Category: defense spending

A Debate on Subsidies

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January 12, 2025

by Stephen Stofka

This is ninth in a series of debates on various issues. The debates are voiced by Abel, a Wilsonian with a faith that government can ameliorate social and economic injustices to improve society’s welfare, and Cain, who believes that individual autonomy, the free market and the price system promote the greatest good.

After a few pleasantries, Abel began, “Last week, we finished talking about the government’s role in the social contract. The scope of that role is the key difference between your group and mine.”

Cain nodded. “Your group thinks of the federal government as an insurance company. Our group tries to keep your group in check. It’s not easy.”

Abel replied, “Your group may believe in a more limited role for government as a general principle, but you advocate policies that contradict that principle. Take housing as an example. It is a private good that is heavily subsidized by the federal government.”

Cain tilted his head in an equivocating manner. “Let me stop you there. Are you asking whether our group supports federal underwriting of thirty-year mortgages? In principle, we shouldn’t. The federal government should have a minimal role in the exchange of private goods. As a practical matter, the entire housing market would collapse if the federal government did not underwrite most mortgages in the U.S.”

Abel interrupted, “But your group doesn’t support the federal government’s student loan program.”

Cain nodded, “That’s right. An education is a different type of good than a house. An education can’t be separated or alienated from a person. A house can. I would prefer that the federal government not be involved in the mortgage market, but few states have the resources to underwrite mortgages. Private banks prefer not to underwrite 30-year mortgages at low interest rates. Only the U.S. and tiny Denmark have 30-year mortgages at fixed interest rates (source).”

Abel said, “But the higher education market would collapse without federal student loans, grants and subsidies. That same practical reasoning supports the federal involvement in underwriting higher education loans.”

Cain shook his head. “Housing has a concrete public aspect to it. Education doesn’t. The Constitution specifies a role for the federal government. It is to provide for the ‘general welfare,’ not private welfare. An education is inseparable from a person’s private welfare.”

Abel objected, “But private welfare contributes to the general welfare. This is a sticking point between our two groups. Your group regards the general welfare as only those goods or services that are available to all. The sum of individual welfare is the general welfare.”

Cain replied, “Look, everyone who wants a subsidy claims that their private welfare will contribute to the public good. Car manufacturers want protective tariffs and subsidized loans, claiming that it will help preserve jobs. Ranchers want below market rates on grazing land for their catttle, claiming that they will be motivated to act as good stewards of that land and help preserve it. College students want subsidized loans and grants on the premise that their improved skills will contribute to a better society, a more productive work force.”

Abel argued, “But your group is more likely to support subsidies for ranchers and farmers.”

Cain shrugged. “The subsidy for grazing fees is about $100 million, according to one estimate. Americans have $7.5 trillion in federally backed mortgages at an interest rate that is at least 5% below market. That’s an indirect annual subsidy to homeowners of $350 billion, with a ‘b.’ Subsidies to farmers and ranchers are like drops in the bucket compared to the subsidies to homeowners. Divide that $350 billion by approximately 50 million federally backed mortgages and each mortgage holder gets an average annual subsidy of $7000. The federal government looks like it has deep pockets. Everyone wants to stick their hand in those pockets. It’s the road to ruin.”

Abel argued, “But the federal government has a long history of handing out subsidies. In the 19th century, they gave out vast tracts of western lands to the railroads for pennies an acre. After the tracks were built the railroads sold the land to developers for many times what the railroads paid. Then the developers sold the land for many times that to homesteaders. Subsidies are a tool of government.”

Cain interrupted, “Tools to achieve what? Policy goals. Who sets those policy goals? The politicians in Washington. What is their policy goal? To get re-elected. How do they get re-elected? By gettting subsidies of some sort for their constituents. What is the sum of those individual efforts by elected officials? A government whose main purpose is giving out subsidies. There has to be some principle in place to limit that kind of largesse.”

Abel asked, “So what? End all subsidies? That is not going to happen. America binds all these regional interests together by handing out subsidies to homeowners, students, farmers, ranchers, people of every business type. In an earlier era, Senate leaders inserted earmarks for those senators who held crucial votes. Former OMB director George Shultz quipped, ‘the budget process was a fight of the parts against the whole and the parts always won.’ (Behn 1977, 109).”

