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Granny, Deficits and Financial Repression



May 03, 2013 – Comments (0)

Board: Macro Economics

Author: yodaorange

A critical part to not repeating mistakes is to learn what went wrong in the past. You might recall some of my posts that insist you must ask the right question(s) to get the right answers. If you cannot determine the right question, the odds of finding the right solution are dramatically decreased.

Recently it has been widely reported that the US Federal Budget Deficit as a percentage of GDP is dropping and will continue to do so. Another METARite referenced a Calculated Risk blog post that discussed this. [1] The post quoted Goldman Sachs chief economist, Jan Hatzius, that listed the three main reasons for the sharp reduction in the deficit:

1) Lower spending
2) Higher tax rates
3) Economic improvement i.e. GDP growth

I can agree with Jan that the deficit is shrinking and all three of his points are correct. What I am dumbfounded about is that he TOTALLY OMITS the NUMBER ONE REASON the deficit is shrinking. It is not just Jan, but Bill McBride who is a great guy, totally omits it also on Calculated Risk. Matter of fact, I do not recall seeing anyone properly identifying the number one factor.

To illustrate, I will use a simple case, then back it up with actual numbers.

How to grow GDP, reduce the deficit and make the world a better place in one easy step

1) Have the US take in $2.5 trillion in tax revenues

2) Have the US spend $3.5 trillion

3) Means that the US borrows $1 trillion

4) Since government spending is a direct component of GDP, the GDP just grew by $1 trillion. This is out of about a $15 trillion base. So without the extra $1 trillion GDP shrinks to $14 trillion, which would be a 6.7% REDUCTION in GDP.

5) Somewhat exaggerated the US Treasury can borrow the $ 1 trillion at ~ 0.00% interest rates.

6) Bottom line of this one year event is that the current year deficit, NOT the cumulative deficit, will NOT grow since the borrowing costs are zero

7) Since GDP goes up, the debt to GDP ratio SHRINKS.

8) It is a great game made possible by the ability to borrow at zero interest rates. This is where financial repression comes in. As you might imagine, if interest rates dramatically increased, the game no longer works. This is why financial repression is likely here for a decade or longer. Financial repression is the single largest factor on why the debt/GDP is shrinking. All of the factors that Jan listed are way down the list. . .

So you say: “Yoda, how much did financial repression reduce the Federal Budget Deficit in Fiscal 2012?”

The answer is ~ $366 billion. The reported deficit was $1,086 billion. The interest expense component was $359 billion. This works out roughly to an overall interest rate of 2.24% for all of the US debt ($16,050 billion.)

The overall interest rate in 2008 was 4.52%. Financial repression has reduced the rated from 4.52% down to 2.25% which is where the $366 billion come from.

So what is NOT to like. Lower annual deficits. Increased GDP growth. Decreased debt to GDP ratio. All is well.

. . . except for Granny. Granny messed up and thought she could count on her CD’s paying a positive real interest rate of about 2.0%. She thought wrong. Her income gets sacrificed at the altar as part of helping the overall US economy. It would be nice if Jan and Bill would at least thank Granny for her sacrifice in helping the debt/GDP ratio.

The larger problem is that once again if you omit the number one factor, you will probably target the wrong solutions. Maybe none of us will live long enough to see financial repression end. You have to think that eventually interest rates will normalize. WHEN, NOT IF they do, you have a problem. The US will no longer be able to borrow at zero interest rates . . . and that is the problem that Jan, Bill and others ignore in their analysis. They should at least put a footnote that says something like: We are assuming Financial Repression does NOT end. If it ends, all bets are off.

Here is the actual data from the US budgets. The interest rate is a simple calculation from the interest expense divided by the cumulative budget deficit. This is an approximation as there are all kinds of bills, bonds and notes being issued all of the time. The approximation is still indicative of what is really occurring.

[See Post for Table]



[1] Calculated Risk: The Rapidly Shrinking Federal Deficit

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