A Quick Review of GDP, Deficits, and Debt
If Twitter is to be used as a barometer of discord in Washington, there is a clear discontinuity among interpretations of the US economy’s health and sustainability. Opinion holders point to any number of indicators including GDP growth, muted stock market performance, expanding deficits, strong corporate earnings, depressed wages, low unemployment, and increasing inflation. This conflicting information makes analyzing the current administration’s financial and economic decision making ever more difficult.
As the conversation continues to polarize it can be helpful to take a step back and review the underlying fundamentals of GDP growth. This background will allow for a deeper understanding of what is truly driving growth and the implications of current policy.
An Overview of GDP
Gross domestic product (GDP) is an economic indicator measuring the total output of an economy. Time periods over which GDP is increasing are referred to as expansionary periods. Time periods over which GDP is decreasing are referred to as recessionary periods. The United States has been in an expansionary period since 2009.
The basic equation for calculating GDP is as follows:
Visually we can represent this formula with the following graphic:
Expansionary and Recessionary Policy
During recessionary periods the Federal Reserve and government policy makers look to the GDP equation when deciding how to offset the negative consequences of a recession. During these times the Federal Reserve may react by (1) lowering the interest rate it charges to banks to borrow money, (2) reducing the required reserve ratio (the percentage of a bank’s deposits that must be saved rather than invested), and (3) purchasing bonds currently circulating in the market (quantitative easing).
During these times the Federal Government will generally react by implementing expansionary fiscal policy. Expansionary fiscal policy takes the form of (1) increased government spending (2) lowered taxes and (3) deregulation. In recessionary periods government revenues tend to decrease, so increased spending is typically fueled by debt. As a result, in recessionary years the annual deficit tends to increase significantly.
During times of economic expansion (at least in theory) the Federal Reserve and government policy makers will begin to reverse the expansionary policies implemented while trying to pull the economy out of a recession. Doing so gives them slack to be able to engage in similar practices during the next recessionary period. This of course is not always the case. There are numerous examples of governments who fail to reign in expansionary practices during times of economic growth. The United States is currently pursuing this strategy.
Recent Fiscal Policy in the United States
While the statistics and numbers purported are sometimes overstated, the administration’s claim that GDP is on the rise is in fact true. However, it is still important to put this growth in perspective by evaluating prior trends and the impacts of recent fiscal policy on GDP numbers.
As is mentioned in the Key Notes and Takeaways section above, GDP growth is up. This growth has been attributed to a wide array of forces depending on who is discussing the issue. To analyze the significance of this growth it is important to return to the GDP equation.
As is shown in the above formula, in light of the GOP tax stimulus and increased deficit spending, it would be extremely concerning if GDP levels did not rise. If GDP did not increase in light of these events it would indicate a significant drop in investment and/or net exports. Increased deficit spending and the tax stimulus bill do not account for total GDP growth in 2018, but they certainly contributed to the higher numbers realized.
The Role of Deficits and Debt
It shouldn’t be news to anyone that the US Federal Government’s debt has been on an upwards trajectory for quite some time. This increase can be attributed to a number of macroeconomic events from recessions, to wars, to socioeconomic paradigm shifts on debt and equity.
Debt acquisition is ultimately a form of borrowing from future wealth. Purchasing a $200 watch on a credit does not mean the purchasing individual is $200 richer. As the debt must ultimately be repaid, the individual has effectively borrowed from his or her future wealth. If the debt requires the purchaser to pay interest, these interest payments will further subtract from future wealth and crowd out spending on other goods and services. Similarly, debt incurred to fund tax stimulus programs and increased deficit spending is adding to GDP now by borrowing from GDP in the future
Returns on Investment — While the principle of borrowing from the future is true in many circumstances, the watch example does not take into full account the role debt plays in a business or government setting. The concept of returns on debt, as introduced in The Missing Piece of Healthcare Reform, adds a second level of complexity when evaluating an entity’s long-term wealth position. In an effort to not fully rehash the topic, suffice it to say the following: if an entity can invest the money taken on as debt, and earn more with that investment than must pay in interest, the entity may end up wealthier than it would have been in the absence of debt.
The argument that increased debt levels are in any way justifiable is predicated on assertions that (1) the money transferred back to individuals and businesses in the form of reduced taxes will be invested in ways that increase GDP and, as a result, increase tax revenues and (2) the sources of increased government spending are investments that will generate returns.
To tackle the first argument, in order for a tax cut to pay for itself, the money given back in the form of reduced taxes would need to be invested in assets that reap enormous returns. The returns would need to be so great that the lower marginal tax rate collected on those returns would replace the debt and interest incurred to finance the tax breaks.