Cain interrupted, “That practice promoted increased spending and deficits. When the government borrows money, that increases the money supply and inflation. Then the Federal Reserve has to fight inflation by adjusting interest rates. Higher interest rates causes a drop in investment which can raise unemployment. There’s just a whole cascade of economic effects.”

Abel argued, “In 2006, John Boehner, the former Speaker of the House, ended all earmarks in the House. Have deficits decreased? No, they have gotten worse. So has the polarization in the Congress and in the country. The public is like a pack of hungry dogs. Give each of them a little bit of meat and they won’t tear each other apart.”

Cain shook his head. “Tell the voters on the campaign trail that they are a bunch of dogs. The problem with your group is a lack of respect for the public and way too much respect for politicians and experts.”

Abel conceded, “Ok, maybe the hungry dogs imagery wasn’t the best, but look at the defense industry. It wields a lot of influence on Capitol Hill and your group is a big supporter of defense contractors. Defense is one of the few legitimate constitutional duties of the federal government, you say. Each individual representative in Congress votes for more defense spending if it will mean more federal tax dollars coming into their state. Each representative competes for defense dollars even if it is wasteful. It’s pork barrel politics.”

Cain said, “The saying goes, ‘something that can’t last forever won’t.’ The country can’t keep running deficits and borrowing money from the private sector. The interest on that debt keeps getting larger every year. It’s unsustainable. Deficit spending is a security issue. If and when a large war breaks out, the country will not be able to muster a strong response.”

Abel nodded. “Our group agrees that deficit spending is a problem. Your group thinks that earmarks are a big part of the problem. We don’t. Pork barrel politics joins people together. All the different constituencies in the country gather together to pull one of two ends of the rope. What we need is higher taxes on upper income households to afford those earmarks.”

Cain shook his head. “Higher taxes reduces investment.”

Abel interrupted, “So your group says. During the 1990s, both taxes and investment increased. In fact, investment increased at the highest pace since World War 2, and we had budget surpluses by the time Clinton left office at the end of the decade. Higher taxes do not reduce investment.”

Cain argued, “Look, the birth of the internet and the computer age was a special case. That exception does not support your case.”

Abel smiled. “Taxes and the effect of taxes is a whole other discussion. See you next time.”

Cain nodded and turned to leave. “Until then.”

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Photo by Anna Samoylova on Unsplash

A 2010 analysis by the Congressional Research Service found that few developed countries offer 30-year mortgages at fixed interest rates. https://crsreports.congress.gov/product/pdf/R/R41432/3

An analysis by the Center on Biological Diversity estimated an annual subsidy of $100 million to ranchers in below market rates for grazing fees. https://www.biologicaldiversity.org/programs/public_lands/grazing/pdfs/CostsAndConsequences_01-2015.pdf

Federally backed mortgages rose from $707 billion in 2009 to $5 trillion in 2010 and have risen steadily since then. https://fred.stlouisfed.org/series/BOGZ1FL403065005Q

Behn, Richard. 1977. “The False Dawn of the Sunset Laws.” The Public Interest (Fall): 103-118. doi: https://www.nationalaffairs.com/public_interest/detail/the-false-dawn-of-the-sunset-laws.

The Federal deficit as a percent of GDP https://fred.stlouisfed.org/series/FYFSDFYGDP

Tevlin, S., & Whelan, K. (2000). Explaining the investment boom of the 1990s. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.221415 In the seven-year period 1992-1998, investment growth averaged a record-breaking 11.2%. A copy of the paper can be found at https://www.federalreserve.gov/pubs/feds/2000/200011/200011pap.pdf

No Man’s Land

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March 24, 2024

by Stephen Stofka

This week’s letter continues a look at taxes. This week the House passed a series of six spending bills that will avert a partial government shutdown. A majority of Republicans voted against the measure and Marjorie Taylor Greene, the bombastic representative from Georgia, filed a motion to remove Mike Johnson, the current House Speaker. It is unlikely to come to a vote because Republicans have only a one-member majority in the house after Mike Gallagher (R-WI) announced his early departure from Congress. A vote for a new speaker risks the chance that Democrat Hakeem Jeffries (D-NY), the current Minority Leader, might win the vote and become Speaker.

