US Deficits and Sustainable Debt

As Congress and the Trump Administration begin to work on their fiscal program, with the potential for tax cuts and expenditure increases, it's important to think about whether our current deficit is sustainable. Now Japan is fast approaching a point where debt issues will overwhelm their financial system. (My senior capstone read a paper by Hoshi & Ito^Note that lays forth that case, arguing that the breakdown point will occur by 2027.) The US is not Japan: we have a growing population, less debt, and smaller deficits. Nevertheless at some point we too will need to put our fiscal house in order.

...we don't need to run a surplus, but the current deficit isn't sustainable...

What follows uses a simple (but standard) arithmetic framework to clarify what matters. As long as debt to GDP is stable, we should be OK, because the demand for financial assets grows with the economy. In general institutional investors such as pension funds hold government bonds for good reasons, and that a particular bond has matured doesn't change that. So they want to buy new bonds to replace the old. In other words, at today's level of debt, the Treasury can "roll over" debt, issuing new bonds to replace old. There's not only no need to repay our debt, financial markets would be hard-pressed to find alternative assets if we did so. Indeed, 20 years ago, under the impact of the Clinton administration's budget surpluses, Federal debt was declining rapidly and there was hand-wringing about how financial markets could function if all the debt was repaid. Some of that public worrying was partisan, used by those who wanted to argue that large tax cuts were OK.

Our economy is also growing. So even if the absolute amount of debt continues to rise, potentially debt to GDP will not. Indeed, that's what happened following WWII. By the end of the war debt surpassed GDP, but fell to just over 20% by 1974. This didn't happen because we ran budget surpluses. Quite the contrary, on average we ran small deficits after 1948. But we did grow, enough to outgrow our debt. But today we're running significant deficits and not growing.

Interest rates matter. In the 1950s and 1960s they were relatively low, so the interest the Treasury paid on our debt didn't offset growth. Today we again have low interest rates, but we also have low growth. So we need to ask whether that changes the situation.

Again, what we want to look at is whether debt is stable relative to GDP. That is, if B is the stock of bonds and Y is GDP, is B/Y growing? On its own – assuming bonds are rolled over – the stock grows with accumulated interest: _t+1 = B_t(1 + i), where B_t is the stock of bonds at time t and i is the nominal interest rate. Similarly, GDP grows at Y_t+1 = Y_t(1 + g) where Y is nominal GDP and g is the nominal growth rate. Hence debt to GDP will grow at:

B(1+i)
Y(1+g)

To put this to use, we need three pieces of information: what is the level of debt, B/Y; what is the growth rate g;, and what is interest rate i. That will give us an indication of whether debt is sustainable, and if not, what level of surplus is needed to keep it within bounds.

The first is easy: Federal debt is approximately 100% of GDP, that is, debt to GDP ratio is 1.0 – convenient for arithmetic, as multiplying by 1 is easy. We then need to know the ratio (1 + i)/(1 + g). When i and g are single digits in percentage terms, as in the US, that ratio is approximately 1 + i - g. In other words, with our debt ratio of 1, B/Y will shrink as long as (1 + i - g) is less than 1. The critical issue then is the value of (i - g). If i > g then our debt level will rise, unless we run surpluses. If i < g then we can run (small) deficits indefinitely, as happened during 1949-1974, yet not see our debt level rise.

Now while it might seem that we ought to be able to earn better than the growth rate, this is fundamentally an empirical question. Thanks to the Great Inflation of the 1970s and 1980s nominal interest rates and nominal growth varied wildly. But real growth and real interest rates stay within fairly narrow bounds, except at the depths of our recent Great Recession. The graph below sets forth those data. Excluding the peak around 2009 we find that the average level of (i - g) is about -0.6%. If we include the peak, the average is roughly 0. Now as the graph below indicates, real long term bond yields fell over the past 15 years and are now on the order of 0.8%. Investors, rightly or wrongly, have not built strong growth into bond prices. So to date there's no evidence that the Fed's ongoing normalization of interest rates will raise real interest rates relative to growth. If so, we can run deficits of 0.6% of GDP forever.

