It is almost State of the Union time. So what is the real state of our union's finances, specifically our federal budget? Are we going to hell in a hand basket? Or do we have nothing to fear but fear itself? I crunch the numbers so you don't have to.
For fair comparisons over time, I provide numbers as a percentage of our economy, specifically Gross Domestic Product.
The Past. Let's start with what we know: the past. Below is a breakdown for federal spending in 2007, as a percent of GDP, in which total outlays were exactly 20% of GDP . (State and local government spending was another 17.4% of GDP, bringing our total government spending to 37.4% of GDP, above that of Switzerland, Australia and Ireland, but slightly below the OECD average of 40.4%.)
National Defense 4.05
Income Security* 1.86
Net Interest 1.74
All else combined 0.81
* Excludes federal retirement and disability, but includes unemployment compensation, housing assistance, and food and nutrition assistance.
On the income side, the federal government raised 18.8% of GDP, leaving a deficit of 1.2% of GDP.
Some of you might already be surprised. You might think foreign aid, for example, is breaking us, but it is only 0.11% of GDP. Agriculture is 0.13%. The space program is 0.11%. In fact, retirement and disability programs (primarily Social Security), health care (primarily Medicare), national defense, and net interest amounted to 78% of the 2007 federal budget and 15.6% of GDP.
On the debt side, our "total" federal debt in 2007 was 65.5% of GDP. However, much of that was simply IOUs from one side of government to the other. The net debt "held by the public" was 36.8% of GDP. That number, for my money, is the one that matters.
At this point, let's get Social Security straight. You might have heard of a "trust fund." It doesn't exist. The "trust fund" is simply IOUs from the "general" side of government to the Social Security side. But every year, so much money goes into the government from payroll taxes and so much money comes out of it in Social Security checks. These are just two more streams of government income and outgo.
Overall, 2007 was a pretty good year, budget-wise. Since World War II, income has been around 18% of GDP. For the last 25 years in particular (1983-2007), it averaged 18.3%. So 2007's 18.8% was in fact a bit above average. (Note to liberals: tax rate cuts were not the problem.)
On the spending side, we have averaged almost 20% of GDP since World War II. For the last 25 years it averaged 20.8%. So 2007 was about average, and in fact on the low side compared to the previous 25 years. (Note to conservatives: spending has not really been that bad. Note to liberals: our wars in Iraq and Afghanistan did not break us. Spending over all of President George W. Bush's years almost exactly matched the post-WWII average.)
The deficit averaged 1.6% of GDP since World War II, and 2.5% over the last 25 years. So again, 2007, at just 1.2%, looked pretty good. Over all the Bush years, it averaged 1.9%, also not that shabby.
The debt held by the public has averaged 36.2% of GDP since 1960, and was even higher before that. In the last 25 years it averaged 40.5% of GDP. So again, 2007's 36.8% was near average and actually on the low side of the last 25 years.
You would have to say, at the end of 2007, that the federal budget looked pretty good. Income, outgo, deficit and debt were all near post-war averages or even on the good side of average. And 2007 was not an oddball year. The entire Bush years, 2001 through 2007, were close to average in these respects.
That was the good news -- 2007. It has been all downhill since. We are now talking in units of trillions of dollars. A trillion dollar bailout. A trillion dollar stimulus. A trillion dollar deficit. We are looking at trillion dollar deficits in both 2008 and 2009.
All to cure a recession that so far has amounted to a drop of 1.1% in real GDP in the second half of 2008. Real GDP grew in the first half of 2008. (My opinion: we are using nukes to kill a tick. This recession started as a mild downturn, but our government's reaction to it is what is spooking the markets, and the real economy, now.)
How much is a trillion dollars? A little over 7% of GDP -- over a third of the entire federal budget of 2007.
Now things don't looks so good. As a deficit, 7% of GDP is even higher than those of the Great Depression. In fact, our deficit never exceeded 6% of GDP since 1930, except at the peak of World War II itself.
