What Happens if We Don’t Go Over the Fiscal Cliff?

One thing that I think people aren’t currently appreciating about the Fiscal Cliff is that congress is mostly debating how they plan to shrink the deficit, not really if they’re going to shrink the deficit.  So, whether there’s a compromise or not, the US economy is going to be facing a similar picture in 2013: deficit reduction.  (Of course, if we don’t “go over the cliff” this deficit reduction might happen slower than in a compromise, and certainly a lack of compromise wont be good for market psychology, but from a technical spending point of view the outcomes are actually rather similar.)

In order to take a look at how the US economy has fared in past periods of deficit reduction, below is some important data linking GDP growth to deficit contraction.  The chart shows the data for every year that there has been a contraction in the deficit as a percentage of GDP since 1929.

Over that time frame there have been 42 years that the government has spent less money relative to GDP than it did in the previous year, and the good news is that in the vast majority of those years, there has still been positive GDP growth.  Real GDP only contracted in 7 of those years and Nominal GDP only contracted in 3 (two of which were in the depression).  The reason that nominal GDP has fared better is that there is actually a strong history of inflation in years of deficit reduction–something to definitely watch for in 2013.

What Happens to GDP when Deficits are lower
Source: Federal Reserve

If the deficit shrinks by the full fiscal cliff amount of ~$500B next year, that would mean that the deficit would shrink by ~3% of GDP.  Below is some data to put that into context relative to other years in which the deficit contracted by a large amount in a single year.  Many of the data points are clustered around the post WWII period (when we ran our largest deficits captured by the data), but low real GDP growth and high inflation are characteristic of most of these years.

Deficit Reduction GDP

Federal Debt Compared to Household Net Worth

Much of the recent discussion about the fiscal cliff has focused on the role of the wealthy and their obligation to shoulder the public debt load.  With the debt at $16T and the relative concentration of wealth in the US, the wealthy might not ultimately have much of a choice.  The top quintile of wealth is going to have to shoulder almost all of the load.
America is a wealthy country, so technically there is enough money to extinguish the whole debt if we needed to, but it would likely take extending the scope of taxation beyond income and into wealth.  The savings rate in the US (“leftover” income) is already very low, so there isn’t a whole lot of room to tax income more without severely impacting consumption.  There is, however, plenty of wealth, but it happens to be highly concentrated because low income households don’t save much.  The top 20% of households hold 85% of the country’s net savings.
Below is a chart of what the richest Americans’ wealth looks like in relation to the Federal debt.  The Forbes 400 could only cover ~10% of the total.  The top 1% could cover the whole amount, but it would require a one time tax of 71% of their net worth (which includes assets like real estate, which would be tricky to implement).
If Uncle Sam wanted to keep a hypothetical debt extinguishment tax to 30% of an individual household’s net worth, it would have to extend the tax across the top 20% of households, which would include households with an average net worth of ~$700k (that works out to ~210k for that household).
Source: Federal Reserve, Avondale Estimates of Net Worth Based on 2007 Wealth Concentration Statistics.
Importantly this analysis only includes today’s debt.  It does not take into account the unfunded liabilities from social security and medicare.  It’s a little scary to think that the majority of American households have almost no savings and will be absolutely dependent on these programs as elderly.  These two programs combined are estimated to have an NPV liability of ~$50T, which theoretically wipes out the net worth of the whole top 20%.  Before anyone goes into crisis mode though, all that really means is that something will have to change over time.

Publicly Traded Federal Debt Continues to Rise

US Federal debt is broken down into two different categories: publicly traded and non-publicly traded.  The non publicly traded debt is typically intergovernmental debt–more specifically it is debt that is owed to Social Security.  Those who are less concerned about Uncle Sam’s debt situation tend to write off the intergovernmental debt and exclude it from Debt to GDP calculations.  This is why you may have seen widely variant accounts of what the US Debt to GDP ratio is.