Most Republicans in the House and Senate have taken a “no-new-taxes” pledge called the Taxpayer Protection Pledge. The Americans for Tax Reform (ATR) database lists 191 members of the House and 42 members of the Senate who have taken the pledge. They have committed to not raising income tax rates. Additional tax revenues that arise from eliminating a tax deduction or loophole must be dedicated to lower taxes, according to the ATR’s FAQ page. Republican representatives implicitly committed themselves to increasing deficits but that is an unpopular political stance. They pledged to reduce spending but not military spending, the largest discretionary category in the budget. They pledged to reform entitlement programs like Social Security,  Medicare and Medicaid, but rural Republican voters repeatedly rejected such reforms because they depend on those programs. Each time Republican members of Congress stepped away from the issue to save their political hide.

Many conservative members of Congress protest the social spending programs that crowd out other priorities. In 2010 defense spending was over 5% of GDP, more than twice the percentage of the state and federal spending on Medicaid. Defense spending has been reduced to 3.6% of GDP and Medicaid spending has grown to 3.2% of GDP. I will leave the series and chart links in the notes. As a share of GDP, Medicare has grown from 0.5% in 1967, two years after the program was enacted, to a current level of 3.6%.

The trustees are projecting a per capita growth rate of 5.4% and the program is now almost half funded by general tax revenues. Dedicated payroll taxes and cost sharing by Medicare recipients were supposed to fund the program entirely. Democrats want to raise taxes to shore up underfunded entitlement programs they instituted last century when they had filibuster proof majorities. Republicans view these higher taxes as a moral hazard, a reward for Democrats’ excessively optimistic promises and poor planning.

Voters in rural counties form a strong Republican base but depend on state spending and taxes from urban taxpayers to support the infrastructure central to their local economies. The growing of grains and vegetables, and the raising of animals requires natural resources that include land, water and food. Highways and utility lines in sparsely populated counties connect farmers and ranchers to their markets. Despite gains in efficiency, the farming and ranching industries are less efficient than industrial production. Crops and animals do not pay taxes. People do.

Elected officials must play a game with their constituents. Politicians in state legislatures could enact a head tax on dairy cows and beef cattle to cover the cost of those direct and indirect costs. Federal officials could enact a pollution tax on cattle and chickens whose concentrated effluent contaminates interstate waters. However, such taxes would raise the prices of milk and beef in grocery stores. Officials are hesitant to enact specific taxes like that because such taxes arouse voter anger and risk a politician’s career. Lawmakers prefer to fund such costs with general tax revenues. The costs appear as line items on a state or federal budget that is hundreds or thousands of pages long and disappear in the thicket of words.

The private economy is not capable of supporting the current social and defense spending at this level of taxation. Neither political party wants to compromise on their priorities and the interest expense on the debt will grow, exacerbating the tensions between both political parties. That interest is now 3.5% of GDP, about the same as defense and Medicare spending. That interest is entirely funded by a deficit. We are borrowing to pay the interest on the debt we have accumulated.

The blue line will continue to rise, pushing the orange line upward as well. The political parties will stay entrenched in their ideological bunkers, creating a daily drama covered by mainstream and social media whose coverage incentivizes posturing rather than compromise. Just as Britain did in the inter-war period a century ago, we are steadily losing resilience, ready to falter at the next crisis.

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Photo by British Library on Unsplash

Notes on social programs: Defense spending is series FDEFX at the FRED database. Medicaid is series W729RC1. Medicare is W824RC1. Each series link is a percentage of GDP.

The Interest Payment Load

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November 26, 2023

by Stephen Stofka

This week’s letter is about the federal interest paid on the country’s debt. Why does the U.S. pay more on its debt than other advanced economies? In the second quarter of this year, federal government paid 20% of its revenue in interest, almost three times the average 7.34% percentage of similar countries. High interest payments crowd out spending in other areas. They spark even more debates about the debt itself which is now 120% of GDP. This added interest expense exacerbates animosities in a country that is already fractured by divided perspectives and priorities.

