The Thoughts that Haunt Me

A profligate government bureaucrat with you behind him!
(c) Can Stock Photo

More and more, the words haunting me are the ones I wrote in the final sentence of my last post:

The federal debt may be the single biggest threat to national security — bigger even than Russia, China, Iran, or North Korea.

What truly scares me is the federal government is allowing the national debt to increase without paying it off. Consistently, the federal government simply rolls the debt over. What this means is that as treasury bonds mature and the government must pay back the principal as well as interest for all the other outstanding bonds, they do it by selling more bonds to get the money for these pay-outs. The debt is not only not paid off, but it is increased by the interest the government must pay on it! As long as this is true, the national debt will increase at a rate that is directly proportional to the size of the debt. This is the very definition of exponential growth!

The Nature of Exponential and Super-Exponential Growth

Suppose that the number of dollars in the national debt is given by N, and that it increases over a period of time dt by the amount dN. Then if N increases at a rate directly proportional to itself, for example at an interest rate r, its rate of increase is given by

Those of you who know calculus will recognize a differential equation when you see one, but for those of you who do not, fear not! The only thing you have to appreciate is that the solution to this equation is given by

where N(t) indicates N is a function of time, N₀ is the value of N at t = 0, and e is a constant called Napier’s constant, which is approximately equal to 2.71828… Plots of N(t) for various values of r are shown below.

If r is negative, the growth becomes decay, giving the curves decreasing in amplitude with time. Notice that for any one value of the interest rate r, the rate of increase of the national debt becomes faster as time goes on. This is because the rate of increase is directly proportional to the amount of the debt itself and this value is increasing with time. You can see from the various plots as the interest rate increases, the growth of the debt becomes ever more explosive. If the interest rate is itself a function of time and is increasing, then the growth becomes even more explosive and is called super-exponential and in mathematics such a process is called a tetration.

Of course, our interest rates do indeed change with time, primarily at the behest of the Federal Reserve. It is because of the possibility of super-exponential growth of the national debt that I have thought it unlikely that the Federal Reserve could significantly raise interest rates anytime in the near future; or at least it is one of the reasons. After all, after its short hiatus with sequestration, the federal debt is once again on the increase, as shown in the plot of it below.

Currently, the national debt stands at 105.7% of GDP! Research by the economists Carmen Reinhart and Kenneth Rogoff has shown that once the national debt of a country exceeds 90% of GDP, the denial of economic assets to the private economy just to finance the national debt progressively decreases the growth of the economy. They conclude:

Median growth rates for countries with public debt over roughly 90 percent of GDP are about one percent lower than otherwise; average (mean) growth rates are several percent lower.

And of course the lower the GDP, the less the tax revenue of the federal government and the more it will have to add to the debt with deficit financing.

We are rapidly approaching the point of time at which exponential growth of the debt will begin to overwhelm the federal government. The Heritage Foundation has estimated that by 2035, less than two decades from now, if nothing is changed in federal expenditures, then entitlements (Social Security, Medicare, and Medicaid) will absorb around 34 percent of the GDP. Not of the federal budget, but of the GDP! Since federal revenues have typically been around 19 percent of GDP, entitlements, which are the fastest growing part of the federal budget, plus interest payments should totally absorb every single penny of federal revenues long before 2035.

How long before this catastrophe happens? That will depend quite a bit on how we decide to attack the problem, but a guess of five to ten years would not be entirely unrealistic. If this prospect does not panic you, it should! For once we reach that point, the government will not have the net income after paying for entitlements and the national debt to do anything else at all. That would include defending us from ISIS, Russia, China, and Iran.

The Basic Economic Problem

At this point we should review what it takes to have a healthy, growing economy. In a healthy economy that is providing for current needs, the demand for any one good and service is balanced by its supply. Because these supply-demand balances are determined by microeconomics with the economic values of individual consumers and suppliers, intrusions by the state into the internal workings of the economy almost always mucks up the system. That is the fundamental reason why only a free-market economy can be truly healthy. If you are not persuaded about this basic fact, please read the posts Why Socialism Does Not Work, Adam Smith’s “Invisible Hand” and Evolution, Central Planning for Chaotic Social Systems, How to Solve Problems in Chaotic Social Systems, and Chaotic Economies and Adam Smith’s Invisible Hand.

