The Not So Big Problem of the U.S. Budget Deficit

One and a half trillion dollars in added debt per year seems like an insurmountable problem, but is it? The red ink pouring out of Washington has so many people up in arms that our economy may falter or sink into a double-dip recession. Our leaders should review the 1930s before embarking on such austerity.

After World War II, the United States had a national debt of around 120% of GDP. The United States never paid any of that debt down... ever. Okay, there were two years with a small budget surplus, but that was so small it was only a fraction of a percent and the next year it was spent. So what gives? The national debt was huge in 1945, never paid down, and became a small, manageable debt in subsequent years. Why? And more important, how?

We need to fast forward to the 1990s and the largest budget surpluses our federal government ever had. (On percentage terms President Andrew Jackson paid off 100% of the national debt. It did not last long.) How did President Clinton run so many and so much surplus? It was simple really. President Clinton understood that the budget deficit can be eliminated by increasing spending slower than economic growth. It takes a few years, but it always works and keeps the economy humming.

Let me illustrate. If your national economy is $1,000 and the government takes in $90 in taxes and spends $100, you have a budget deficit of $10. If the economy grows 5% the next year to $1,050 and tax revenue collected remains the same in percentage terms, you collect $94.50. If spending increases 2%, your government spends a total of $102. The budget deficit for the year is $7.50, a decline of 25% in your budget deficit.

When using really big numbers, like the size of our real economy and government finances, the numbers are compelling. The federal government can spend more and actually be financially in a better fiscal position as the debt is a smaller percentage of the economy. Running a budget surplus can injure a national economy, especially in weak economic times. The real trick is to increase the total national debt less than the economy grows.

During a recession the economy shrinks so the debt burden grows fast and scares politicians and guys on the street. It shouldn't and here is why. Economic performance is measured in inflation adjusted terms. If the government reports 3% economic growth and inflation is 2%, the economy grew 5%. The government adjusts the numbers to reflect real growth. However, the economy grew 5% in dollar terms. If the national debt grew less than 5%, not he 3% reported, the deficit is easier to manage than the year before.

With all this said, $1.5 trillion deficits are not something we want to repeat each year. However, the sky is not falling. The national debt of the United States is well below all-time highs compared to GDP and is currently under 100% of GDP. The concern is how fast we are increasing the debt burden.

Congress does not need to irritate the President into lowering spending. Just increase spending slower than the economy grows and in a few years we are back in the black.

Now you can smile and enjoy the day.

Wealthy Neighbors

The lesson I am about to share took 20 years to sink into the frugal accountant's skull. I see a couple thousand people per year on a professional basis. This provides me the opportunity to see what works for others; it also makes painfully clear the things that do not.

About 225 of my clients are wealthy, defined as $1 million or more in liquid net worth. The remaining 1800 clients want to be wealthy, defined the same.

There is a striking similarity to the 225 wealthy clients rarely shared by the non-wealthy list. The striking difference is in the investments they make. The wealthy clients follow Warren Buffet's two rules:

1. Never lose money.
2. Refer to rule one.

Wealthy clients are married to these two rules and you cannot pry them away from this philosophy no matter how good the salesman is.

Popular media only solidifies the minds of the wealthy that their way is right. The media says the stock market returns on average 10% per year in the long run. The wealthy say, "In the long run we are dead." When it comes to stocks, the wealthy know "figures do not lie, but liars figure."

If you pick the right entry and exit points you can justify any position you want. One lie is using 1928 as your starting point. When the stock market is at an all time high and calculated from 1928, a non-high stock market entry point, you get very nice returns. However, if you look at the true long term results of the Dow Jones Industrial Average from January 1, 1900 to today, you have a hard time breaking a 5% return.

The S&P 500 is a broader based stock average and has been with us since 1950. The stock market has enjoyed the greatest gains in history for the last 60 years. The 1950s was the best decade for U.S. stocks ever and the 1980s and 1990s were pretty good too. Still, the S&P 500 total return since 1950 is only 7% with 2 of the six decades experiencing a negative return.

Wealthy clients know the stock market at best produces 7% returns with lots of risk and downside. They also know that 5% is the best you should hope for with stocks if you know what is good for you. The 10% stock market returns are a lie and the wealthy know it.

So what are the wealthy doing? CDs and Treasuries.

Shocking. Isn't it?

It should come as no surprise that the wealthiest individuals in a community take little to no risk on a large portion of their money. A typical client with over $1 million in liquid net worth has no debt and does not look wealthy. Farmers, that high paying job we all want to get into, are a perfect example. Not every farmer is rich. But those that are save like no tomorrow. They frequently tell me they "never take off the pile."

Wealthy people invested in 30 year Treasury bonds back in the year 2000 when they locked in 7% or better. Interest from Treasury securities are state tax free. Interest rates are lower now, but the wealthy Treasury bond holder received $700,000 in interest in the last 10 years state tax free. The government still owes them another $1.4 million over the next 20 years plus the return of the original $1 million.

Remember the old articles about how much it costs to buy a home with a 30 year mortgage. Well, Treasury bonds work the same way in reverse. It is like the government paying you taxes. I like that. If you buy a $100,000 home with a $100,000 mortgage with a 30 year term at 7% you will pay the bank a total of $239,508 if you make no early payments. Treasury bonds work even better to your advantage. When you make a mortgage payment a portion is principle. With Treasury bonds the government only pays interest. A $100,000 30-year Treasury at 7% interest will pay you $210,000 in interest over the term plus your original $100,000. The government pays you $310,000 over the life of a 30 year Treasury bond. And the wealthy know it.

Interest rates are lower today. So what are the wealthy doing now? CDs. More accurately, long-term CDs; the 4 and 5 year kind. You see, the wealthy know that 4-5 year CDs pays around 3% with a small penalty for early withdrawal. If rates go up, they pay the fee and reinvest at the higher rate. They win at every turn.

When interest rates go higher for 30 year Treasuries, they will make the switch.

As I conclude this post I want to share what I see from my side of the desk. I have never seen a client in tears because they have a low interest rate on their bonds or CDs. They want higher yields, but are willing to wait. Stock and mutual fund investors at least once a month come in for help. They sufferd a large loss and the money will no longer carry them through retirement. In some cases they need to go back to work. The stress is clear on their faces and body language. I want to help, but the damage has been done.

Consider what the wealthy do. Invest in boring. It is safer. Besides who wants the kind of excitement risk implies. Only use excess money for mutual funds and stocks. You will sleep better.