In the second quarter of 2022, before the Fed began to raise rates, the federal government paid 13.6% of its revenues in interest (I/R) to service the debt. That was 6% less than the percentage in 2023 and represented $280 billion, more than twice the $128 billion spent in 2022 for the SNAP (food stamp) program. The higher interest payments, however, were about the same as the 50-year average I/R of 19% (median = 17.8%). In 2021, the 27 countries of the Euro area reported to the World Bank that they paid 3.11% of their revenues in interest (see note below).

Over the past fifty years, the federal government has collected about 20% of GDP in taxes. In the chart below, I have added both averages to the chart of federal interest payments as a percentage of revenue. The average revenue is almost identical to the median so this average is representative of a variety of economic conditions and policy responses over the long term.

As an approximation, the interest expense is 20% of revenue and revenue is 20% of GDP so interest expense has averaged 4% of GDP. However, neither the public nor policymakers are accustomed to average. For two decades, the Fed has kept interest rates low to accommodate economic recovery after the dot-com bust, 9-11, the financial crisis, the slow recovery from that crisis and the Covid-19 pandemic.

The pandemic simulated several critical conditions of a large scale war and the inflation that followed was typical of those inflationary periods following wars. I will cover that in next week’s letter. To curb an accelerating inflation, the Fed began to systematically raise rates from zero in the spring of 2022. In six months it raised rates by 2%, a rapid change that was six times faster than the period from late 2015 to early 2019 when the Fed gradually raised rates by the same 2%. By early 2023, the Fed raised rates an additional 2% within six months.

As a consequence of the higher rates, the government has paid higher interest rates on its debt. (The reasons for that are complex). We have become so accustomed to “easy money” and lower interest rates that the sudden increase in interest payments has caught the attention of both the public and policymakers. Will this further fracture political sentiment ahead of the 2024 elections?

At the beginning of this letter I mentioned divided perspectives and priorities. What are they?  Some give priority to the social programs that promote individual citizen welfare as essential to a general welfare. Their opposition may deride them as socialists but they are more properly called institutionalists because they champion a lot of control and planning by a central government to achieve that welfare. Those who oppose institutionalist policies also care about individual welfare but think that well-intentioned bureaucrats in government can cause more damage to the general welfare than they repair. These might properly be called marketists who believe that the price system distributes resources in an efficient and sustainable manner.  They respond that a centrally planned economy creates moral hazard, rewarding individual needs instead of personal hard work, planning and integrity.

Institutionalists label marketists as capitalists or plutocrats and accuse them of being mean-spirited and driven only by profit and self-interest. Vulnerable communities do not have the resources to help themselves, the institutionalists argue. Marginalized communities need to draw from a central funding pool. They must overcome decades of legal policies that disenfranchised them to benefit other groups. Marketists respond that profits reward people for taking risks. The willingness to accept risk is a key component of technological innovation that benefits all of society.

Interest payments have nudged aside defense spending to become the third largest percentage of federal receipts. The top category is health insurance like Medicare, Medicaid, CHIP and payments under the ACA which take up 30% of federal receipts (see note below). Social Security comes in second. Cuts to either of these programs have been a “hot rail” for conservative politicians. Everyone in Congress talks about cuts to defense spending but not in their district because it supports the local economy. The issue of rising interest payments and the federal debt is a safe one for politicians of both parties to run on in the upcoming election. According to Open Secrets, $14.4 billion was spent on the 2020 election, double the spending of the 2016 election. As candidates complain about excess spending, voters might consider why the major parties will spend about $100 for each of the votes in this coming election (notes below). I would call that excess spending.

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Photo by Joshua Woroniecki on Unsplash

Keywords: health care, ACA, Social Security, Medicare, defense spending, interest payments

Health Care Note: The health care programs are 24% of the federal budget including deficits, according to an analysis by the Center on Budget and Policy Priorities.

Election Spending: $14,400 million / 160 million voters ≈ $86 per voter in the 2020 election.

