Once again our good friends on Capitol Hill and at 1600 Pennsylvania Avenue have put forth their budget, and once again they prove that they either don’t realize or don’t care that their profligate spending will ensure that we have a never ending recession.  I know I’ve done this before, but since we’re headed down Debt Alley again, I’m going to explain why deficits are going to choke off recovery:

A fundamental identity of macroeconomics is called the National Income Identity which breaks out the components of the total economy that sum to the GDP.  It states that the GDP is equal to the sum of consumer spending, investment, government spending, and net income from international trade.  GDP is also equal to the sum of consumer spending, taxes, and savings.   Symbolically:

GDP = C + G + I + (X – IM) = C + S + T

Some simple algebra can recast this equation into two interesting forms.  First, we can see exactly from where the money for government spending comes:

G = T + (S – I) + (IM – X)

This tells us that government spending is funded from a) tax revenue (T), b) crowding out private investment by diverting savings to bond sales (S – I), and c) foreign entities reinvesting their dollars, which flow out of the US economy by way of a trade deficit, in bonds (IM – X).

The second form shows the investment potential of the economy – money available to invest in the private economy to replace depreciating assets, invest in technology, and, most importantly, hire new employees.  It is:

I = S + (IM – X) – (G – T)

This tells us that capital for investment comes from a) savings (S), b) reinvested dollar outflows (IM – X), and is diminished by governmental deficit spending (G – T).

Now the numbers: The GDP estimates are in the range of 14.5 trillion dollars.  The budget calls for 3.69 trillion in spending with 2.09 trillion in taxes (1.6 trillion dollar deficit).  The trade deficit runs generally 38 billion per month; that rate extrapolates to 456 billion annually.  The savings rate (percent of GDP minus taxes) is estimated to be in the 5% range; this gives 620 billion in savings.  How does this budget do?

I = S + (IM – X) – (G – T) = 600B + 456B – 1600B = -544 billion (-3.75% of GDP)

What does this mean?

1. Every dime of GDP which does not go to consumer spending and taxes will be diverted to fund the government – nothing for investment, zero to replace depreciated equipment, nada to invest in technology, and bupkis for new hiring.

2. Even after crowding out every bit of investment, the government STILL needs \$544 billion more.  This is where the Fed starts printing money and debasing the currency.

The “Progressives” (who know so much better about what’s right for America than us – just ask them!) like to jump on President Reagan’s back about his deficits.  His biggest was 1986: \$221.2 billion (\$990.4 billion in spending with \$769.2 billion in tax receipts) in a \$4.428 trillion GDP; 3% trade deficit (\$133 billion) and a savings rate of 8.5% (this is from St. Louis Fed data), making savings \$311 billion.  So, how does this measure up?

I = S + (IM – X) – (G – T) = 311B + 133B – 221.2B = \$222.8 billion (5% of GDP)

Five percent of GDP available to invest.  GDP grew 3.5-4% during that time.  By the way, if you want to have a 5% investment pool available in the current economy you’ll need to cut \$1.221 trillion from the budget, leaving a deficit of “only” \$379 billion (and I don’t want to hear a word about hiking taxes – those who do get an F and a lecture about how increasing marginal tax rates steepens the Investment-Savings curve and reduces total economic output).

So why do the “Progressives” run deficits which can never be sustained?  I have three ideas:

1. They have no clue about principles of macroeconomics which any first year economics student knows well (so what are Romer, Goolsbee, Summers, Bernstein, et al doing to earn their pay?).

2. They know about these macroeconomics principles, but don’t care.

3. They wish to “fundamentally transform the United States of America”, and this is a step in that process.