And when we add two trillion to our debt, the public will be holding over 50% of GDP in debt. That is more than at any time since before 1960. The only good news is that Japan and Germany, for examples, have it even worse: 182% and 65%, respectively, in 2007. (Which might explain why the US still draws investment from abroad; we're not great, just better than our competitors. But how much longer can that last?)
The Future, the Rosy Scenario
Let's pretend our current recession ends soon, in 2009, and the trillion-dollar games come to an end with it (extremely optimistic conditions). Without any of that trouble, we still have more people retiring and spiraling medical costs. Social Security and Medicare are going broke. How bad?
The Social Security Administration itself puts it this way:
In 2007, the combined cost of the Social Security and Medicare programs represented about 7.5 percent of GDP. Social Security outgo amounted to 4.3 percent of GDP in 2007 and is projected to increase to 5.8 percent of GDP in 2082. Medicare's cost was smaller in 2007-3.2 percent of GDP- but is projected to surpass the cost of Social Security in 2028, growing to 10.8 percent of GDP in 2082 when it will be 85 percent larger than Social Security's cost. In 2082, the combined cost of the programs would represent 16.6 percent of GDP.
Now 2082 might seem like a long way off, but the SSA's report includes data from here to there. These entitlement programs are expected to grow much faster than the economy even in the near term. While in 2007 they combined to 7.5% of GDP, they will require 12.3% of GDP in 2030. That means an extra 5% of GDP worth of government spending in only a few more years. That is one quarter of the entire current federal budget.
Where will we get it? We're running trillion dollar deficits now.
I calculated future federal budgets for this rosy scenario using pretty simple arithmetic and assumptions. The assumptions were
- The current recession and banking difficulties are solved in 2009, with the effect being to bump up our debt (held by the public) from 37% to over 50% of GDP by 2010.
- Social Security and Medicare grow as described by the Social Security Administration. Other federal retirement and disability programs will grow at the same rate as Social Security. Other federal health programs will grow at the same rate as Medicare.
- National Defense spending will be cut from just over 4% of GDP to 3% of GDP.
- All other programs will remain flat as a fraction of GDP, at 4.4% of GDP.
- Interest payments will be proportional to outstanding debt, in the same proportion as in 2007.
- Receipts will remain at the level of the average of the last 25 years, at 18.3% of GDP.
The results are presented in the table below, where 2007's numbers are actual, the rest estimated.
Future Federal Budget (% of GDP) In A Rosy Scenario
All other areas
This table is based on very austere budgets, including a 25% cut in defense spending and flat spending in all areas other than retirement, disability and health. Yet the situation is unsustainable. After 2020, the wheels come off the wagon (deficits over 10% of GDP and debt over 100%).
Look at even 2020, with a deficit of almost 6% of GDP, before things get really bad. Where would you cut?
Even if we eliminated national defense spending entirely by 2020, we would still have a deficit of almost 3% of GDP, a high number - the equivalent of over $400 billion in today's dollars.
I should also add that today's 4% of GDP going to defense is historically low already. It was at or above that level from 1941 through 1994 - over half a century. It stood at 1.7% when Pearl Harbor was attacked. It stood at 3% when we suffered the 9/11 attacks. There is a good argument that letting it go below 4% leaves us vulnerable and encourages our enemies. Even the Communist Party USA is proposing cutting defense "only" 50% .
Non-Defense Discretionary Spending
We could eliminate all such spending entirely and still have a 2020 deficit of 1.8% of GDP, the equivalent of over $250 billion in today's dollars. Take a look at what such spending covers:
- Community and regional development
- General government
- Housing and commerce
- International affairs
- Judicial system
- Natural resources and the environment
- Space and science
- Unemployment compensation, housing assistance, food and nutrition assistance
To eliminate the 2020 deficit by cutting only the above discretionary spending areas and national defense combined would take a cut of about 70% in all those areas. Republicans get into trouble for simply not letting such programs grow fast enough. A 1% cut is considered "draconian." We are talking of a need for cuts of well over half of almost everything the federal government does outside of retirement, disability and health programs.