World Bank data: https://data.worldbank.org/indicator/GC.XPN.INTP.RV.ZS?end=2021&start=1972&view=chart. You can download an Excel file at https://api.worldbank.org/v2/en/indicator/GC.XPN.INTP.RV.ZS?downloadformat=excel to view interest payments for countries and regions dating back several decades.

Assumptions

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May 21, 2023

by Stephen Stofka

This week’s letter is about the role of assumptions in our lives. They play an important part in the claims we make to others so they are implicated in our self-esteem and personal relationships. They become integrated in our decision making process, affecting choices that have a lasting influence in our lives.

An assumption is an unspoken part of claims and assertions. The technical term in the study of rhetoric is an enthymeme. An example of an enthymeme is that people should be encouraged to vote because democracy depends on the full participation of citizens. The unspoken assumption or premise is that democratic government is good for citizens. A syllogism makes a claim based on two clearly stated premises. The enthymeme leaves out one of those premises and it is this mutual understanding of the unspoken premise that binds people together. However, if both parties do not accept this unspoken premise, the issue cannot be resolved. This lack of agreement in an unspoken premise is a key aspect of religious and political debates. Our decision making often consists of enthymemes containing vague assumptions. This rhetorical tactic explains how we can fool ourselves into thinking we are above average investors.

Researchers construct an assumption that becomes a hypothesis when they design an experiment to test that assumption. Most of us don’t follow such a formal process. Our assumptions are tested by our observations, by the natural experiments of unfolding events. All too often, we fool ourselves by paying particular attention to those events which confirm our assumptions. We form a growing conviction that our assumptions are confirmed by the reality we observe around us. We make predictions of the future by converting our assumption into a conviction and we are shocked when events upset that conviction.

An example is the recent bankruptcy of Silicon Valley Bank (SVB). Depositors assumed that Gregory Becker, the company’s CEO and member of the board of directors at the Federal Reserve’s San Francisco branch, would be a prudent manager of depositor funds. They were stunned when they learned that Becker and Daniel Beck, the company’s CFO, did not hedge the bank’s interest rate risk, a management practice finance majors learn in school. Both men resigned but benefitted handsomely from their employment at the bank. At a Senate hearing this week Becker rejected responsibility for the fiasco, blaming regulators and customers for the bank’s downfall. His financial survival depends on minimizing his role in the whole affair and defending himself against accusations of fraud.

Economists assume that people are rational, that they are capable of making choices that will maximize their welfare. They make a further simplifying assumption that each person is both principal and agent, making the decision and realizing the benefits and costs of that decision. In a principal-agent relationship, however, the agent and principal are separate. They have different motivations because the benefits and costs are not the same. As a society becomes more complex, the principal-agent problem grows geometrically. The voices we hear most are those of the agents – Becker, the Senators, the regulators – whose actions must satisfy their own welfare while they serve the principals – teh citizens and depositors.

Objections to raising the U.S. debt limit go like this: the country is spending more than it receives in taxes. Like any household, we must cut our spending and live within our budget. The unspoken assumption is that the government’s budget is a scaled up version of a household’s budget. Politicians often court this fallacy of composition because they know that people yearn for simple explanations of complex issues. The U.S. currently spends over 20% of its income on defense, as the chart below shows. This would be equivalent of a family making $80,000 a year and spending $16,000 on a security system.

According to the Treasury Department (n.d.), 38% of tax collections are FICA taxes used to fund Social Security and Medicare. Imagine if a family sent 38% of their income to their parents or grandparents. These are just two examples that might lead us to reject the assumption that a family’s finances are like those of a government. In political debates like these, one side clings to the unspoken assumption because it is the linchpin of their argument.

Investors are cautioned not to put all their eggs in one basket. Diversification spreads the risk among asset classes. When we buy our first house, the down payment may take all of our savings, making us vulnerable to economic changes that impacts our income. We may make this gamble based on the assumption that in a worse-case scenario, we can sell the house for at least the same price we paid for it. During the financial crisis, homeowners were shocked to learn that their home values had declined. Many assumed that rising home prices were a natural law like steam that rises from a pot of boiling water. Ten million families that had gambled their savings on this assumption were wiped out during the crisis.

