Is The US Government Bankrupt?

No. The US government is not bankrupt. Not even close. It does spend a great deal more than it “earns” however. Consequently, its financial position is deteriorating rapidly. Since the economic crisis began, the government’s debt has increased by $4 trillion to $15 trillion, and government debt as a percentage of GDP has jumped from 65% at the end of 2007 to 99% at the end of 2011. This is the highest that ratio has been since 1948, soon after the end of World War II. This increase is alarming, but not a reason for immediate panic. The ratio of Japanese government debt to GDP breached 100% in 1996 and now stands at more than 230%.

When the economic crisis began in 2008, government tax revenues collapsed and government expenditure surged. As a result, the government’s budget deficit exploded. Revenues fell from 18.5% of GDP in 2007 to 15.1% in 2009, while expenditures rose from 19.7% of GDP to 25.2% over those two years. With revenues down and expenditures up, the budget deficit blew out to the highest level since 1945, jumping from 1.2% of GDP in 2007 to 10.1% of GDP in 2009. Over the next two years the budget deficit improved only slightly, to 9.0% of GDP in 2010 and to 8.7% of GDP in 2011.

Once the crisis began, tax revenues fell for three main reasons. Unemployment soared, so fewer people paid income tax. Corporate profits plunged, so businesses paid less tax. In 2011, taxes paid by corporations amounted to 1.2% of GDP, sharply lower than the average of 1.9% over the past 40 years. Finally, Congress cut taxes in 2009 and also extended tax cuts from earlier years that would have expired otherwise. The combined result was to reduce the government’s tax take to the lowest share of GDP since 1950. So, despite the often expressed belief that federal taxes are extraordinarily high, that is not the case; they are extraordinarily low, at least by past standards.

Partially offsetting the collapse in tax revenues was an $83 billion profit earned by the Federal Reserve and transferred to the federal government. It’s astonishing how much money you can make when you make the money. The Fed has “printed” approximately $2 trillion since the crisis began, money it used to buy (interest-paying) government bonds and mortgage-backed securities.

Government spending increased for four main reasons, only the first of which was directly related to the crisis. Spending on “Income Security” jumped $231 billion (63%) between 2007 and 2011. This was the result of the spike in the unemployment rate which peaked at 10% of the workforce. Most of the rest of the increase in spending cannot be blamed on the economic shock. Medicare spending increased by $111 billion (30%) over those four years. Social Security outlays increased $145 billion (25%). Finally, military spending surged $155 billion (28%). Keep in mind that while the sharp increase in spending on the final three categories was not caused by the crisis, that spending did help alleviate the crisis because when the government spends money, that spending boosts the economy. [See Economic Forecasting, 101; posted February 15, 2012.] The question, of course, is how long can the government continue spending so much money before it goes bankrupt.

The following table provides a breakdown of total government spending during 2011.

Government spending is classified as either Mandatory or Discretionary. Mandatory spending consists primarily of benefit programs, such as Social Security, Medicare and Medicaid. The Congress generally determines spending for those programs by setting rules for eligibility, benefit formulas, and other parameters rather than by appropriating specific amounts each year. Discretionary spending is controlled by annual appropriation acts; policymakers decide each year how much money to provide for given activities, including defense (i.e. military spending), law enforcement, transportation, the national park system, disaster relief, and foreign aid. During 2011, the United States spent $700 billion on defense, or 19.5% of total government spending. That amount is roughly equivalent to the amount of military spending undertaken by all the other countries in the world, combined. Non-defense discretionary spending amounted to only 18% of total government spending.

Based on current laws, the budget deficit is projected by the Congressional Budget Office to drop sharply from $1.3 trillion in 2011 (8.7% of GDP) to $1.1 trillion this year (7.0% of GDP) to $585 billion in 2013 (3.7% of GDP) and to $345 billion in 2014 (1.5% of GDP). If that occurs, the United States (and, therefore, the world) will be plunged into a very severe recession. The projected decrease in the deficit is expected to occur due to tight spending constraints (coming into effect due to the Budget Control Act of 2011, which imposed caps on discretionary spending through 2021) and due to a very significant increase in taxes, a 44% increase. Taxes are currently scheduled to jump because a number of “temporary” tax cuts are due to expire at the end of 2012 and 2013. These include temporary tax reductions enacted in 2001, 2003, and 2009; the 2 percentage point reduction in Social Security taxes paid by employees; and an increase in the number of individuals affected by the alternative minimum tax (AMT).

Should this extreme budget tightening occur, the US economy would contract sharply, unemployment would soar and most members of Congress would be voted out of office in November 2014. The members of Congress, therefore, in order to protect their jobs, can be counted on to pass new laws that will increase government spending and further extend earlier tax cuts. That means it is highly likely that the US budget deficit will continue to remain near or above $1 trillion a year for many years to come. As long as it lasts, that deficit spending by the government will keep the US economy from collapsing into a depression. The question again, however, is how long can it last before the government goes bankrupt.

I give it about 10 years, to 2022. In that case the Mayans would have been off by only 10 years -- for if the US government goes bankrupt, it will be the end of the world, or, at least, the end of the world as we have known it. During the weeks ahead, we will consider how that outcome could be averted. We will also look at many of the most important factors that will push asset prices up and down over the nearer term.

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