Why the US Debt Limit Agreement is Only a Temporary Solution

Most people assume that the mismatch between US federal government revenue and expenses will go away, with enough time. All that is needed is a little “patch” now, and some more time, in order for the mismatch to disappear.

I don’t think the mismatch can be made to go away, partly because the mismatch between government revenue and expense is far worse than most realize. Furthermore, high oil prices seem to lead to recession, making it more difficult to fix the gap between government revenue and expenses.

There is good reason to believe that oil production will not increase materially in the next few years. With oil demand from China and India continuing to increase, the mismatch between oil supply and demand can be expected to get worse with time, leading to more recession, and a greater gap between US federal government revenue and expenses.

Because of these issues, about all recent debt limit agreement can be expected to do is push the problem down the road for a few more months. Eventually, we will be back into recession, and the revenue /disbursements mismatch will be worse than it was the last time around.

Mismatch between Government Revenue and Expenditures is Very Large

The way I look at federal spending is to look federal government revenue and expense on a combined basis (including budgeted programs, off-budget spending, and Social Security) using historical data from the Congressional Budget Office (CBO). Instead of comparing amounts to GDP, I compare amounts to non-governmental wages (Private Industry Wages + Proprietors Income) from the Bureau of Economic Analysis, since I believe this gives a more stable base, and since, as a practical matter, most taxes are on wages.

When we look at Federal Government expenditures and revenue in that way, what we see is as follows:

Figure 1. Federal Government revenues and expenditures on a cash basis, compared to non-governmental wages, based on BEA and CBO data.

While revenue is down by about 5 percentage points recently, spending is up by close to 20 percentage points. My calculations include increases in internal debt but do not include increases in external debt, so really reflect what the Federal government has spent on a cash basis. If we categorize outgo based on categories given in the CBO report, and compare them to my non-governmental wage base, this is what we find:

Figure 2. Federal Government Expenditures as a percentage of Non-Government Wages, based on CBO and BEA data.

Based on Figure 2 information, there has been huge growth in the category called “Medicare, Medicaid, etc.” This category would also include unemployment insurance (to the extent it is funded by the federal government), plus many other mandatory federal programs, such as food stamps and Supplemental Security Income. The increase in the “Medicare, Medicaid, etc.” category is easy to understand with the recent recession, because there are many people who are unemployed or underemployed.

My non-budget spending category is determined by subtraction–comparing how much external debt actually increased to the expected increase based on the sum of the various programs. This approach will tend to understate non-budget spending (such as military spending and stimulus spending).

If we look at revenue (Figure 2), also using CBO amounts, we find that the decline in revenue reflects a combination of decreases in all categories, not just personal income taxes. Corporate income taxes are also recently lower, as is the “Other” category, which includes excise taxes (such as on gasoline) and estate taxes.

Figure 3. Federal government revenue breakdown, as percentage of US non-governmental wages, based on BEA and CBO data.

The thing we notice, both from Figure 3 and from Figure 1, is that Federal Government revenues have never exceeded 40% of non-governmental wages for very long. Government revenues are now at 34.6% of non-governmental wages. The drop in individual income taxes started back in 2001, at the same time the percentage of the US population with jobs started declining (Figure 4).

Figure 4. Ratio of number of people employed to US population, based on BLS and Census Department data.

In Figure 1, we saw that the size of the gap between revenue and expenditures was of the order of magnitude of 20% – 25% of non-government wages. If the mismatch between revenue and expense is a permanent one, we really need this much more revenue to fund the current system (not considering the big increase in Social Security payments in the next few years, as “Baby Boomers” retire). But looking at where revenue comes from in Figure 3, there is no possible way to get this much additional revenue. If individual income taxes were to be the sole source of this increase, we would need to triple individual income taxes, to provide enough revenue in total. More taxes on the rich would barely scratch the surface of this problem.

The Reason our Problem is a Permanent One

We are used to thinking of the use of debt as something to be expected, but this is something that is not really true, unless the economy is in long-term growth mode. If the economy is growing (Scenario 1 of Figure 5), it makes sense for the government and individuals to borrow, because the future appears to be better than today, and offers good prospects for debt repayment, with interest.

Figure 5. Two views of future growth

The problem comes when the economy can no longer grow, or actually begins to decline (Figure 5, Scenario 2). Most economists do not even consider this possibility, but in a finite world, at some point, this will have to happen because finite resources deplete. The only exception might be if we can figure out a way to somehow disassociate growth from the underlying resources used to manufacture and transport goods and services, but this seems extraordinarily unlikely.

Oil supply has a been a problem since 2005. Regardless of how much price has increased (or decreased), there has been little change in world oil production.

Figure 6. World oil production, compared to Brent price, based on EIA data.

