments. In other words, without continued deficit spending we can’t even pay our bills. It is no longer a given that money will continue to emerge indefinitely from the ATM.

In this regard, the credit rating downgrade was justified. Fannie Mae and Freddie Mac are backed by the full faith and credit of the federal government, and therefore they have now been downgraded as well. Social Security is supported by the full faith and credit of the federal government. Medicare and Medicaid are similarly sustained. But as a result of these entitlements, the full faith and credit of the federal government is buckling under the strain.

Unfortunately, the full faith and credit of the federal government is based on the ability to get that revenue increasingly from a much smaller percentage of those of us who actually pay income tax. The Democrats have tried to spin the idea this was a Tea Party downgrade and our real problem is that taxes need to be raised, especially on the wealthy.

Since 1960 the federal government has consistently collected between 15% and 20% of the nation’s gross domestic product (GDP). Given the wild change in marginal tax rates over that same time period and even accounting for both the recessions and economic growth, it has been remarkably stable. When measured as a percentage of GDP, spending and revenue numbers should remain relatively constant. As we get richer, revenue and spending should rise proportionally and the percentages of GDP should not change.

Although this has been true for revenue, it has not been true of spending. Our spending recently has exceeded 25% of GDP. Because we are in a recession and revenues are closer to the 15% mark, we are going about 10% of GDP further into debt each year.

Additionally, there is a diminishing return for government spending. Another dollar spent on stimulus, investment or spurring economic growth is worth less than 30 cents in reducing our deficit. We simply can’t spend our way into prosperity.

I’ve worked with many families struggling with credit card debt. The change of behavior required to cut back on spending is nearly impossible until no other choices are available. Even then it is difficult. Most of the time people won’t reduce the features on their cell phone, cancel their gym membership or stop eating out until they hit bottom and everything falls apart. Unfortunately, when Congress hits bottom we will be standing under them to soften the fall.

It is as though U.S. businesses have no choice but to rent space from our country. Raising taxes is like trying to help America become more competitive by increasing rent and forcing businesses to raise their prices. We can’t become more competitive by raising prices. In a global economy, the best contribution that our government can make is to give us low rent and more efficient management. Government needs to spend less.

While we continue to invest in this country, six countries enjoy more economic freedom and a lower debt and deficit: Hong Kong, Singapore, Australia, New Zealand, Switzerland and Canada. And all still have AAA ratings.

These are the countries that may continue to have what used to be called the American style of GDP growth: 6.5%. With our increased government spending and reduced economic freedom, we will be stuck with the European malaise level of 2 to 3% GDP growth. And obviously anything growing at 6.5% will overtake something growing only at a 3% rate of growth. Overweight your investment in these.

If this was a Tea Party downgrade, it is only because the Tea Party wasn’t strong enough to overcome congressional politics as usual. We need government workers who will vote for smaller government. Less government means more freedom. And more freedom means faster GDP growth.

Photo by Megan Marotta

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

5 Responses

  1. Doug Morris

    It is disappointing to read such poor economic advice coming from someone I greatly respect.

    You correctly point out that our tax revenue is 15% of GDP compared to historical rates of 15 -20%. Can we not afford to increase our tax burden, bringing it closer to the 20% level? Warren Buffet argues that we can. He feels that the uber-rich, such as him, are under-taxed. Remember that before the Bush tax cuts, our economy was booming and we had federal budget surpluses. Increased tax rates are not the problem, they are the solution.

    If we could somehow pass legislation to both cut spending (especially Social Security and Medicare which are on a trajectory to skyrocket as our population ages), and increase taxes, (especially on the wealthy who enjoy some of the lowest taxes in history), our economy would improve as business and consumers come to trust that our government can responsibly handle our fiscal house.

    Should, however, we attack our fiscal problems with spending cuts only; we face one of two dismal outcomes. Either cuts are insufficient to deal with the deficits and we continue with our current failed fiscal path, or, somehow, we pass cuts deep enough to deal with the problems and we witness the virtual dismantling of Medicare, Social Security, the Defense Department and most other federal, state, and local spending. Unemployment will rise (think 20 – 40%), GDP will shrink, tax revenues will shrink, and we could possibly see rioting in our streets like Athens and London.

    Proposing that we try to solve our problems with spending cuts alone is irresponsible. Spending cuts – yes. Increased taxes – yes. We need both.

    • David John Marotta

      I think the dismantling of Medicare and Social Security is not only inevitable, but also good for America. Those programs should be means-tested and you and I should receive none of those benefits. In my book that would be spending cuts, but spending cuts on the rich. I’d prefer losing all of my Social Security entitlements than have higher taxes for small business owners. Revenue is at 15% because small business owners are struggling.

      Those programs should increase benefits and only give them to the neediest 20% of Seniors.

      Personally I think that is the best compromise imaginable. Would you be willing to give up all of your Social Security?

      This isn’t poor economic advice, as every economist would agree that people spending their own money is more efficient than government bureaucracy and inefficiencies.

      • Doug Morris

        John said:
        “I think the dismantling of Medicare and Social Security is not only inevitable, but also good for America. Those programs should be means-tested and you and I should receive none of those benefits. In my book that would be spending cuts, but spending cuts on the rich. Those programs should increase benefits and only give them to the neediest 20% of Seniors.”

        I agree. Means testing is the best possible solution to the future growth in those programs. They must be cut, we cannot afford the taxes needed to support the tuture benefits comintg to the baby boomers. But I would stop at at 50% of Seniors, not 20%, and even that would be politically impossible. I’d be pleased if we could lop off the wealthiest 25%.

        Yes, revenues are down because of the recession, but also because of the Bush tax cuts. Reverse those tax cuts and we would be well on our way to cutting our deficits. This would be far lessdamaging to our economy than the comparable spending cuts, as the multiplier effect of spending is estimated to be 2 or 3 times that of taxing. Cuts only will kill our already fragil economy.

        • David John Marotta

          I would challenge your claim that there is a “multiplier effect of spending is estimated to be 2 or 3 times that of taxing”. Were that to be true, we could spend our way out of our economic troubles.

          Here from George Mason University is an article, “Does Government Spending Stimulate Economies?

          In response to the financial crisis, Congress passed the American Recovery and Reinvestment Act (ARRA) in February 2009, which totaled $789 billion in government spending. President Obama reassured anxious Americans that this spending would “revive our economy” and “create 3.5 million jobs” over the next two years.1

          A new study by Harvard professor Dr. Robert Barro and Charles Redlick tests this claim and the economic theory that underlies it by using defense spending as a proxy for overall government spending.2 Their research finds that greater government spending does not aid the economy; in fact, it causes decreased consumption and investment.

  2. Richard Steven Gregg

    Same old thing, cut spending but “not in my back yard” (nimby). Everyone wants their piece of the pie and someone else cut, so nothinig happens. I just found out that FHA, Fannie, or Freddie (whatever you want to call those phoney government agencies) are still bailing out the $500,000+ new home market, by issuing cheap loans. The banks won’t do it but they will. Probably just another giveaway 2% down loan that will go soar someday. And they have lost billiions already..The banks are just using that cheap fed money to feed more plastic to the people, raise their fees on everything,, buy government treasuries, and a few ultra safe investments. The federal government has been taken for a ride…! The ultimate fall guy…!