By Ben Strubel of Strubel Investment Management. This article appeared in our December 2011 newsletter. To subscribe go here.

Many people, particularly politicians, use their household budget as an analogy and a starting point when discussing the U.S. federal government deficit and debt. Let’s examine that common comparison and discover how and why that’s an egregious error. To start, we’ll build a simple household budget.

The median household income in 2009 was $50,221. To make our sample household budget simple, let’s round the amount up to $50,400 ($4,200 a month) and let’s say it’s all after-tax income.

A monthly budget for our fictional household might be as follows:

Income $4,200
Housing Costs: $1,470
Food: $550
Apparel: $170
Travel & Transportation: $670
Healthcare: $250
Entertainment: $250
Miscellaneous Expenditures: $400

Total Spending: $3760
Budget Surplus: $440

 

Our household budget doesn’t look too bad. The savings (or surplus) might be a little low, but other than that things look fine. It’s also important to realize for households having a budget surplus is a good thing. The bigger the surplus the better from a standpoint of financial stability.

Now let’s say one of the earners in the household loses his or her job and is unable to find another one (shouldn’t be much of a stretch to imagine this in the current economy). Now household income drops to $3,000 per month. How can we fix the budget? The answer is easy: Start cutting expenses.

We need to find $760 in expenses to cut to balance the budget. No more eating out, so we will save $200 per month. Miscellaneous expenses can be cut too, down to $200 per month. Now we need to cut another $360 in expenses. Only one person is traveling to work, so transportation costs should drop. Remove vacations, and we might get the travel and transportation line item down to $500. Slash entertainment and start shopping at discount stores to reduce the apparel line item, and now the budget is in line with the reduced income. Piece of cake! Sure, we had to make some tough and probably unpopular choices for the family, but we did it. Part of the reason we could do it is we had complete control over most (if not all) of the budget line items and we knew exactly what our income was.

Well, it’s different for the U.S. federal government.

The federal government doesn’t work like households for a number of reasons. First, the government’s revenue is not fixed like a worker’s salary might be. Most of the government revenue comes from individual income taxes (45% in 2008), payroll taxes (36% in 2008), and corporate income tax (12% in 2008). Those tax payments are highly dependent on the level of economic activity each year. Full employment and upward pressure on wages would lead to higher tax revenue. Recessions, high unemployment, and deflationary pressure on wages leads to sharp drops in tax revenue. Thus, it is impossible for the government to know with a high degree of certainty what tax receipts will look like in any given year.

Second, government expenditures are not fixed either. With a household budget, expenses can be greatly adjusted. For example, individuals can buy clothing from a luxury retailer versus a discount store or a thrift or Goodwill store. Almost any line item in a household budget can be changed up or down. Again, government budgets differ in that many expenses are not fixed but depend on the health of the economy. In a healthy economy with full employment, welfare, S.N.A.P. (food stamps), unemployment insurance, social security disability, and a myriad of other federal aid program payments fall. These types of outlays are referred to as automatic stabilizers. During good times the payments fall, but during recessions they increase so as to “stabilize” the economy. During a recession more people will go on welfare, need food stamps, file for unemployment benefits, and file for social security disability. In addition, some non-obvious expenses increase. High jobless rates are associated with high rates of depression and other medical problems, leading to increased usage of healthcare resources. Crime tends to go up as well (although this phenomenon has been strangely absent in the current recession in the United States).

In short, the federal government has very little direct control over the budget deficit. In a healthy economy, the deficit tends to shrink or stay small as tax revenue increases and automatic stabilizer expenses fall. In a recession, the opposite is true. In a recession, government spending naturally rises and makes up a larger portion of the aggregate income for the private sector. It is not the result of specific policies or an indication that the “size” of the government is growing. It simply reflects the drop in private sector activity and subsequent tax payments, and the rise in government outlays.

Let’s say you want to reduce the deficit.* What should you do?

*It’s important to remember that for countries like the United States that operate in a floating exchange rate, sole issuer, non-convertible currency system deficits are neither good nor bad. The deficit should simply be high enough to ensure full economic activity, including full employment. The only thing to worry about is inflation.

 

Goofus Tries to Reduce the Deficit

Goofus decides the deficit in his country is too high and needs to be reduced. Since Goofus has a poor understanding of both economics and history, he decides to go the austerity route, which is to cut government spending and raise taxes. It can’t be any more complicated than that, he thinks.

Goofus implements a package of reforms similar to what the U.K., Australia, and many countries in Europe are pushing through. Goofus lays off large numbers of government workers. He slashes social assistance programs like jobless benefits, pensions, and healthcare programs. That should save money on the cost side. Now on to new revenue. Goofus decides to raise taxes on real estate, income, and consumption. The preliminary budget estimates look good, and Goofus proudly announces the country’s budget will be in a surplus very soon (just like many of those European leaders).

Except something strange happens. All those government workers that Goofus laid off now don’t have any income to spend. They stop going out to eat and stop going to the movies. They put off buying a new car. They don’t buy any new clothes. And what about the pensioners who saw their monthly incomes reduced? They cut back on spending too. People who are lucky to have jobs look around and see their friends and neighbors getting laid off. Although they still have income, they are reluctant to spend it. After all, if Sarah in the office beside you got laid off you might not be far behind. Better put off that purchase of a new TV. With less traffic in their stores, retailers begin to lay off employees. Manufacturers, in turn, see less demand for their products begin to close factories, reduce hours, or shut down production lines.

What about those new taxes Goofus implemented? People without jobs don’t pay much in income taxes. People who don’t go shopping don’t pay much in consumption taxes.

Goofus’ budget estimates were way off. In fact, the budget deficit grew. With more people out of work and economic activity slowing, tax receipts plummeted. Despite reducing individual social welfare

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