To reiterate, we don't need to run a surplus. However, we do need to bring the budget close to balance. Unfortunately, our current deficit is about 3% of GDP. Now that's a vast improvement over the -10% of GDP level at the trough of the Great Recession. Employment growth and profit growth led to stronger income tax receipts, while the improved employment situation led to a drop in "safety net" expenditures. That combination lowered the deficit by a full 7% of GDP. Unfortunately we can't expect further gains, as profits are now high and (un)employment low. There is however downside potential. So we ought to count on the deficit averaging out at -3.5% of GDP, not -3.0%.

...that means we need to "enhance revenue" by 4% of GDP, not cut taxes...

That does not factor in the aging of the baby boomers, who haven't fully retired and whose healthcare expenses will continue to rise until offset by rising boomer mortality. Such retirement-related expenses will likely come to at least 1% of GDP. Hence we need a fiscal adjustment on the order of 4.0%-4.5% of GDP. Congress needs to "enhance revenue," not cut taxes.

Note: Hoshi, Takeo, and Takatoshi Ito. 2014. “Defying Gravity: Can Japanese Sovereign Debt Continue to Increase without a Crisis?” Economic Policy 29(77): 5–44.

Tesla: First the Cash, Then the Crash

Tesla recently (briefly) surpassed both Ford and General Motors in market capitalization. My own prognosis for Tesla's longer-run prospects aside, once the Model 3 launches cash flow will improve markedly. Financial markets may interpret that as validation of the high price they've put on Tesla shares. That however is a predictable result of the nature of cash for an automotive assembler, and will have nothing to do with Tesla itself. But it does mean that you shouldn't short Tesla yet.

...you shouldn't short Tesla yet...

Why do I believe this will happen? As our alumnus Bill Cosgrove emphasized in him many visits to Econ 244, in up cycles car companies spin off stupendous amounts of cash. In down cycles they're cash incinerators. Let's examine one source of that (there are others).

Historically dealerships financed the biggest asset in the auto industry, the inventory that sits on their lots. In particular, they pay for cars as they roll off the assembly line. (To be precise, dealerships' banks pay for them via the financing of "floor plan".) Suppliers contributed, too, because they are paid 90 days in arrears. In the early years of the industry they were the biggest cost of production. From the 1920s that role diminished, as Ford and General Motors integrated vertically into making their own engines and frames and bodies. But over the last 25 years car companies systematically spun off their internal parts into standalone operations, Delphi in the case of GM and Visteon in the case of Ford. So paying suppliers in arrears is again qualitatively important. Now when sales increase, for example up 2% in the month, car companies then take in 2% more cash, but pay out nothing more. It's only after 3 months do the payments to suppliers start to rise. That process continues as long as sales rise, irrespective of underlying profitability. A rising tide raises all ... wait, that's not the right image.

Or maybe it is. Because at some point the tide goes out, and with it goes the cash flow. The process reverses. Now car companies are taking in less money, but they're paying out the same amount or – if sales were rising and not just flat – amounts that will continue to increase for 3 months. Worse, it often takes a while to react, as a car company you don't want to slow production because of one odd month. And so the factory pushes metal onto dealership lots. As sales continue to fall, inventory piles up, and at some point the dealers push back, and stop ordering cars. In other words, inventory adjustment amplifies the pace of the downturn. Cars companies burn through cash. They turn from printing presses of profits into incinerators of money.

So when the Model 3 launches, Tesla will report a significant improvement in cash flow. Tesla investors will get good news for a few quarters, as the first 100,000 cars roll off the line and make their way into the garages of the more well-heeled of the enthusiasts who laid down their $1,000 advance deposit. This shift in finances will appear to validate the case for Tesla's high stock price.

But sales can't keep rising forever, particularly as Tesla will only have this one new model, and in a market where consumers are shunning sedans. At that point Tesla will begin hemorrhaging cash. They will have to pay suppliers more and more even as revenue stagnates and then falls. Worse, because they don't have independent dealerships, their debt will also explode as inventories build up. They won't be able to cut output fast enough, because they will have to keep paying suppliers for the higher level of orders prevalent 3 months earlier. They won't be able to cut sales staff, either, if they want to stay in business. Unlike traditional dealerships, their stores won't have service revenue, because most Tesla's will be new. That will be made worse by the nature of their product, as there won't be the oil changes that help service operations generate profits for dealerships even when car sales tank.

...don't short Tesla – yet...

So don't short Tesla – yet. But that time will come, because of the nature of the auto business.