It's Not the Debt Level, It's the Economy (Stupid)

NEW YORK (TheStreet) -- All credible projections of federal spending show entitlements, especially Social Security and Medicare/Medicaid, exploding in coming years -- unless, that is, Congress and the President do something to fix the situation.

In 1982, projections were that Social Security faced insolvency by 1990. But that didn't happen because President Reagan and House Speaker Tip O'Neill reached a compromise and a solution that kept the Social Security program viable for a while longer.

Today, due to demographic and other factors, the growth rate of Social Security, Medicare/Medicaid and the other entitlements has budget-busting and debt-level implications that have caused consternation and uncertainty in the business community and financial markets.

When Congress and President Obama will be forced to confront the spending issues, their choices will be: raising taxes, reducing benefits or, via compromise, some combination of the two. But we know they won't act until the spending issues become a recognizable crisis and their political futures require action.

This is most likely to come in the form of "invisible hand" economic actions wherein the dollar drops in value relative to other currencies and interest rates rise as the international community relies less and less on the dollar as the world's reserve currency. If that doesn't cause enough political pressure to bring about the necessary spending controls, then the U.S. economy may well lose its premier status.

The Reality of the Debt

One argument in the current bickering is the country will never be able to repay the $17 trillion of debt it has accumulated. From an economic point of view, the debt level itself isn't the issue. The issue is how fast that debt is growing and its cost.

Unlike an individual whose debts all come due upon death (either the estate pays the debt off, or the lender(s) writes it off), a country doesn't die. As long as the growth rate of the debt is less than the growth rate of the economy, and as long as interest rates remain reasonable, the debt will never have to be repaid. From this point of view, the most significant single statistic with regard to the debt is its relationship to GDP.

The concept is similar to that of an application for a mortgage. The borrower needs a reasonable "debt payment/income ratio" to qualify. The more pre-existing debt one has, and the more of one's income it takes to service that debt, the less creditworthy the individual becomes.

After World War II, the debt to GDP ratio was 120%. Why wasn't it a disaster then? The answer: 1) the war had ended and spending was reduced and 2) the economy grew faster than the debt. By 1974, the debt to GDP ratio had fallen to 32%. It rose after that, to 66% in 1996 after the recession of the early 1990s. Then it fell to 56% during the strong economic growth years of the late 1990s and the spending control emphasis of the Congress -- which was accepted and then embraced by President Clinton.

By 2008, as a result of debt growth outpacing economic growth during the George W. Bush presidency, the ratio rose to 70%. Then came the financial crisis and Great Recession, with weak economic growth in its aftermath. The debt to GDP ratio now stands at more than 100%, a level that makes the international community nervous.

Conclusion

There are two key concepts here: 1) controlling the size of the fiscal deficit to control the growth rate of the debt (this implies confronting the entitlement growth issues) and 2) growing the economy fast enough to accommodate a rising level of debt (which implies that the rate of economic growth be faster than the growth rate of the debt).

Spending, entitlement growth, the growth of the debt and economic growth are all interrelated. If confronting the entitlement issues is off the table in the current political negotiations, as it appears to be, then the only chance at avoiding a true debt crisis is for the economy to grow.

The longer the politicians bicker about the budget, taxes and spending, the more that uncertainty will hold back economic growth. That clearly shows up in all of the business surveys.

For everyone's benefit, it behooves Washington to put some degree of certainty back into the business markets, at least for a time period that will allow a return on new capital deployment.

The longer-term question is whether or not federal spending growth will allow the debt to GDP ratio to decline. If it does, then the fiscal issues in Washington will disappear, just as they did post-World War II. If it doesn't, one should prepare for those "invisible hand" economic implications.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Robert Barone is a partner, economist and portfolio manager at Universal Value Advisors, an investment advisory firm in Reno, NV.

He previously held positions as an economist for Cleveland Trust Company and as professor of finance at the University of Nevada. During his tenure at Comstock Bancorp in 1996 he became a Director of the Federal Home Loan Bank of San Francisco, serving as its Chair in 2004.

Barone also served as Director of AAA of Northern California, Nevada and Utah and a Director of its associated insurance company. He currently serves on AAA's Finance and Investment Committee. Along with his son Joshua, he founded Adagio Trust Company in 2000. Barone received a Ph.D. in Economics from Georgetown University.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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