February’s reading of the 20-City Case-Shiller home price index showed no change in home prices in the past year. Home prices have fallen in some western cities where prices increased strongly in the past five years. From June 2022 to February 2023, Denver’s home prices have declined 6%. While the change in inflation has moderated, there is disagreement within the Fed’s interest setting committee whether to pause interest rate hikes. Continued rate increases could exacerbate price declines in some western states. Home owners may have to reevaluate their assumption that home prices only go up.

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Photo by israel palacio on Unsplash

Keywords: Defense spending, tax revenue, budget, household debt, debt

S&P Dow Jones Indices LLC, S&P/Case-Shiller 20-City Composite Home Price Index [SPCS20RSA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SPCS20RSA, May 18, 2023

U.S. Bureau of Economic Analysis, Federal government current tax receipts [W006RC1Q027SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/W006RC1Q027SBEA, May 18, 2023.

U.S. Bureau of Economic Analysis, Government consumption expenditures: Federal: National defense [A997RC1A027NBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/A997RC1A027NBEA, May 18, 2023.

U.S. Bureau of Economic Analysis, Real government consumption expenditures: Federal: National defense [A997RX1A020NBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/A997RX1A020NBEA, May 18, 2023.

U.S. Treasury. (n.d.). Fiscal Data explains federal revenue. Government Revenue | U.S. Treasury Fiscal Data. https://fiscaldata.treasury.gov/americas-finance-guide/government-revenue/#:~:text=So%20far%20in%20FY%202023,U.S.%20Department%20of%20the%20Interior.

Public Goods and Private Values

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April 16, 2023

by Stephen Stofka

This week’s letter is about the funding for public goods. More than sixty years ago economist Charles Tiebout predicted that we would splinter into different communities based on our use of and desire for public goods like schools, highways, public transportation and other facilities. Let’s dig in!

In his 1948 textbook Economics: An Introductory Analysis, Paul Samuelson introduced the definition of a public good as non-rival and non-excludable. Non-rival means that one person’s consumption of a good does not lessen another’s consumption. National defense is an example. It is difficult to exclude people from a public park or a radio broadcast so these are considered public goods. Samuelson introduced these two characteristics to distinguish public goods from common or pooled goods like a public lake. When there is a plentiful stock of fish, no one notices that when one person catches a fish, someone else cannot catch that particular fish. Overfishing results when people catch fish faster than they can replenish their stocks.

In his eager efforts to systematize and mathematize economic concepts, Samuelson sometimes introduced provocative simplifications. In two separate articles published in 1955, economists Stephen Enke and Julius Margolis gave examples of public goods that were rivalrous. A crowded public highway or school does lessen other people’s consumption. Charles Tiebout (1956) pointed out that one of Samuelson’s simplifying assumptions was that public goods were provided by one source, the federal government.  In 1954, state and local spending was actually twice that of federal spending, excluding national defense. In the chart below, the orange bars are state and local spending, which does include police protection. While it is a public expenditure, a police response to one incident means that they are not available for another call so the police are rivalrous.

A few years after the Johnson administration ushered in the social reforms collectively termed the Great Society in 1964-65, federal spending overtook state and local spending. These programs included Medicare, Medicaid and what were called Food Stamps and Welfare at the time. Today the spending roles are reversed. Without including spending on national defense, federal government spending and investment is almost twice that of state and local.

Samuelson pointed out that there is no market mechanism to price public goods. What is the appropriate price for defense, highways, schools and other public goods? Charles Tiebout (1956) argued that the price for these goods is determined in the voting booth by a public that desires to keep its taxes low. Voters will support those public goods which they consider valuable and will use. Tiebout predicted that voters would migrate to communities where they were among taxpayers who shared similar preferences for a particular set of public goods. If a couple had young children, they would vote for more school funding. Their children would get the benefit while the community as a whole bore the expense. People who liked to golf would favor communities with a like-minded interest who would vote for a public golf course. Tiebout wrote, “The greater the number of communities and the greater the variance among them, the closer the consumer will come to fully realizing his preference position.”

