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Wednesday, October 26, 2011

Why Washington will collapse

It's mathematically guaranteed, given the total failure of the supposedly responsible party, the Republicans, to even openly discuss the fiscal realities, much less address them. The Market Ticker walks through the numbers:
NOW we need to cut the federal budget not with a knife or a scalpel, but a chainsaw. Bachmann has said "43%." There were gasps when she uttered those words. Sorry, that's not enough. (Take your heart medication before continuing folks.)

Here's the math.

Last year (Calendar 2010) we ran a 12% of GDP deficit, $1.7 trillion. This year we are tracking to run about $1.4, but we have three months left. If history repeats as to size it'll come in around $1.4 trillion, which is approximately 9% of GDP. This is within the rough range of 9-12% of the last three years. The last year of Bush's Presidency we ran somewhat over 9% of GDP. Obama has run 11 and 12%, respectively, and this will be ~9-10%, so there's no change in that regard.

But withdrawing the deficit spending is not enough because the withdrawal of that money, when it runs through the economy, then produces a (gross) reduction in tax receipts. Figure 1/3rd of that deficit spending ultimately returns to the government in the form of taxes in some form or fashion by the time all of the "turns" those funds made in the economy (e.g. from company making the presidential limo to the folks making the alternator to the folks making the copper wire to the mine pulling the copper out of the ground), and subtract that off as well.

So now we need to reduce spending not by $1,700 billion but that plus about another $500 billion for the tax impact, for a total of $2.2 trillion out of $3.7 trillion spent. About $500 billion of our spending at present is interest so this means we have: $3.7 - $2.2 - $0.5 = $1 trillion in total actual federal spending available to us out of an original $3.7 trillion.
One can - and I will - take exception to the estimate of $800 billion for the net revenue consequences from what economists describe as "the multiplier effect", but the more important point is that changing government spending patterns will have an effect on the economy. It is as foolish to apply a static government spending cut model as it is to apply a static tax revenue model. Now, we can come up with a total range of estimates by utilizing the very high multiplier of optimistic Obama administration economists, who assumed it to be 1.6, then comparing that to the actual Four Wars multiplier of Robert Barro, which worked out to 0.8.

At present, federal tax revenues are $2.3 trillion. This means tax revenues/GDP are 2.3/15.0, or 15.3 percent. For the maximum range, we'll ignore the BEA's estimate of G and go with the actual amount of federal spending, which is $3.7 trillion. The range of multiplier effects means that the net contribution of that government spending to the economy is somewhere between $5.92 trillion (Obama) and $2.86 trillion (Barrow). Applying the Tax/GDP ratio indicates a TOTAL tax benefit of between $906 billion and $453 billion from ALL $3.7 trillion in government spending, which means that Karl's estimate of $800 billion in lost taxes from the aforementioned 1.7 billion reduction is almost surely too high, even before we notice that the 0.8 multiplier means that reducing government spending would tend to increase GDP and therefore tax revenues by a factor of 1.25.

So, in order to obtain the most conservative estimate of the tax effect, we have to multiply (1.25 x 1.7 trillion) x .153. This would indicate a benefit of $325 billion to GDP from the reduction in spending rather than an additional loss. On the other side, (1.6 x 1.7 trillion) x .153 means a maximum tax revenue loss of $416 billion.

I'm not sure where Karl got his interest figure, (it looks like he used the 2015 estimate), but the reported interest on the national debt is $240 billion for 2011. So, in order to prevent the debt situation from expanding, and depending upon which economist you trust concerning the multiplier effect, federal spending must be reduced to somewhere between $2,085 trillion on the high end and $1.344 trillion on the low end. And here are the current big-ticket items:

$761 billion - Social Security
$468 billion - Medicare
$269 billion - Medicaid
$598 billion - Unemployment/Welfare
$679 billion - Department of Defense + Foreign Wars

So, this is why the Tea Party and the Republican Party cannot possibly salvage the situation They're not proposing the end of ANY of these major programs even though the nation can only afford to keep two of them, three in the unlikely event that both Defense and Social Security are entirely junked. Since that's not going to happen, given the way in which the incompetence of politicians presently inhabiting Washington aren't willing to even consider such drastic action, the financial collapse of the US federal government is assured.

Because I harbor Austrian School inclinations and the propensity for government malinvestment is obvious, I think the higher figure based on Barro's multiplier is the more relevant one. It's hardly a surprise that the Keynesian model would make government spending look more desirable and cuts to that spending more horrific, and obviously the administration economists were incorrect about that 1.6x multiplier given the failure of their $787 billion stimulus plan. But I found it to be interesting to discover that the $2.085 trillion figure works out to a 43.6% required reduction in federal spending, which tends to suggest that Michele Bachmann's economists are utilizing an equation similar to the one that I have worked out here. Perhaps old Crazy Eyes really does read Mises at the beach.

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