These considerations certainly tell us that when government begins to allocate a large fraction of available economic resources for what politicians think is best, the economy and its growth will suffer. In order for there to be growth, an appreciable fraction of the economy’s output must be saved and not consumed for net investments over and above what is required for replacement investments. This is true even for mature economies such as ours, in which growth will come by investments to increase total factor productivity. This process is described in the post The Solow-Swan Model and Where We are Economically (1), plus the second and third essays in the same series.

Who should get the assets for investments and decide their allocation, if not the government? I suggested in Distribution and Use of Wealth in U.S. Capitalism that a natural and efficient mechanism for deciding this question is provided by free-market capitalism. Every citizen with money in his or her possession can vote on which and how many goods will be produced: one vote per dollar. The reason why we want people possessing more dollars to have more votes is they are precisely the people (on average) who have made the wisest past decisions to maximize economic growth. If some of these members of the highest economic strata make unwise economic decisions, the market will take dollars away from them and award those dollars to people who make wiser decisions. Then by allowing prices to seek their market prices according to the Law of Supply and Demand and the Law of Marginal Utility, the economic demands of people will be optimally satisfied under current economic conditions. Not only will they be optimally satisfied, but they will be most efficiently satisfied with the least waste of resources, and with maximal economic growth over time.

There is actual empirical evidence that we should want to minimize the government’s role in the economy, which I discussed in the post The Rahn Curve, Hauser’s Law, the Laffer Curve and Flat Taxes. In that essay I demonstrated that the Rahn curve — a plot of GDP growth versus government expenditures as a percent of GDP — is an accurate description of economic reality. In particular I showed that at least since the first quarter of 1947 to the present, we have been on the descending branch of the Rahn curve, where increasing government expenditures decreases GDP growth.

Since the mapping of the Rahn curve to the Laffer curve — a plot of government revenue as a function of effective tax rate — is at least conceptually simple, being on the descending branch of the Rahn curve means we are also on the descending branch of the Laffer curve. This implies that increasing tax rates will decrease government revenues because they would take asset allocation away from the private sector of the economy and give it to the government, thereby decreasing GDP growth. As we all should know from hard experience, the government almost always makes bad investment decisions.

Finally, Hauser’s Law tells us from 1945 to the present federal tax revenues have almost always been around 19% of GDP, come rain or shine and no matter what the tax rates. This is demonstrated in the plot below.

This data tells us, along with the Rahn curve and the Laffer curve, that increasing tax rates would be profoundly counterproductive. Increasing the tax rates would decrease economic growth, so that government revenues — which are almost always 19% of GDP, no matter what the tax rate — would be less than what they would have been with a lower tax rate. In fact, all of this data should inspire an epiphany that a flat tax of around 19% would be optimal.

How We Got Into This Fine Mess

How did we get ourselves into this awful mess? With such an immensely complicated subject as the economy of a great nation, one should not be surprised that several factors have contributed to our present plight. Below is at least a partial list of relevant explanations.

1. First among the explanations is the dominance Keynesian economic doctrine has had ever since the Great Depression of the 1930s. Relying on it, politicians have felt they could safely interpose their economic judgements over those of the free-market. Almost everything I have written in the Leftist Vs. Neoclassical Economics theme, the Economic Crises theme, The Federal Reserve and Central Banks theme, and the State of the Economy theme shows this to be a profoundly mistaken assumption. Because of the reliance on Keynesian economic ideas, our economic progress has been far less than what it might otherwise have been.
2. More particularly, government regulations have had a strangle-hold over many businesses, particularly small businesses. Examples of these economically destructive effects can be found in the posts The Burden of Economic Regulations, The Debilitating Effects of Obamacare, Economic Effects of the Dodd-Frank Act, and The EPA, CO2, Mercury Emissions, and “Green” Energy. Every reduction of GDP due to excessive government intrusion into the economy digs the government’s financial grave yet a little deeper.
3. Consideration of the Dodd-Frank Act from the last list item suggests we have used corporations and businessmen as undeserving scapegoats for our economic troubles. If one looks very hard at the historical evidence of past economic crises, one can discern that government actions have been the primary causes of crises over the past century, particularly of the Great Depression and of the Great Recession. Such perceptions of market failures and culpability rather than government failures have led us to damage our economy with excessive regulations on companies, rather than address the real causes of government economic interference.
4. Then there are the attempts by Keynesians to use monetary policy to stimulate economic growth, given their long-running, misplaced faith in some version of the Phillips curve. Yet long run low interest rates in pursuit of a stimulated economy has only given us long-term economic damage. In particular “stimulative” monetary policy has discouraged savings, and inflated asset bubbles in the real estate market and in the stock markets.
5. Finally there has been the looting of the Social Security Trust by politicians (particularly Democratic politicians) to fund government projects. In the process they have converted Social Security into a Ponzi scheme, where current retiree benefits are funded by younger and fewer workers. This means that now the difference between Social Security pay-outs and payroll taxes must be funded directly by the federal government’s general fund. This is the fastest growing part of the federal budget. In fact the entitlement programs — Social Security, Medicare, and Medicaid — currently account for about 44% of all federal spending, By contrast the Defense Budget at less than 20 percent of federal outlays is less than half the size of the entitlements and has been declining, not increasing.