Economists tell us that if an item such as oil is in short supply, prices will rise, and either more of the item in short supply will be found, or a substitute will be found. It seems to me that there is a third alternative, which we are now encountering. In the agricultural world, if a required nutrient is not in available in adequate supply, the yield of the crop is reduced, based on the amount of the limiting nutrient. (This is called Liebig’s Law of the Minimum.) It seems to me that we are encountering the corresponding problem with the economy now, if high oil prices are thought of as a limiting an essential part of the economy.

Oil is used in very specific ways in the economy–for example, in transportation, in growing food, in operating heavy construction equipment, and in making many products including synthetic fabrics, asphalt pavement, and pharmaceutical drugs. There are no good substitutes within any short-term time horizon.

When oil prices increase, consumers tend to cut back on discretionary purchases, because oil price increases tend to cause food and commuting expenses to rise, and these are necessities. Earlier this year, economist James Hamilton showed that oil price spikes were associated with 10 out of the last 11 US recessions. Now, oil prices are again high, and economic growth during the first half of 2011 was less than 1%. We are again seeing signs of recession. If oil is really a limiting input for the economy, this is exactly the type of response we would expect from high oil prices.

While world oil production is flat as shown in Figure 6, consumption of the United States and many other “developed” nations is down recently, especially during the 2008-2009 recession.

Figure 7. Oil consumption based on EIA data.

The reason for the decline in oil consumption of Europe, Japan, US, and Australia is competition for limited supply. Oil consumption in my “Remainder” category (including China, India, most oil exporting nations, and many small “lesser-developed” countries) is rising rapidly.

I believe the reason for the shift in oil consumption to less-developed countries is because oil consumption tends to go to the countries where the jobs are–in part because the jobs, themselves often use oil, and in part, because those with jobs have the financial resources to buy goods and services made with oil. So as we import more goods from abroad, the countries we buy from prosper, and our own economy meets more recessionary headwinds.

Going forward, it is not at all clear that world oil production (Figure 6) will increase above its current level. In fact, it may very well decrease, as old fields become more depleted. Given the likelihood of continued growth in the “Remainder” category (Figure 7), this means that the United States and other “developed” countries may continue to experience declining oil consumption. Not surprisingly, given this background (high oil prices reflecting limited oil supply tending to cause recession, and oil consumption tending to go where jobs are), low oil consumption seems to be associated with a low number of available jobs (Figure 8).

Figure 8. Relationship between US jobs (from BLS) and US oil consumption (EIA "product supplied")

This relationship becomes even closer when we adjust for the long-term downward trend in oil consumption (Figure 9).

Figure 9 - US oil consumed per person employed, based on EIA and BLS data, with fitted exponential trend line.

An Unwind in Private Debt Makes our Current Problems Worse

When the economy is growing, as in Scenario 1 of Figure 5, it is possible for private debt to continue expanding. But once the economy stops growing and starts shifting toward decline, growing private debt become much less possible. Part of this decline in debt occurs simply because it doesn’t make sense to borrow from the future, and pay back the loan with interest, when the future provides fewer goods and services than today. Also, in a declining economy, businesses see no need to borrow to expand their businesses. Instead, they repay existing loans, and don’t take out new ones. In addition, there tend to be many more defaults in a declining economy. (See my posts The Link Between Peak Oil and Peak Debt – Part 1 and The Link Between Peak Oil and Peak Debt – Part 2.)

When we look at the recent trend in United States non-governmental debt together with the increase in governmental debt, the graph is quite disconcerting:

Figure 9. US Domestic Debt, split between government debt (external only) and non-governmental debt. Based on Federal Reserve Z.1 data. Excludes Foreign Debt.

Our economy is used to the stimulus it gets from increasing debt. The government can try to increase debt to make up for the lack of increase in private sector debt. But if growing debt really no longer makes sense, because of the difficulty the economy has growing when oil prices are high, then attempts to make up for the shortfall in private debt will never work. Private debt will keep shrinking, and government will be too small to make up the shortfall. Furthermore, in a declining economy, repaying governmental debt is likely to prove impossible.

Is There a Solution?

It is hard to see a solution to the mismatch between revenue and expenses. Laying off government workers and cutting back government safety-net programs will tend to be recessionary. Raising taxes will also tend to be recessionary. Low-cost oil has enabled our current standard of living. As low-cost oil is replaced by high-cost oil, we need to expect our standard of living to fall, because we will find the cost of many essential items increasing, without our salaries increasing. Even adding more high cost oil (say, from deep-sea locations) won’t fix this problem.

Government programs have tried to hide the trend toward more job layoffs and a lower standard of living that comes with lower oil consumption through stimulus programs and bailouts, but this cannot continue indefinitely, because the underlying problem has not been fixed. Eventually, the mismatch between government revenue and expense will become more evident, and the government will find it needs to cut back on many popular safety-net programs, or find the interest rates it needs to pay for sovereign debt significantly raised.