It’s getting problematic to hide this debt though because the last few years of deficits have been mostly financed by floating new tradable debt.  The chart below shows publicly traded debt as a percent of total Federal debt.  Prior to 2008 the ratio was about 50/50.  Today Federal debt is nearly 70% publicly traded.  This is concerning because it’s obviously more difficult to control publicly traded debt.
The other issue is that as the Fed extends its maturities more and more, the maturity profile of the truly publicly floated debt becomes shorter and shorter.  Short term funding is what causes banks to be susceptible to bank runs and was the primary point of failure for Bear and Lehman.
Public Federal Debt as Percent of Total

What’s so Great About GDP Growth if We’re Not Building Wealth?

I’m going to be traveling for a bit until after labor day, so this will be my last post until then.  Sorry to leave everyone with a rant, but I think this is an important concept worth pondering.

One of the main reasons that our economy feels so stagnant is that our economic policies are focused on maximizing the wrong economic indicator.  We fixate on GDP growth, when in actuality this is the second derivative of what really matters for economic well being: wealth.

Wealth is most important because wealth is the key determinant of how much one can consume.  Wealth is distinctly different from income.  A person with a high net worth and no income is generally better off than a person with a high income and no net worth.  Income is important because it controls the pace at which wealth growths, but our ultimate economic goal as individuals is maximization of wealth and by extension, consumption.

In an economic sense, GDP is an income measure (even more accurately a revenue measure).  As an income measure, GDP itself (i.e. $15T) is the growth measure.  If all of GDP were saved in a year, wealth would grow by $15T per year.

As a society we follow GDP, but we are even more concerned with GDP growth (for example 3%).  This is mostly misguided because it is the second derivative of what we actually should care about.  GDP growth measures the pace at which the growth of your wealth is growing.  It is an acceleration measure.

In physical terms, wealth, GDP and GDP growth are akin to position, velocity and acceleration.  If you are trying to reach a destination, who cares if you are going fast and headed faster in the wrong direction?

If our intended economic destination is the maximization of wealth, we as a society have been failing miserably.  The charts below measure the aggregate net worth of US households: Assets-Liabilities.  Two major factors are left off of the headline number which are added back into these charts:  1) Federal Government Debt, which Ricardian equivalence argues is a direct liability on the household balance sheet 2) Inflation adjustment.
When one adds government debt and the declining value of the dollar back into the picture, the outcome is bleak.  There has been no increase in real household net worth since 1999.  If one adjusts the chart further for a per capita number it takes real household net worth back to 1997 levels.  Worst of all if we include the very real but unfunded liabilities of Social Security and Medicare (someone has to pay for these programs if not the government), household net worth all but vanishes.  
We have been failing to increase wealth because our economic policies have been designed deliberately to destroy it in order to pursue GDP growth.  Low interest rates and large deficits are policies that force more debt and inflation in order to generate GDP growth.  These policies can stoke economic activity, but do so in a way that directly restricts the accumulation of wealth by actively combating what has already been saved.  Negative real interest rates are by definition wealth decaying.  Debt wasted on an unproductive asset is similarly harmful to net worth.  The above chart implies that over the last 12 years these wealth destructive policies have wiped out all of the GDP produced during the period.  Thus our aggregate net worth has remained flat.

Our current policies are the equivalent of declaring economic war on one’s self–like tearing down a perfectly good home in order to rebuild it.  The rebuilding of the home contributes to GDP for the period, but did it make the dweller any better off?  Destroying and rebuilding valuable assets doesn’t increase wealth it destroys it.

Why do we as a society continue to push our foot to the gas pedal trying to go as fast as we can in the wrong direction?  What is the value of producing one more widget per year if we destroy two saved widgets in order to do so?  When will these destructive and misguided economic policies end? Sadly, it probably wont be with any official running for office today.

Is "Fiscal Cliff" taking mind-share from "BRIC" and "PIIGS"?

Last week I posted a chart comparing “fiscal cliff” on google trends to “green shoots” and “moral hazard.”  Since then, I thought of two other good terms for comparison: “BRIC” and “PIIGS.”  Below is a chart comparing these. Somewhat surprisingly, fiscal cliff has overtaken references to PIIGS and BRIC in news reference volume.