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Monday, June 17, 2019

Time for Congress to Plan for Fiscal Panic

We are heading for a recession, and with this recession things are going to get rough. Really rough. Congress is entirely unprepared - but they don't have to be. They can alleviate the situation, even as divided as they are today.

The core of the problem, of course, is that Congress is  running a staggering budget deficit:
The federal deficit in May reached $208 billion, surging 42 percent over last May’s monthly deficit figure, according to new Treasury Department data released Wednesday. The figure put the cumulative deficit for the eight months of fiscal 2019 at $739 billion, within range of the full 2018 deficit, which amounted to $779 billion, according to the Treasury figures. Treasury estimates that the full deficit will exceed $1 trillion by the time the fiscal year wraps up at the end of September.

We should not have a deficit of this size - 25 percent of total spending - smack in the heart of the strongest economy in decades:
  • Unemployment is at 3.9 percent, the lowest it has been since 1969;
  • Workforce compensation is increasing almost at three percent per year, faster than it has in ten years;
  • Workforce participation has finally stabilized, after declining steadily for over a decade; 
  • In 34 states, unemployment is below four percent, and in eleven of those the rate is below three percent. 

GDP growth is finally above three percent (four-quarter moving average) which is not spectacular - it was above three percent for three quarters in 2015 - but the growth rate has been accelerating for eight quarters in a row now. This shows underlying strength, and together with the numbers from the labor market it means that we are at the peak of the business cycle.

As I have explained before, this cyclical peak will soon come to an end, a point that makes the current budget deficit even more serious. With the latest Treasury budget report pointing to a $1.1-trillion deficit for the 2019 fiscal year, we are headed for a fiscal disaster once the inevitable recession comes. 

Yes, a disaster. The reason is a combination of an inefficient tax reform and the complete inability of Congress to keep spending under control. This combination sets us up for a disastrous fiscal situation.

Some conservatives, and a lot of Republicans, have lauded the tax Trump reform as a great achievement and boost for the economy. Yes, it was good compared to the alternatives, and it gave our corporate sector a badly needed rebalancing of their tax burden. That said, though, it did not boost the bottom line of the household sector nearly as much as would have been needed; once they have reaped the full benefits from the changes to the corporate income tax, there will not be enough steam in the economy to sustain our current growth levels. 

To do that, we need an across-the-board alleviation of the tax burden on America's families. Although 79 percent of the personal current taxes we pay are federal - the rest being a combination of state and local personal taxes - most middle-class families pay relatively little in federal income taxes. Two thirds of all federal personal income taxes are paid by 20 percent of all individual taxpayers; the distribution of state and local taxes is far more even. 

In other words, if our economy is going to see more growth and another boost in household earnings, we need a widespread reduction in state and local personal income taxes. Since that is not going to happen, at least in a concerted fashion, and since Congress in its current majority configuration is as likely to pass another tax reform as they are to cut spending, we will simply have to accept that:

a) There is a recession coming, and
b) It will lead to a rapid, massive increase in the federal budget deficit.

To get an idea of what we can expect, let us go back and look at the last two recessions. In the Millennium recession the budget swung from a surplus (yes!) of 13 percent of spending to a deficit of eight percent of spending. That is a 21-percentage point shift. However, that was nothing compared to the growth of the deficit in the Great Recession: even though we already had a deficit of six percent of spending in 2008, in just one year that had ballooned into a deficit of 15 percent of spending.

Thanks to Obama's useless American Recovery and Reinvestment Act (ARRA), the deficit exploded into 40 percent of spending in 2010.

Let us we disregard the very large swing from the Millennium Recession and the ARRA, and instead stick to just the one-year deficit expansion in 2009. Doing so, we get the following scenario for a recession in 2020:
  • According to the Office of Management and Budget, the estimated budget deficit for 2019 is 20 percent of total federal spending;
  • Total spending, in turn, is now above $3 trillion in the first eight months of a calendar year and will likely top $4 trillion for the whole year;
  • A deficit of $1.1 trillion - as predicted by the Treasury - is 27.5 percent of outlays;
  • Another ten percentage points of spending would add $400 billion, taking the deficit to $1.5 trillion.

This, however, is a mild scenario. Given the sharp increase in the deficit in the Millennium Recession - a mild recession compared to the Great Recession - a more reasonable scenario would be that the deficit increases by 20 percentage points, to 47.5 percent of total federal outlays. 

Now, all of a sudden, we are looking at a deficit of $1.9 trillion.

This is equal to the budgets for defense, Medicare and Medicaid, combined. To balance the budget Congress would have to shut down all these three programs - completely.

Either that or basically double both corporate and personal income taxes.

And we haven't even talked about what a rise in interest rates would do. If the interest on the already-existing federal debt went up by one percentage point, that cost increase would eat up every time that the federal government currently collects in corporate income taxes. Just a one percentage-point increase.

There is no other way to put this: we are staring into the barrel of a fiscal crisis of Greek proportions. We have run out of options to money-print ourselves out of this, and we have nowhere to raise taxes without hitting the 80 percent of taxpayers that currently only pay a third of all federal taxes. 

Even if we doubled the corporate income tax and not a single corporation did anything to alleviate the increase - as probable as life on the moon - it would only bring in another $250 billion. Barely a dent in a $1.9-trillion deficit. 

As for the interest rate, a much more likely scenario is that a deficit of the proportions discussed here will increase the rate toward 4.5-5 percent. We are now talking $600-700 billion in extra spending - just to pay interest on existing debt. Never mind the new debt that will be added in the next recession.

It does not matter which way we slice the recession scenario: there is no way for Congress to avoid the dungeon of fiscal panic. Unfortunately, Congress is deadlocked by the Democrats' insane hatred for our president and the inability of Republicans to even unite behind something as minute as Rand Paul's penny plan. Therefore, we can expect interest rates to shoot up sharply with the next crisis, and we can expect there to be a lot of chatter about tax hikes - especially if the deranged socialists in the Democrat party continue to dominate their 2020 presidential candidate field. Both these variables will depress economic activity, first in the corporate sector and then in the form of stagnant household spending.

There is still something we can do, though. It is not much but at least we can ask Congress for two things:

a) At least start conceptualizing the fact that you may have to make drastic, rapid and merciless spending cuts to avoid an implosion of the U.S. economy; and
b) Make an agreement to protect national defense and Social Security from those cuts; these are the two biggest programs and should appeal to each side of the aisle.

With this agreement in place, Congress can start tackling cuts in all other programs, no matter how painful those cuts will be. The alternative, namely, is to let the country go under. Literally.

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