Whatever Happened to the “D” Words?

October 20, 2014.   Having just published a book predicting a federal debt default in 2021 (and describing what can be done to prevent it), I am beginning to feel rather lonely. Everyone seems to have forgotten how close the country came to financial Armageddon six years ago. The “occupy” movement petered out. The “tea party” fervor peaked and is heading toward irrelevance. And concerns about the fiscal dangers to American governments have gone from front page news to deadening silence. Even in the midst of hard-fought election campaigns, you have to listen really hard to hear any of the “d” words—deficit, debt, or default. Part of that is the normal news cycle—issues like ISIS terrorists, the Ukraine, and Ebola have understandably dominated recent news. But it is also that a sense of complacency has emerged as the financial crisis and Great Recession have diminished in the rearview mirror.
Five years of sluggish economic growth and a smattering of austerity measures have reduced the federal deficit and improved the fiscal condition of most states. Even the perennial fiscally challenged state of California has managed to balance its budget (more or less). The federal deficit has fallen to under $500 billion in FY 2014 (October 1, 2013 to September 30, 2014), from a stimulus-induced high of just over $1.4 trillion in FY 2009. Both of these minor miracles have been accomplished with the help of a surging stock market and some smoke and mirrors. In the case of the federal government, some austerity in the form of tax increases and expense tightening have helped reduce the deficit. But the bulk of the “savings” have come from the extraordinary fiscal and monetary interventions in the economy. And the most significant area of actual expense reduction is the result of the military withdrawals abroad.
The federal government now essentially owns and controls the mortgage business in America, through its takeover of Fannie Mae and Freddie Mac. In FY 2014 the government received an estimated $70 billion from these two GSEs (Government Sponsored Enterprises). That source of offsetting receipts is expected to largely disappear in the future, and will become a negative outflow from the Treasury when Fannie and Freddie incur losses. The GSEs are no longer allowed to build capital reserves against future losses, which will now be absorbed in their entirety by the taxpayers during the next downturn. Meanwhile the Federal Reserve currently owns $2.5 trillion of the federal debt and $1.7 trillion of mortgage-backed securities. After expenses, the Fed returns the interest earned on this debt to the U.S. Treasury, to the tune of $100 billion in FY 2014. This source of revenue will also decline, as the Fed has been winding down bond purchases (quantitative easing) and will eventually begin to liquidate its positions.
The bottom line is that about $170 billion of current federal receipts are direct short-term effects of extraordinary fiscal and monetary interventions. Many billions more have been collected by the federal government (and state governments) from banks and other businesses since the recession. The four largest banks alone are reported to have paid approximately $100 billion in fines and penalties during recent years. Tax receipts have also been helped by the Fed-induced increase in asset values, particularly the artificially fueled rise of the stock market. The resulting capital gains, dividends, and bonus distributions make for a very convenient (and fleeting) source of high rate taxable income. On top of all these one-time financial benefits, the U.S. government is paying interest on the ever-growing debt at historically low rates, which will eventually (possibly soon) begin to increase.
How much further will Washington be willing and able to control spending? Some of the belt-tightening has already been reversed; and the military savings are likely to disappear in response to a very unstable world situation. At the same time, we are just now beginning to see the tidal wave of baby boomer retirements. That means millions and millions more long-lived retirees collecting Social Security and Medicare for more and more years. And then there is the cost of another recession—the last one doubled the federal public debt in four years as a result of lower tax receipts, stimulus spending, and increased benefit payments. No one likes to use the “r” word either, but the average time between recessions has historically been about six years—which is right around the corner. When the next recession does arrive, the government and the economy are ill-prepared to deal with it and to find a way to climb back out again.
According to my calculations, the real federal deficit (the difference between continuing revenues and expenses) remains at $750 to $800 billion. That is better than immediately post-recession but still in the danger zone. And the deficit is almost certain to start to increase again, even before the next recession and without the expected interest rate increases. When either or both of those events are factored in, the numbers get downright scary. The federal debt is $12.8 trillion at the end of September, 2014, not including the $5 trillion the government owes itself. That is the most the federal debt has been, as a percentage of the economy, since the one-time massive borrowing for World War II. And that does not include the trillions of dollars in state and local debts or the several trillion dollars of unfunded public pension liabilities. Unfortunately the numbers speak for themselves—we are nowhere close to being out of the woods.