Much ado has been made of federal deficit and long-term debt as of late, with plenty of political jawing and posturing to go around. While the interest on debts payments will comprise larger and larger portions of the fiscal budget in the coming years, growing federal deficits contribute to repressed economic investment. While the linkage may not be obvious, with a little bit of algebra, we can deduce a negative relationship between the yearly federal deficit and investment.
You may be familiar with Gross Domestic Product, or GDP as it is referred to in short. It is a statistic that serves to measure the overall size of national economies. For reference, U.S. GDP currently stands just shy of $15 trillion, which is almost triple that of the People's Republic of China, the world's second largest economy. While many may be familiar with GDP, fewer understand how it is calculated. The simplest equation for calculating GDP is as follows:
GDP = Personal Consumption + Domestic Investment + Government Spending + Net Exports
Personal consumption represents everything purchased by households as a final sale. The reason it counts final sales to end consumers only is so that no material is double-counted. Domestic investment is any business expense made to increase future production. Government spending counts everything from local governments all the way up to the federal level, but excludes transfers such as Social Security. Net exports represents U.S. exports minus imports, which was -$380 billion in 2009. This trade deficit is driven largely by the country's dependence on foreign oil.
Now that we know what is tracked is national production, the next thing we need to do is find out where all that money is going. Think about your own paycheck for a moment. Where does it all go? Likely a portion is already taken out for taxes before it hits your hands. After that, you pay your bills, buy your groceries and maybe spend a little on yourself or your family. That covers the consumption avenue for your hard-earned money. What about the rest? Anything left over will end up in the bank, as savings. All personal and business incomes, as represented by our national GDP, can thus be set as equal to the nation's taxes, consumption, and savings. We must also add government transfers payments such as Social Security and Medicare as income. The formula then, looks like this:
Incomes = Expenditures
GDP + Transfers = Consumption + Savings + Taxes
Now we can substitute that formula for GDP that we covered earlier into the equation:
(Consumption + Investment + Gov't + Exports) + Transfers = Consumption + Savings + Taxes
Now since we are interested in finding out what Investment is equal to, we set out to algebraically isolate it. This is achieved easiest by just subtracting everything else on the income side of the equation. We are left with the following:
Investment = Savings + Taxes - Gov't - Transfers - Net Exports
Now we have a simple equation for what contributes to investment and growth in our national economy. Now it may seem counter intuitive that higher taxes yield more investment, but consider the three sources of investment: individuals and corporations, foreign investment, and our own government. Taxes are the government's source of income, and thus it's primary avenue for investment. But what of the original argument, that the federal deficit harms investment? Well, the federal budget is in the investment equation. Do you see it?
Investment = Savings + (Taxes - Gov't - Transfers) - Net Exports
Now we can make the investment equation even easier.
Investment = Savings + Government Savings - Net Exports
Voila! We have successfully boiled down a pair of economic equations into a simple expression of where investment comes from: savings, government investment, and foreign investment (which is what a trade deficit represents). Now what can we do with this knowledge? At the least, we can see that each of these three components affect investment and thus economic growth. The more savings we accrue, the more we have to invest. The more government accrues in budget surpluses, the more it has to invest. The more we borrow from abroad, the more we can invest.
However, when any of these start to dip, we must increase the others, or suffer a decrease in investment. So at a time when Americans are hard-pressed to increase their savings, and the government is running record deficits, we have had to turn to borrowing foreign money to keep investment up. The problem with relying on foreign investment, instead of government surplus, is in the interest payments on foreign loans. Interest payments become part of future government spending obligation, further ballooning future government deficits. This becomes a gradual cycle that continues to grow government deficits and increases dependence on foreign borrowing for growth.
In his State of the Union address, the President restated his desire to reign in the federal deficit. Deficit spending in the United States has already resulted in a debt that clears 60% of our GDP. Which means, it would take 60% of everything this country is capable of producing in a year just to pay off our debt. Under our current path, it would take two full years of production, or 200% GDP, by 2038. In order for the American economy to sustain growth, the growing yearly deficits have to be brought under control, and ideally morphed into surpluses under which investment can blossom with the combined assets of our savings and foreign investment. The Fiscal Commission outlined several reform recommendations to address the ballooning deficits and the looming fiscal crisis. There are real solutions, but it will require real policy decisions. The kind that are politically difficult. Will anyone step up?
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