We’ve all fallen off the fiscal cliff

If the headlines from a week ago are to be believed, Congress got its act together and cobbled together a last-minute deal to avoid sending the U.S. economy off the fiscal cliff. Needless to say, I don’t believe it. Yes, superficially, the new legislation prevented the U.S. economy from becoming the equivalent of a high-speed train wreck. However, it didn’t deal with the broad, deep, fundamental problems that are weakening the foundation of the U.S. economy. We have the same problems we had before this legislation passed, and the U.S. economy will eventually go off the rails. It won’t be sudden. It will play out like a painfully slow train wreck. Rather than a couple dozen freight cars piling up in a matter of seconds, it will take a decade or two, but it will happen nonetheless.

Many journalists went over the fiscal cliff. A perfect example is Michael Sivy, who wrote a blog titled “Lots of goodies were stuffed into the fiscal cliff deal.” While increasing taxation was necessary to avoid the fiscal cliff, Sivy points out that quite a few dubious-sounding tax breaks were built into the legislation—motorsports racetracks, foreign investors, television and movie production, railroad maintenance, development in Samoa, and so on. He goes into specifics, citing the amounts of these tax breaks, so kudos for the research, but I think he has missed the point. The biggest tax break he cites is a tax credit for renewable diesel fuel (biodiesel), which amounts to $2.2 billion over five years. That sounds like a lot of money, $440 million per year, but compare that amount to the federal government’s total expenditure for 2012, $3.8 trillion, and it’s peanuts. It amounts to 0.0116 percent of the federal budget. I suspect that our representatives are pleased when journalists focus on such minutiae. As long as we’re focused on $440 million, we won’t turn our attention to the $3.8 trillion of government spending, and start asking all sorts of pesky questions about this vast amount of money. If we focused on that, and if we didn’t like the answers to our questions, we might be inclined to run down to the polling place during the next election cycle and use our ballots to throw our representatives out of office.

Lincoln Mitchell homes in on the main issue with this sentence: “…now that we have avoided that, we can go back to the steady decline that has characterized our economy in recent years.” He turns it into a political diatribe, so let’s skip that and take a look at the numbers. The Office of Management and Budget makes this easy, providing historical data on federal revenues, expenditures, and deficits, and debt.

Taking the long view, the U.S. ran up huge deficits to fund WWII; the federal debt was about 120 percent of gross domestic product (GDP). The economy grew over the decades, and by 1980, the debt was about 40 percent of GDP. Regrettably, this trend didn’t last, and we’re nearly back to where we were in the 1940s: the federal debt is about equal to GDP.

Of course, this raises a question: Why do economists compare the federal deficit to GDP? It’s (extremely) misleading because, in the words of the staff of The Economist, the U.S. “taxes itself like a small-government country, but spends like a big-government one.” Therefore, it would make more sense to compare the federal debt to the amount of federal revenue. In 1940 the money was going out much faster than it was coming in; the federal debt was $51 billion, and revenue was $6.5 billion, so the ratio was about 8 to 1. By 1980, growing revenue had reduced the ratio to 1.76 to 1. Today the ratio is nearly as bad as it was in 1940: it has grown to 6.6 to 1.

To put this into perspective, imagine you’re an average wage-earner in an average household: Your household income is about $50,000. Now let’s imagine you ran up debt on a credit card to the tune of 6.6 times your household’s annual earnings. Your debt would be $330,000. Of course, the government is facing the growing burden associated with mass retirements as the Baby Boomer generation approaches retirement age. If we were to continue the household analogy, imagine you have to deal with $330,000 in debt as your children approach the college age. Let’s throw in a crisis, such as Hurricane Sandy (your house needs a new roof), and a tenacious problem that has to be dealt with sooner or later, such as Iran’s nuclear ambitions (your car needs a new transmission), and it starts to look like your finances are a train wreck in slow motion.