Wednesday, April 27, 2011

Who will tell the people.

For all the yelling and screaming about the national debt, you would think that Democrats and Republicans disagree about everything, when in fact they are in almost total agreement when it comes to fiscal matters. Or at least that is what the historical data seems to suggest.

The fundamental source of agreement is that Americans should get what they want, and they should not have to pay for it. Republicans think Americans want tax cuts and a strong national defense—and they should not have to pay for it. Democrats think Americans want healthcare and roads and schools, and should not have to pay for them. And most of all, Republicans and Democrats alike think that Americans should have unlimited access to drugs and medical care the closer to death they get—and certainly no one should be asked to pay for it.

At least that is what the historical record shows.

As illustrated below, federal personal income taxes paid—the purple line—have not kept pace with the growth of national income and GDP since 1980, much less with the growth in federal spending. That is to say that with all the growth in the Federal Government since Ronald Reagan came to town to shut it down, Americans have seen personal income taxes decline modestly as a share of national income. Stated simply, for every $100 of income earned by Americans in 1980, they paid $11 in personal income taxes, and over thirty years later that number was $10. And, as illustrated here as well, since 1980, total taxes—including personal and corporate income taxes, excise taxes, social security taxes and the rest—have rarely paid for all that we want, and we have made up for it by issuing debt.

Oddly enough, however, what we seem to want—what has been funded by Democrat and Republican Congresses and Presidents—has remained more constant than one might think. Since 1980, even as how much we pay has not changed materially, what we buy has not changed much either. After decades of partisan warfare, no area of federal spending has grown as a share of national income or GDP other than healthcare. In 1980, we spent 5% of GDP on defense vs. 4% today. In 1980, we spent 5% of GDP on non-defense discretionary spending vs. 4% today. In 1980, we spent 8% of GDP on non-Medicare/Medicaid entitlement spending—stuff like veterans benefits and student loans and farm subsidies—vs. 6% today. All of the growth—and therefore arguably all of the debt incurred since the bygone era of balanced budgets—has come for Medicare and Medicaid spending, which collectively grew by almost 200%, from 2% of GDP to 5%.

As the graph above illustrates by the divergence and convergence of the green and purple lines, instead of constraining spending—one of the original theories behind the tax cuts of the 1980s—declines in tax receipts have simply led to increasing levels of public debt, and conversely increases in tax receipts have led to moderating debt levels. That is to say, for all the arguments and blame about debt levels, the simple fact is that year over year we have been making a simple choice: Do we borrow or do we pony up our own dollars to pay for the budget that our elected officials approve.

The current debate over deficits and debt has been more about political theatre and gamesmanship than about constructive solutions. As one looks at the historical data, it is hard to avoid the conclusion that for past 30 years, all rhetoric aside, the national political establishment has come to accept that we do not have to pay for that which we want to receive. And this is a universal affliction, indifferent to political party. Everyone has been willing to cut what they don’t like on the margin; but no one has been willing to either tackle—or pay for—those things that everyone seems to want.

As suggested above and illustrated below, the primary source of spending growth has been healthcare. Perhaps this is not news to anyone, but it is surprising to note that since 1980, no other area of the federal budget has grown as fast as GDP and national income.

This trend has been uniform through Republican and Democrat administrations. As illustrated below, during the Reagan-Bush years, when military spending grew faster than GDP growth, its growth, in the end, was far surpassed by Medicare and Medicaid.

During the Clinton years as well, when both military and overall discretionary spending lagged behind GDP growth—and for the only time since early in the Nixon presidency that the federal actually had a balanced budget—healthcare cost growth continued unabated.

Finally, in the George W. years, when all manner of spending surged ahead, Medicare spending once again led all areas in spending growth.

For all the outcry about debt and deficits, the story is simpler that we want to imagine. First and foremost, we lost our way thirty years ago when in both the political and personal worlds we allowed ourselves to believe that it is ok to borrow instead of pay for those things that we want. And second, it is all about healthcare.

To his credit, Congressman Paul Ryan has put the issue of Medicare spending on the table, and suggested for the first time in memory that sustaining costs will require that people pay more. For his part, President Obama did the nation and his own legacy a great disservice when he chose to walk away from, rather than embrace, the admirable work of his commission on debt and deficits. That commission produced a politically balanced and thoughtful set of recommendations. While the commission lacked the super-majority vote of support that would have mandated an up or down vote by Congress—in part due to the aforementioned Congressman Ryan—it deserved that vote.

The nation has limited time to grasp this problem. To date, we have not felt the pain of the debt that we have accumulated over the past thirty years, as the interest costs we pay have been declining steadily. The irony is that the status of the dollar as the global reserve currency has been of particular benefit to us in the wake of the financial crisis. Just as our debt has been accelerating, our interest costs have reached historic lows as each global investors and central banks have continued to pour money into the dollar as the only freely convertible safe haven.

But when the global recovery comes, our costs are likely to accelerate. As the graph below illustrates, federal interest costs will accelerate rapidly with any return to normal interest rates. The average maturity of federal debt—data on which is not readily available—has been in the four to five year range over recent years, but may well have declined with the duration impact of QE2. Accordingly, this graph suggests that if our interest costs average in a return to historical interest rate yields—our net interest costs will quickly skyrocket, and within five or six years will exceed the current costs paid for either defense or Medicare spending.

This is not a radical scenario, but just based on a normal interest rate cycle. The disaster scenario happens if the bond market turns against the dollar and the reserve currency status of the dollar comes to an end.

The challenge that we face is to address our fiscal problems while we still enjoy our privileged access to capital. It is not a crisis yet—right now it is just political theatre. Somehow, for all the talk, most politicians just do not really believe that we are at risk. If they did, would they still be content to play the same games and use our fiscal challenges as one more prop for gaining partisan advantage?

As Americans, it is time to grow up and either pay for what we want, or to formally disavow wanting it. And we must all recognize that the debt that we have built up is our debt: It is the consequence of our political choices spanning a generation.

The President should reconsider his rejection of his own commission, and embrace it now, if it is not too late. Jerry Brown has already written the words for him:

If you are a Democrat who doesn’t want to make budget reductions in programs you fought for and deeply believe in, I understand that. If you are a Republican who has taken a stand against taxes, I understand where you are coming from.

But things are different this time...

We have seen the enemy, and it is us.