The problem is obviously not just "earmarks" or "fraud, waste and abuse."
So what if we try to raise revenue over that 18.3% of GDP figure? Well, we can try, but it's never been as high as even 21% of GDP in our nation's history. Since World War II, the top marginal income tax rate has varied between 28% and 92%, yet the total amount of money actually collected by the federal government has consistently averaged about 18% of GDP, staying between 16% and 20% in all but one year since 1950 . In the last 25 years, 1983 through 2007, the average was 18.3%.
The federal government needs to collect over 24% of GDP in 2020, and over 30% by 2030, to avoid a deficit. As I stated, it has never done such a thing, not even at the peak of World War II (peaking at 20.9% of GDP).
The real money and the real problems are in the Social Security and Medicare/Medicaid type programs -- the entitlements. Social Security is less scary; it is projected to go from 4.3% to 5.8% of GDP in the next 74 years. That's just a 1.5% of GDP type problem. Not pleasant, but we should be able to handle that.
The biggest problem, and therefore the biggest payoff area, is in health spending. Health spending continues to grow faster than inflation, faster than other areas of the economy and even faster than Social Security. We already spend much more on health care than any other country in the world, whether measured on a per capita basis in real dollars or as a fraction of GDP.
Our governments (federal, state and local) already spend more than most other countries that provide universal health coverage, yet we still do not have universal coverage .
We have a health care problem. But it is not a "coverage" problem. It is a cost problem.
If there is just one priority in government finance, it must be health care.
Obama and "Nixon Goes To China"
We have less than 10 years to get our mess straightened out. In that time we need to do something drastic with health care, meaning getting its costs under control. We also need to keep a lid on discretionary spending and even cut it. Social Security payroll taxes might need to be raised a bit by 2020, or benefits cut.
In short, to avoid financial catastrophes such as government default and bankruptcy that would otherwise come in the 2020-2030 time-frame if not before, President Obama must make some bold moves. And in the opposite direction of his fan base.
Even the "rosy scenario" described above assumes keeping a lid on most spending after this year, and already includes severe cuts in defense spending.
If a President Obama merely muddles his way through, adhering to this rosy scenario, we will still see ugly deficit and debt numbers. The trouble is, not ugly enough. Obama and the Democrats could blame 3% deficits as the hangover from the mess inherited from President Bush, and do nothing to address the real problems. The trouble is that the numbers don't become truly alarming until after 2016.
Politically, President Obama could get away with it. Maybe even through two terms.
Ironically, President Obama could really be our savior. In fact, he might be the only person who could get away with what needs to be done. We are talking cutting government programs and raising regressive taxes. No Republican could do this; the electorate would hand him his head.
We should see soon which path President Obama takes:
(a) More spending and taxing, as well as massive public works projects, single-payer health care, the "Employee Free Choice" act, global warming hysteria, weakened defense, the return of the "Fairness Doctrine", etc.
(b) A political muddling through, racking up deficits in the 3% of GDP range by 2012 to 2016, but addressing no long term problems.
(c) Doing a "Nixon Goes To China" to reduce government spending. Health care reform that reduces costs. Social Security benefit cuts and/or increased payroll taxes. Real cuts in discretionary programs. And a very quick end to bailouts and stimuli.
And all this is predicated on our current recession being fairly mild and ending this year.
Optimistic? I'm not. I think we'll probably get choice (a), with (b) as a possibility. In either case, Obama's successor will have his or her work cut out for him or her. If a miracle occurs and Obama picks path (c), it won't be apparent for at least another year or two, assuming we get through this recession OK.
What we need are severe limits on government spending and real reform of entitlements, especially health care, to reduce costs. Yet both Barack Obama and John McCain completely ignored these issues in the presidential campaign. In fact, Obama promised new and expanded programs and trillion dollar bailouts and stimuli. McCain promised about the same, but without earmarks.
Maybe that's why the S&P 500 is about 35% lower than it was a year ago.