Over the past five years, the government has applied the usual demand-side remedies in the epic battle against The Great Recession. The graph shows the time profile of past recessions and recoveries as compared to the Great one that we are still in. Though stimulus has been applied in heroic proportions, the employment high ground of five years ago has not been revisited. This graph clearly reveals this recovery lags all others in the post WWII era in which stimulus spending was considerably lower.
At this moment in history, the realization that continuing to run deficits to win the recessionary battle is compromising the ability to win the war of fiscal sustainability — and without that goes future entitlements, at least in real terms. Thus a trade-off of now vs. the future needed to be confronted.
As former Wells Fargo CEO Richard Kovacevich puts it, at the end of the day, the fiscal cliff deliberations continued to put the stimulus on the overstretched Federal Credit Card. In his words our federal budget is equivalent to a family earning $22,000 per year, but spending $38,000 per year with an existing credit card debt of $143,000. The next leg of the saga is to raise the debt ceiling so we can continue to max out a higher credit card limit.
What all this did was to reveal in plain sight that our leaders, who are likely a reflection of our population at large, are members of the Now Generation.
Overcoming our current inability to deal with the bigger problem of fiscal sustainability is key to economic growth as well as maximizing future fiscal proceeds and government benefits. To do so requires an inter-temporal trade-off.
This is a classic test of immediate vs. deferred gratification.
This trade-off was memorably tested in the “Marshmallow Experiment” of children aged 4 to 6 by Stanford psychologist Walter Mischel who found in a follow-up study that children who were capable of deferring gratification eventually went on to earn higher scores on their SATs and achieved other life accomplishments that require some front-end investment.
Now it is important to note that the Stanford Marshmallow Experiment offered higher returns as compared to present returns. That is, the promise of two marshmallows later vs. one today was made by Professor Mischel, not the U.S. fiscal system.
In our case with projected growing entitlements, we just can’t vote them in and expect them to happen. We need an environment that would be conducive to fiscal discipline so as not to allow unaffordable debt overhead, lest Reinhart and Rogoff effects of slower growth and government default set in. While this might seem Utopian it has happened, even in the U.S.
The Gramm-Rudman-Hollings Balanced Budget Act nearly 30 years ago addressed the issue of defining a framework to self-control government deficits. Basically, the Act created the requirement that adding a dollar of spending would require identifying a specific spending reduction. This caused each dollar of additional spending to be traded against some existing obligation as a yardstick of value.
Well you can image how popular that was, even then, when leaders could pass the marshmallow test! Regrettably, the automatic self-constraint mechanism was found to be unconstitutional and was replaced by a succession of legislation that watered down the spending and deficit constraints and brought us to our current state of allowing debt to compromise the economic growth engine along with fiscal sustainability.
In today’s societal trade-off, Congress likely has already put us in an environment in which one marshmallow today will only perhaps generate a fraction of a marshmallow tomorrow. That is, growing marshmallows for the future requires deferred gratification today so that today’s debt is not a deterrent to economic growth and future government revenues and marshmallows.
One factor that reinforces the lack of will to bring about deficit and debt control that could lead to additional future marshmallows is the unwritten American ethic to not willingly fork over to the federal government more than 20 percent of annual GDP in all forms of collected taxes. If individual income tax rates would generate Treasury Revenue that exceed that proportion of total GDP, deductions and exemptions have been added to the tax code to keep the checks written within society’s actual shadow ceiling.
Even during the height of WWII, with an economic boom and confiscatory individual and corporate income tax rates, the government was only able to raise an income share of 20.9 percent of GDP from all tax sources — even though the federal spending shares of GDP was 43.6 percent in that wartime period.
Since then, only capital gains of the tech era generated a Treasury revenue share of GDP barely in excess of 20 percent of total income. The state of the economy is the primary determinant of the Treasury taxes paid, so a slow-growth economy spells big trouble for the deficit almost irrespective of tax rates being agonized over in Washington.
The rates that Congress does apply are more for political showmanship and a statement of the collective values, wants and needs of its members rather than a reflection of actual revenues received — though I doubt most of them realize it.
In 2011, the Treasury collected only 15.4 percent of total GDP against spending of 24.1 percent, accumulating debt equal to 8.7 percent of the current GDP pie. This will continue for as long as the eye can see or until the deficit can no longer be financed or pawned off on the central bank.
On top of those implicit American inhibitions, the issue of shared sacrifice in the face of imminent danger is also a passé American ethic, as discussed here by Lacy Hunt. In 2011, the bottom half of the income spectrum contributed but 2.4 percent of individual income taxes receipts, and the recent taxing the “wealthy” adjustment only reduces that proportion.
We can only guess what tomorrow’s marshmallow allotment will be. But with no deferred gratification constraining debt blow-up, no shared sacrifice, and no willingness to give up more than 20 percent of GDP, future gratification will fall on the back of the central bank until inflation inescapably reduces tomorrow’s marshmallows in real terms.
If there is any rationality to it, what Congress and the President seem to be saying is that they realize there is no Professor Mischel to supply two future marshmallows and that the government’s ability to do so is already lost, except via money illusion of the printing press. So, their logic has become, deferred gratification on our watch is senseless.
Investors thus far have been concerned that would be the unintended consequence, but it now appears to be the unspoken plan. Investors would be wise to protect themselves.
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