If the GOP tax bill does recoup the cost of decreased tax revenues (financed via government debt) it would be the first US tax reform measure in the last century to conclusively do so. Evaluations of the Coolidge, Kennedy, Reagan, and Bush tax cuts show that while tax cuts do increase economic activity, it is almost unfounded to claim they pay for themselves.[i] Even if there was historical evidence supporting the proposition that the GOP tax cuts would reap positive returns, this round of cuts would have to do so while battling the largest debt numbers in US history.
Based on projections by the Congressional Budget Office and the Treasury department the bill is in no way on track to recoup costs. In fact, current projections show the bill significantly adding to the US debt figure.
This is not to say that reduced taxes do not have a positive impact on GDP. Reduced tax rates give consumers and companies additional money to invest and spend on goods and services. Certainly, absent rapidly accelerating debt figures and mounting interest, lower taxes are desirable and lead to greater economic efficiency.
The second argument related to government expenditures generating returns is basically indefensible given the composition of current spending. As the government has the responsibility to provide certain public goods and services it is not unreasonable to expect that some categories of expenditures will never generate returns. It is the mismanagement and waste imbedded into these expenditures that is the problem. This waste is ultimately financed with debt and it serves to crowd out other revenue-generating government expenditures.
Interest Rates — The unprecedented debt levels in the United States adds a second level of complexity to the argument that debt can be used to generate returns. As the debt continues to grow, an increasing percentage of the annual budget must be dedicated to paying off interest. Interest payments generate no revenue and provide no social benefit. Furthermore, increasing debt levels and interest payments inherently adds risk for investors. Basic finance teaches us that risk must be rewarded in the form of higher interest rates.
The United States benefits from being the reserve currency of the world and has enjoyed relatively low interest rates in the face of escalating deficits. This luxury is afforded on the assumption that demand for US Treasuries will always increase to meet supply. This necessity has made the United States increasingly reliant on foreign purchasers of its debt. Article three of the Evaluating the Genuine State of US Trade series goes into the concept in greater detail.
Tying it Together
While the escalation of the US debt number is not necessarily new news, what is making headlines is the growth in the annual deficit number over the last two years. This increase is raising attention due to its magnitude and the fact it is escalating while the United States is nine years into an expansionary growth period. Reduced tax revenues combined with increased government spending has lead to an estimated 27% increase in the budget deficit between 2017 and 2018.
Not only are these numbers problematic from a debt and interest point of view, there is a secondary risk related to the implementation of expansionary fiscal policy during a time of sustained growth. Expansionary policy during times of economic growth has the potential to overheat the economy and lead to bubbles.
Overheating refers to a state wherein the economy has exceeded the GDP growth possible given the country’s productivity level and labor force growth. Exceeding this GDP figure results in inflation and the over valuation of assets in the market. A bubble refers to a group of assets that has so far exceeded their warranted value that a “bursting” or sudden drop in valuation is inevitable.
There are countless historical examples of this exact scenario playing out over time. A particularly interesting case study is that of Greece during the 2008 financial crisis. Prior to the crisis Greece found itself in the middle of an expansionary period while Germany found itself in a mild recession. In response to Germany’s economic condition the ECB (the European Union’s equivalent of the Federal Reserve) ramped down interest rates (a form of expansionary monetary policy). This decision left Greece’s economy to continue to overheat until the financial crisis hit. This overheating is considered one of the reasons Greece was hit so hard by the crisis relative to other European Union countries.
Looking to the Future
Recessions, like it or not, are part of the global economic cycle. As the United States continues on one of the longest growth periods in its history, there are significant market signals that a recession is approaching. The inverting yield curve, negative credit and profit impulse figures, and lost ground in the S&P and Dow indexes, all signal a downturn may be coming in the not too distant future. While it is impossible to predict when downturns will happen, it is important for governments and central banks to be prepared to react in the event of a recession.
The Federal Reserve has taken small steps in increasing interest rates and divesting assets from its balance sheet (increased balance sheet numbers being the result of quantitative easing efforts coming out of the last recession). Nevertheless, interest rates are still incredibly low compared to historic levels and the Fed’s balance sheet has only been reduced by a little over 5% since its high of $4.5 trillion [ii]. These facts indicate that the Federal Reserve has less flexibility to implement impactful expansionary monetary policy in the event of a future recession.
The Federal Government on the other hand has moved in the opposite direction. Rather than practicing fiscal austerity and giving itself room to enact expansionary policy in the event of a future downturn, revenues have been cut, expenses increased, and regulations loosened. Continued escalations in the annual deficit figure gives the government less flexibility if future stimulus efforts are needed to negate the impacts of a recession.