Federal Finances Understood

Who can fathom the numbers being thrown around in conjunction with the federal fiscal situation. No one. The most common attempt is to report the numbers as a percent of GDP. Who cares about relating to the GDP unless you are comparing the spending of the US to another country? By itself numbers expressed as a percent of the GDP don’t mean much. They certainly don’t give you a feel for the issues.

In many years of providing audit support for accounting firms, I learned that the principles used to judge the financial strength of an entity are immutable. To comprehend them, it is just a matter of scale. But how do we scale such large numbers? Duquesne University Economics Professor Antony Davies came up with one that should be meaningful to all of us. Let’s look at the economics of the federal government as if it has the income of a typical family in the US. To do that, we must choose an income. For most of the late 20th and early 21st century, the median income in the US is near $50,000. The exact number is not important, just that it be close enough for each of us to be able to relate. So, we are going to take a family making, $50,000 in 2005. If this family had the habits and commitments of the federal government, here is what they would look like. Are those habits sustainable?

Income went up nicely for a couple of years from 2005, then dropped slightly in 2008, and took a huge decrease in 2009, with a small increase in 2010 (2005 through 2010 income is $50K; $56K; $60K; $59K; $49K; and $50K).

Spending is a different story: 2005 through 2010 shows significant increases for every year but the last. The spending numbers are $57K; $62K; $63K; $69K; $82K; and $80K.

This family, which made between $50,000 and $60,000 per year for the six years from 2005 through 2010, spent $90,000 more than it took in over the six years. The total spending for 2009 and 2010 was $63,000 more than income. In other words, it spent more than an extra year’s income over the period of two years.

The family’s credit card debt is $315,000, and the current interest payment on the credit card debt is $4,500 per year. One note, the family pays about 1.5% interest, which is the lowest ever. More typical is 4% to 5%. When the interest rates get back up to typical, the interest payment on the current credit card debt would be something like $13,500 per year.

Back in the 1980s, the family started putting a little extra money away for retirement pensions and health care. They have accumulated about $68,000 currently (SS plus Medicare Trust funds). But they took out a loan (included in the $315,000) using it as collateral. They spent the money. So, although they have an asset of $68,000 to show for their efforts, their real net worth is not affected by it. To save for the retirement pension and health care they have promised, they have to pay back the $68,000 and save for the future retirement commitments. If they had the money right now, they would need $2,500,000 (SS plus Medicare HI unfunded liabilities plus PV of part B, C, and D). Every year they wait, the number goes up.

So, the family has figured out that they have a financial problem, but they don’t know quite how big it is. The current head of the family (Mr. Obama) proposes to keep the spending at the $80,000 it was in 2010 and, basically, wait till the income catches up (that will take 10 years if income grows like it did from 1990 to 2005; it will never happen if it grows like it has since). The other adult in the family says that the most we can cut spending is $2500 in the first year (remember that we spent $30,000 more than we took in last year). Last year, the head of the family committed to paying health care for everyone on the block. That will add between $20,000 and $40,000 to the debt over the next decade just by itself.

We all know that efforts like this will not come close to eliminating the $30,000 that the family spent more than its $50,000 income in 2010, let alone paying off the $315,000 debt or accumulating money towards the more than $2,500,000 that is needed to fund the retirement pension and health care costs.

What can we do? Well first, we need to recognize that about $25,000 of the $80,000 in spending is dedicated to fixed costs that we can’t change (current spending on SS and Medicare). And about $5,000 of the spending is dedicated to paying the credit card debt. So, only about $50,000 of the $80,000 in spending is eligible to be cut, and it will decrease as the SS, Medicare, and interest on the debt grow.

The financial situation is grim. But if there is one road to success, it will require more income, cutting expenses, and reducing the commitments. Two possible ways to increase income: increase tax rates or decrease tax rates (but that debate is for another time). The rest is clear. Cut expenses a lot and cut future commitments a lot.

Remember the situation over the last couple of years: $50,000 in income; $80,000 in spending; $315,000 in credit card debt; $2,500,000 in unfunded liabilities. Not a very pretty picture.

Looking at it like this makes it clear just how bad the situation is. There are lots of connections and insights you can draw as well. It’s pretty easy to do. If someone tells you something about the federal fiscal situation using billions of dollars, just multiply the amount in billions by 25 (it is actually 23, but close enough) to get the number scaled down to our little family. For example, the Democrats wail that cutting $100 billion out of the budget is a lot. Let’s see how much it is. 25 times 100 is 2,500. So, in our family, that is the equivalent of cutting $2,500 out of spending (3% of spending). Gee, that doesn’t seem like so much when the deficit last year was $30,000. I’d say our family is in deep financial problems, and efforts like that are not nearly enough.