The level of changes agreed to today in today’s debt cap legislation is far too low to significantly change the current situation. We will still be left with a wide gap between federal government revenue and expenses, and the likely prospect of recession in the future.

It is hard to fix the mismatch between government revenue and expenditures. One thought is that we need new types of taxes that will discourage “exporting” of jobs, and encourage “importing” of jobs. We need a clear focus on keeping jobs in this country, even if the goods produced here cost more.

We probably also need to work on finding jobs for people, outside of our current oil-based economy. At one point, it was usual for one family member to remain outside the paid work force, and instead work on raising a garden, preserving food, and taking care of children and the elderly. We may need to go back to this model again, as more of the norm.

I am afraid I do not have all of the solutions. If solutions were easy, we would not be in our current dilemma.

About Gail Tverberg

My name is Gail Tverberg. I am an actuary interested in finite world issues - oil depletion, natural gas depletion, water shortages, and climate change. Oil limits look very different from what most expect, with high prices leading to recession, and low prices leading to inadequate supply.
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53 Responses to Why the US Debt Limit Agreement is Only a Temporary Solution

  1. I like this site very much so much excellent information. “Funny how just when you think life can’t possibly get any worse it suddenly does.” by Douglas Noel Adams.

  2. Doug W. says:

    Gail – I can’t help but think that serious conservation might help in this situation, both personally and collectively. Recent reports that the Japanese have cut energy consumption by 23% since their tsunami and nuclear plant problems shows that it can be done. The drain on our economy with higher energy prices has to be a significant drag on the economy. Conserving energy would partially mitigate this problem.

    I do like your suggested lifestyle changes.

    • I am wondering how the Japanese changes will really work out. The Japanese economy had been growing very slowly (nearly flat) for quite a few years before the earthquake. I am suspicious that there are going to be a lot of round-about effects (layoffs, debt-defaults) that won’t be evident for some months, or into next year. The economy also will have less resilience this way. If a typhoon hits, or there is some other stress, the country will be less able to respond.

  3. Off topic but are you still following Chevron and Equador?

    http://cartalk.com/blogs/jamie-kitman/?p=289

  4. Bill Simpson says:

    I found part of the answer to our debt problem. Google Earth Sagaponack, NY, on Long Island. After the zoom stops, look southeast to the coast. Can people with houses like that help balance the budget? There are many, many huge mansions in, and near, every large city in the USA. Thousands and thousands of them. Google Earth around silicon valley, or outside LA and San Diego. I read somewhere that the average income of the top 115,000 US income taxpayers is about $24 million. And that nearly 400 people in the USA had incomes of a billion dollars in 2007.
    I would like to recommend that everyone watch the CNBC TV documentary by David Faber, ‘Untold Wealth: The Rise of the Super Rich in America’, but it mysteriously disappeared from the long list of specials on the CNBC TV website. (Faber’s ‘House of Cards’, the story of the 2008 sub-prime crash, is still there. They sometimes rerun it on holiday weekends. It is a masterwork, as good as ‘Inside Job’.) After first seeing ‘Untold Wealth’ last year, I was wondering how long it would take to disappear. It only took about a year. I guess the fellow not being bothered by spending $40,000 for one (1) replacement tire on his $2.3 million dollar sports car, in his private museum with the auto elevator in it, was a bit too dangerous for the millions of unemployed Americans to possibly see. They surely didn’t want it to become a stolen YouTube sensation as the Congress discusses raising the age for medicare eligibility to 67 when Canada has nearly free medical care for everybody.
    I just love when people say that even if we taxed the rich at 100%, it couldn’t balance the budget. Fox News, owned by Rupert Murdoch, loves that one. Using that logic, why did I ever have to pay a single penny tax? They wasted what I paid on one bomb in Iraq. (And a couple of trillion more, to give Iraq to the Iranian Quds Force general who now runs the southern half of Iraq. I bet those ungrateful Iranians never even sent George Bush a thank you card for getting rid of their only obstacle to becoming the predominant power in the world’s oil station, Saddam Hussein.) No, the very rich can’t balance the budget. But they can sure get it a lot closer to being balanced. They think their lobbyists can buy them a virtual free ride in Congress, with hedge fund multi-billionaires paying a carried interest tax rate of 15% forever. Until things get tough, they sure can. But eventually, they could find themselves in another Egypt, or worse, another French Revolution.

    • Perhaps your suggestion is part of the solution.

      If share prices start decreasing and debt defaults start increasing, I suspect that quite a few of these rich people will find themselves less well off, without an increase in taxes.