Writing in 1956, Tiebout’s prediction ran counter to the predominant social theory of the American melting pot – that people were becoming gradually harmonized into a single American monoculture. In 2008, Bill Bishop’s book The Big Sort confirmed Tiebout’s prediction. For decades, Americans had been sorting themselves into communities of like-minded preferences and values. Today, few would argue that we live in an increasingly differentiated society of insular interests and values. On social media, we establish community by voicing outrage at those others – what one of them said or did. We form interest clubs with a unique vocabulary, inside references, remarks and jokes that those outside the club don’t get because they don’t understand the context.

In spite of this cacophony of interests and values, there is a clamor for more public goods. More health care, more schools, more public spaces. How are we ever going to agree on the funding for these public goods? The successful ballot initiatives supporting public goods have a common characteristic. They spread the cost evenly by exacting a very small increase in a sales tax rate. People will vote for a public good if it will cost all households a small amount like $20 extra sales tax. This tax, known as a Tiebout equilibrium, acts more like a user fee than a tax.

Each year federal spending less national defense grows a bit more than state and local spending. If local voters cannot agree on spending priorities, this divide will get larger, throwing more of the spending burden on the federal purse and increasing the federal debt. Officials in local districts, frustrated by a lack of voter consensus, will increasingly look to Washington for school funding, children’s lunch programs, health care, public transportation, support of libraries and museums. Where does this end?

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As an aside, defense spending has a unique characteristic. Most government services increase as the population increases. It may not be in proportion but that is the general case. Increases in defense expenditures respond more to the perception of outside threats, not the size of the population. Here is a chart of per capita spending in nominal dollars, spending that has not been adjusted for inflation.

When spending is adjusted for inflation, it is clear that defense spending responds primarily to  perceived threats, not population growth.

After 9-11, real per capita spending on national defense increased by 33%, from $2100 to $2800 per person. In June 2009, President Obama began withdrawing troops to meet a campaign pledge. By the end of his second term in 2016, real per capita defense spending had returned to a level that existed before 9-11. Despite his isolationist rhetoric the Trump administration increased defense spending. This was largely due to pressure from a Republican Senate and House. In the less populous areas of the south, central and mountain west, more defense spending means more government jobs that promise stability and benefits. Republicans may preach small government but the communities they represent value government jobs and the economic benefits that ripples through local communities from military spending.

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Photo by Amy-Leigh Barnard on Unsplash

Tiebout, C. M. (1956). A pure theory of local expenditures. Journal of Political Economy, 64(5), 416–424. https://doi.org/10.1086/257839

Heathens and Wizards

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During negotiations over raising the debt ceiling from July 26th to August 8th, 2011 the S&P500 fell 16%.  The index fell only 1% in the first week of negotiations as it looked like President Obama and Republican Majority Leader John Boehner might strike a deal.  Then the bottom fell out.

In the week of trading since budget talks intensified on Dec. 20th, 2012 the S&P500 has lost 2%. 

Investors are worried but hopeful that Congress and the President can come to some resolution before tax increases and spending cuts automatically take effect on January 1st.  Housing and automobile sales are showing renewed strength; the yearly increase in Christmas shopping was a disappointment but the underlying fundamentals of the economy give reason for cautious optimism.

The rapid decline in last year’s stock market should serve as an example to investors in today’s market.  For the long term investor, a further decline of 5 – 15% will present some buying opportunities – time to make that IRA contribution or to put some sidelined cash to work.

The volatility index, or VIX, measures the relative uncertainty of the broader market using a formula that analyzes the bid -ask spreads of option contracts, which are promises to buy or sell stocks in the future.  When the markets are fairly calm, the VIX index is under 18 – 20.  As markets melted down in October 2008, the VIX rose to 80.  So, 16 is pretty good; 80 is real bad. In the last week of July 2011, this index jumped 20%, then skyrocketed to 48 in the first week of August.

This past week, the VIX went up from the calm range of 18 to 23, indicating the underlying worry.