The Progressive (Non) Solution

The position progressives take with the national debt problem, to the extent they address it at all, is either to transfer spending from the Defense Department to paying for entitlements, or to increase taxes as both Bernie Sanders and Hillary Clinton have proposed. Yet, we have already shown that the entire Defense Department budget would provide less than half what entitlements are costing right now, and entitlement spending is increasing rapidly. In addition, as discussed in The Decay of U.S. Armed Forces, the world is becoming immensely more dangerous with growing threats from ISIS, Russia, China, and Iran. If anything, we will have to increase our defense budget just to survive.

As we also have seen, to increase taxes would be financially suicidal for the government. The Rahn curve tells us that increasing government expenditures will cause GDP growth to fall, while the related Laffer curve tells us that as tax rates increase, government revenues will fall. Both of these statements remain true even if you only increase taxes on the leftist-despised “1%”. I argued in Do the Rich Pay Their Fair-Share of Taxes?  that any increase in taxes on the wealthiest would result in a similar reduction in the country’s total investments. If taxes on high income households are increased by 10% to 15% of GDP, the total investments would be reduced by similar amounts. After all, what the filthy rich consume in any one year is usually a very small fraction of their income and wealth. Therefore, if they are not saints (and how many of us are?), they could easily provide what additional is taxed by reducing the capital they invest by a similar amount, leaving their personal consumption unchanged. Any increase in taxes on the wealthiest would result in a similar reduction in the country’s total investments. As investments fall, so will GDP growth. There is just no way for government to win by increasing taxes.

How We Can Stave Off Catastrophe

Yet, there are ways in which government debt can be brought under control. First and most importantly, since they are the single largest and fastest growing part of the budget, entitlements must be brought under control. I have suggested several ways in which this can be done in The Hard Work: Cutting Entitlements. Secondly, all of those destructive government regulations impeding economic growth should be severely pruned. Prominent in the list of things to do should be total repeal of Obamacare and the Dodd-Frank Act.

In the fourth branch of government, the Federal Reserve, Congress should replace the Fed’s current mandates with the single mandate of maintaining a constant value of money. To that end they should consider requiring the Fed to adopt a monetary rule.

Finally, the federal government must reduce taxes, especially on corporations. Currently, as The Tax Foundation informs us, the “United States has the third highest general top marginal corporate income tax rate in the world at 39.1 percent, exceeded only by Chad and the United Arab Emirates.” While the U.S. has a top marginal rate of 39.1%, the worldwide average top corporate income tax rate is much lower at 22.6%. Europe has the lowest average rate by region at 18.6%. Not only do our tax rates diminish U.S. companies’ competitiveness, but they also provide U.S. companies a tremendous incentive to leave the United States and relocate in a more capital-friendly country. Also, the Tax Foundation tells us  that overwhelmingly economically-developed countries are adopting a territorial approach to taxes. At the present time the U.S. taxes U.S. corporations on all profits earned anywhere in the world, but defers them until the profits are brought back to the U.S. This worldwide approach to corporate taxation is being  challenged by the more frequently used “territorial approach” of other countries.  This usual international practice is to tax corporate income only in the country where it is earned. Both the size of corporate taxes and the world-wide tax approach severely limits the competitiveness of U.S. companies against foreign companies, even here in the United States.

If we can accomplish all these goals, we might yet stave off total economic collapse of the federal government. However, the longer we wait, the more painful it will be.

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