  5. Don Stewart says:

    According to the IMF projections, it is medical expenses which are driving our deficits. Yet see this post by Mark Hyman, MD, on the recent study which showed complete cure of diabetes in 8 weeks by simply changing what people eat:

    http://drhyman.com/new-research-finds-diabetes-can-be-reversed-6187/?utm_source=Publicaster&utm_medium=email&utm_campaign=drhyman%20newsletter%20issue%20#27&utm_term=Get+the+story

    The study, entitled Reversal of type 2 diabetes: normalization of beta cell function in association with decrease pancreas and liver triglycerides, was exquisitely done. The bottom line: A dramatic diet change (protein shake, low glycemic load, plant-based low-calorie diet but no exercise) in diabetics reversed most features of diabetes within one week and all features by eight weeks. That’s right, diabetes was reversed in one week. That’s more powerful than any drug known to modern science.

    So we are bankrupting ourselves trying ineffectually to save people from their own folly. I vote to let them just die if they persist in their folly.

    Don Stewart

    • I agree that our medical system isn’t working. We definitely need a system that aims for keeping people healthy, not maximizing incomes of health care providers. Doctors are so tied in with the system of providing drugs for every ailment, they never even consider suggesting diet and exercise as solutions to their patients.

      Part of the problem too is with the food industry. I think that restaurant food needs to be greatly changed (including portion sizes), and the amount of over-processed food in grocery stores stopped as well. But it is hard to make any of this happen. There are too many people making money off the current system.

      • Don Stewart says:

        Gail
        You might like to check
        http://peakwatch.typepad.com/decline_of_the_empire/

        for some data on defense and medical care as the essential drivers of the disaster. He also shows the lobbying budgets for these two components and their public statements about the dire consequences of any cuts.

        Don Stewart
        PS My view remains, of course, that we cut these two or we fade into oblivion.

  6. arthurrobey says:

    Sorry I came late. There is just so much I can take.
    It seems to me that it is time for triage.

    We divide the population between who is not going to make it. Ignore them.
    Who will definately make it. Ignore them.
    Concentrate on those who might make it.
    Which parts are worth concentrating on?
    I suggest the internet, climate? and space colonisation are worth keeping.

    What should be ignored are malnourished people in ecologically devastated areas and the very rich.

    • It seems like electricity is one of the things that may not make it. Without electricity, a lot of other things fail. This one of our problems. If we can keep governments working as they are today, electricity likely won’t be a problem. So make sure governments don’t cease to function is another major item of importance.

      I am afraid space colonization is never going to make the list. It is just too far down on our list of priorities.

  7. Thomas M. says:

    Excellent post!

    We clearly have a SPENDING problem in this country, not a taxing problem. Even during the “good ole days” when marginal rates were very high, we didn’t collect any more revenue. Once recessions and bubbles are removed, the government has collected about 18% of GDP for the last 60 years. Meanwhile, spending has increased from 18% to 25% of GDP. Simple math.

    Our standard of living is based on cheap money (Government Debt) and cheap energy. These are not sustainable. Therefore, unless we have a miracle, our standard of living will continue to decline. You can’t fix these structural issues with a simple tax tweak. We need a comprehensive strategy to address all the components of our standard of living. Comprehensive strategies are VERY hard to accomplish in a democracy without a major crisis. This is one area where China, with a command and control economy, has a genuine advantage (partially offset by the corruption this type of economic model always fosters).

    We have millions of PhD’s doing “research” in our fine educational institutions. Perhaps a few could spend a little time on:

    Energy: we need to replace oil with something cheap (solar? nuclear?)
    Housing: we need inexpensive and energy efficient housing (passive solar designs?)
    Food: we need less reliance on petroleum in our food production cycle (buy local?, victory gardens? organic?)
    Transportation: we need a distributed workforce (encourage work from home?)
    Population: worldwide, we need to incentivize people to have less children, not more

  8. arthurrobey says:

    Thomas M. The real problem is that our left hemispheres have become dominant. Our left hemispheres produce models of reality, but they cannot differentiate between the model and reality. Whatever models you or I present here are suspect for that reason.
    This has real consequences,
    For instance there has been a lot of work done on Latice assisted nuclear reactions, colloquially called “Cold Fusion”. http://www.lenr-canr.org/LibFrame1.html
    When presented with this non-model reality the Left brain thinks it must be wrong as it is not in the model. And it begins to confabulate.
    After all the model IS reality to the Left brain.
    Another thing that the Left cannot do is “Insight”. It has no understanding of this fundamental error of confusing reality with it’s model.
    We have to find some way of reballancing our two brains.

    • Shunyata says:

      The way of rebalancing our two brains is called meditation – both to generate insight and to cultivate model-independent awareness. This type of meditation, however, should not be confused with the altered-state thrill-seeking commonly labeled as meditation.

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