With U.S. government debt at record levels and a large tax cut recently announced while corporate profits are soaring, I often reflect fondly on the movie “Dave,” starring Kevin Kline. The movie warms my heart because it shows us what could be – within the realm of government budgets (and politics). While I’ll leave the political commentary to someone else, I will say that politicians and our government could benefit from a return to budget basics.
In the movie, the White House Chief of Staff decides to use a stand-in for the President during a public photo opportunity. Things get interesting when the actual President suffers a massive stroke at the time of the publicity event. Looking to hold onto power, the Chief of Staff has the Presidential double, a small business owner named Dave, continue to fill the Commander in Chief’s shoes. While Dave has a big heart and a do-good attitude he also starts to use his new-found power. He first tests these waters by calling his friend and accountant Murray to the White House to review the annual budget. After reviewing the government ledger, Murray declares that if “[he] ran his business this way, he’d be out of business.”
There’s no doubt that the U.S. financial system is a much more complicated structure than an individual household or small business, but as the movie “Dave” suggests, it can still benefit from the simple principles you and I use regarding our own financial affairs. One such principle is debt management. As it stands, U.S. debt to gross domestic product (GDP) is around 105%. Gross domestic product (GDP) is the total dollar value of all goods and services produced over a specific time period. While GDP is a measure of the size of our economy it also describes how much the U.S. produces or earns.
The point is that a higher GDP (i.e. earnings) suggests the government can handle higher debt levels. The same principle applies to an individual: someone with a larger salary can typically handle a higher level of debt, all else equal. But when you divide debt by income or GDP – the debt to GDP ratio mentioned above – lower is usually better. For example, most banks will consider an individual a high credit risk if their total debt level to gross income is above 36%. Now compare that to 105% of U.S. debt to GDP and you can see that our government might do well to start reducing its reliance on debt.
Looking at the historical record, U.S. debt to GDP has averaged 62% since 1940. Today’s levels are well above that and the second highest in our history. Debt to GDP reached an all-time high in 1946, at 119%, when the U.S. issued a significant amount of debt to fund our efforts during World War II. Given the serious threat to world stability during the 1940’s, most would argue the additional debt issuance was a risk worth taking. However, today’s elevated debt levels come during a time of relative peace and following nine years of U.S. economic expansion – the second longest on record.
Shifting back to budget basics, most would agree that times of prosperity and stability are ideal periods in which to reduce the deficit and thus national debt. Or at least not add to existing levels. Unfortunately, the U.S. government has not followed these principles in recent years. Granted, we’ve had some extenuating circumstances such as the Financial Crisis but we’ve also had steady if not subpar GDP growth since then. Most economists – and budget basics – would argue for increasing taxes or at least holding them steady towards the later innings of an economic expansion, when corporate profits are high. However, this time around Congress passed a tax bill that significantly reduced company taxes.
To be fair, there are well documented benefits to running a budget deficit (for a country) and cutting corporate taxes. However, if deficits continue over the long-term, debt levels can mount, ultimately becoming a headwind to future economic growth and prosperity. As interest rates climb from currently depressed levels, so will debt servicing costs. On top of higher interest expense tied to rising yields, the historical record has shown that large tax cuts can boost inflation – especially when implemented towards the end of an economic expansion – and thus contribute further to rising interest rates. At the same time, lower taxes reduce the government’s revenues and make weathering the next recession more difficult.
While the recent tax bill is clearly a near-term positive for companies, employment, and the economy, it can also bring long-term benefits if our politicians implement sound financial policies that balance the budget and bring down government debt levels. In short, our Congressional and Executive leaders might do well to take a page out of the movie “Dave” and return to some budget basics. They might also enjoy a little break in the process.