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 benefits, there are many more people on those programs so that means the cost of those programs to the government actually increased, not decreased.

Goofus’ budget and economy are a wreck. Since Goofus has the intelligence of a wind-up doll, he decides that obviously the answer is more cuts and more austerity. Unfortunately, this only makes the problem worse.


Gallant Tries to Reduce the Deficit

Gallant is much more intelligent than Goofus. Gallant has diligently studied our modern monetary system and knows that the only thing we have to worry about from government spending is inflation. Gallant knows that with high unemployment and reduced economic activity, the threat of inflation from increased government spending is nonexistent. Despite many of his advisors telling him he should cut government spending, Gallant has studied the history of recessions and depressions and government policy responses all over the world, particularly the situations that most closely mirror our own (during the Great Depression and Japan in the 1990s) and learned that a policy of austerity didn’t work.

Gallant decides the key is to get people back to work and get the economy up and running at full capacity. Gallant also likes simple solutions. If you want to put people back to work, why not just hire them. Gallant implemented a jobs guarantee program where the government pays the wages of anyone willing and able to work. Gallant reinstitutes the WPA and CCC from the New Deal. Gallant also knows that the government is somewhat inefficient at allocating labor, so he also arranges for private sector nonprofit charities to hire the unemployed (with the wages paid by the government).

Gallant knows that with jobs scarce and incomes down, it is a good idea to put money directly into the pockets of the private sector with those who need the money the most getting the most benefit. Gallant decides to remove the regressive payroll tax that all employees pay and have the government make the contributions to the horrible accounting monstrosity known as the social security trust fund. He also removes the payroll tax on the employer side for all those who are self-employed.

Gallant is an astute student of economics. While he at the federal level can spend as much as he wants while just keeping an eye on inflation, he knows that state and local government can not. Gallant therefore decides to make one-time grants to all state governments on a per capita basis to spend as they wish. This will help them meet their budgetary requirements and avoid raising taxes or laying off workers in the midst of a terrible recession.

The budget deficit was enormous that first year. In fact, some of Gallant’s advisors fainted and one even built a secret underground bunker behind his house where he stock piled canned goods and gold bullion for the sure-to-be-coming hyperinflation.

The next year, with over ten million people in the jobs program earning incomes and almost everyone paying less in taxes, private spending began to rise. More people went out to eat and bought new clothes. Car sales picked up. People had an easier time making mortgage payments and foreclosure rates dropped. Since people were more sure of their housing situation, sales at home improvement and home furnishing stores increased. Business owners saw the huge increase in sales. Although they worried about the large federal deficit and thought Gallant was a crazy socialist bent on destroying capitalism, they were also greedy and wanted to take part in the growing economy. So they hired more employees to meet the increased demand for their business’s goods and services. Manufacturers saw their products flying off shelves and rushed to open new factories, and add production lines and shifts. Those in the jobs guarantee programs found private employment at higher wages a much better deal than the $8-$10/hr jobs in the government program, so many people left for the private sector.

After a few years a strange thing happened. Despite the government spending a huge amount of money in the early years, the deficit began to drop. Few people remained in the jobs guarantee program since almost everyone had found work in the private sector. With the increased economic activity, incomes rising, and housing prices stabilized, government revenue from taxes was actually increasing. At the same time payments for jobless benefits, food stamps, housing assistance, and other social programs dropped since many people no longer needed that help. They now had good paying private sector jobs or could join the jobs guarantee program. The federal budget deficit started to shrink down to what some called normal levels. Government spending as a percentage of private sectors income dropped.

Who would have thought increasing the deficit actually would decrease it in the long term? Well, Gallant did. And so did anyone else who studied the history of recessions and depressions.


Back to the Real World

Even though the stories of Goofus and Gallant might sound weird to you, it’s what actually happens in the real world. Over the past few years, the world has conducted what might be the largest real life test of the best policy to get out of a balance sheet recession. Austerity or not austerity?

In the red corner (austerity) we have the U.K. and Australia, which both operate the same type of monetary system as the United States. The U.K. is the better comparison because its trade balance most closely matches ours. We can also lump many of the EU nations in as well, since they are undergoing austerity.  It is important to note that EU nations are currency users and thus don’t have the luxury of running up large deficits without the bond markets “permission” so to speak.

In the blue corner (not austerity) we have the United States. I call us “not austerity” because we clearly are not implementing much stimulus either. We have allowed the automatic stabilizers take effect and have extended some minor tax cuts, but otherwise we have kept the natural resulting budget deficit intact.

The results. It’s not pretty for the red corner.

U.K.: The latest employment and incomes figures show unemployment rising to 8.3% and the total employment ratio dropping to 70.2%. Total pay growth has slowed as well. Recent GDP growth has been slowing is predicted to get worse consumer spending remains subdued. George Osbourne’s goal with austerity was to balance the budget by 2014-2015, but with the economic data showing an increasing grim picture the new estimate is that it will be 2017-2018 before it is balanced. Osbourne responded by announcing more austerity. The truth is the budget will not return to balance, as the austerity measures begin to take hold and private sector activity is reduced the government deficit will remain elevated. Should the U.K. continue with its plan we should see growth slow further in 2012 as larger cuts begin to take effect.

Eurozone: In the chart below we can easily see what happens as GDP growth (gray line) dropped during the recession and the EU countries responded by implementing austerity measures. GDP growth then started trending down and debt to GDP ratios (orange line) began to skyrocket.

Some argue that at some indefinite point in the future all of the austerity will “restore confidence” and “position the economy for growth” and consumers will regain the confidence they need to spend and businesses will start investing. These claims are patently false. Unemployment is edging up in many countries and skyrocketing in others. Businesses won’t expand without customers and consumers won’t spend without jobs.

The hope is that by engaging in these austerity measures and pushing unemployment sky high (22% in Spain, 17% in Greece), reducing wages (public sector wages were reduced 20% in Ireland), and depressing the real economy these countries will experience an export-led boom. There are many problems with this line of action as we can currently see. First, it is inhumane to implement such an economic policy that results in pushing tens of millions of people into poverty when clear alternatives exist. Second, like Lake Woebegone where all the children are above average, it is impossible for every country to depend on exports to lead a recovery. If one country is running an export-led trade surplus, then by definition there must be a country running an equal trade deficit.

Instead, these policies shatter a country. This recent NYT article on Ireland does a good job showing what happens when such austerity policies are enacted.

The article ends by saying that for countries with high debts there is no alternative. That is incorrect. For countries with high debts that are denominated in a currency they can print and that operate on a non convertible floating exchange rate system, there are many alternatives (the New Deal programs implemented during the Great Depression are successful examples). Indeed, the only limit is inflation.

In the blue corner, things in the United States look brighter. GDP has been rising sequentially this year, and absent a major shock should continue its mediocre trend of 1-3% growth.