Last week I wrote about the debate over which inflation measure to use, the CPI or deflator.  If you hear about “chained dollars” or “chained CPI”, it is the deflator that they are referring to.  The difference between the two yardsticks is $3 – $5 per month in a $1000 Social Security check.  This afternoon, Senate Majority Leader Harry Reid walked away from negotiations over this issue.  As I write this in the afternoon of Sunday, Dec. 30th, Senator John McCain has announced that Republican Senators have just taken this issue off of the table.  We can expect that the issue will come up again in the coming negotiations over the raising of the debt ceiling.

For the past several years, Republicans both in Congress and at the state level have targeted the growth in state and local spending.  This campaign of austerity, as Democrats call it, or fiscal common sense, as some Republicans call it, has won Republicans the governerships of thirty states.  Most of that spending growth has been curbed.

On a per person basis, inflation adjusted spending is at the same level as the mid 1990s.

For states, this return to mid 1990s spending levels has meant cuts in services to their residents.  Medicaid spending takes an increasingly larger portion of state budgets; because states can not run budget deficits, reductions have to be targeted toward education and infrastructure spending.  In 2011, Medicaid spending averaged 25% of state budgets, more than the 20% spent on education (Reuter’s source)

While Republicans dominated the Congress and Presidency in the early 2000s, they showed little concern for the growth in what they call entitlements, programs like Medicare and Social Security.  Instead, they increased entitlement programs, adding a Medicare drug benefit program.  Since they lost their Congressional dominance in 2006,  Republicans have become more cost conscious – and the next targets are entitlements.  Most seniors who have paid into Medicare and Social Security all their lives do not consider these programs as “entitlements.”  It is a dog whistle word that Republican politicians use to call out to their pack.

Democrats look and look and look but simply can not find any cuts that they can make to the social safety net.  Under the rubric of compassion, the Democratic strategy consists primarily of buying votes with ever more social welfare programs.  In the Democrat view, a government and its citizens are in a partnership.  Republicans rightly point out the dangers in any partnership where one partner, the government, holds all the power.  Despite all the rhetoric about limited government, Republicans are advocates of a different kind of partnership between government and corporations whose political contributions are essentially kickbacks for contracts with the federal government and a more relaxed regulatory environment.

Supposedly vigilant Republicans get out their spending cleavers but can not find any cuts they can make in current defense spending.   The operative word here is “current.”  The Defense Dept lives in a budget bubble that most of us would envy because it has little economic responsibility for soldiers once they leave the service.  Most rehabilitation, medical, housing, retraining and other services that the soldier is entitled to or need are no longer born by the defense department. Congress “dumps” these costs on the Human Services department, routinely targeted by Republicans for spending reductions.  In inflation adjusted dollars, we are currently spending 30% more on defense that we spent during the Vietnam War years, 25% more than during the military buildup of the Reagan years.

At the beginning of this century, we have two parties whose allegiances prevent them from coming to any meaningful compromise.  Tax policy is riddled with temporary tax cuts to promote various social causes. Special interest groups and wealthy taxpayers nibble away at tax legislators, creating a swiss cheese of fairness. Budget planning is a legerdemain practiced by a small coterie of heathens and wizards in budget committees; under current budget rules, there are few reductions in spending, only reductions in projected increases in spending.  Imagine that your family budgets for a 3% yearly increase in your utility bills.  One year, the utility company has no rate increase.  Your family claims that they have cut spending on utilities.

The Defense Dept has no long term accountability for the care of their soldiers.  The Human Resources Departments have no accountability for increases in health care spending; they are on automatic pilot.  Congress has no accountability for passing a budget; they have not done so for six years yet continue to get paid.  Bankers risk huge amounts of money that threaten the savings of millions; the company pays a relatively small fine and the individuals responsible suffer no criminal prosecution because of the difficulty and expense of such trials. The public senses that the political party system is morally bankrupt; that the leaders and representatives of this country are unable to break out of the cycle of partisan brinkmanship; that many representatives are bought and paid for; that most of the public has been left out of the deal. 

The public will either find a way to reclaim their authority over the political process of governing or be left standing helplessly on the sidelines while the two parties scrimmage at midfield, both parties having lost sight of either the goal or the audience.  Political advantage has become their goal.  Party leaders enforce a rigid heirarchy of committee assignments, rewarding those in the party who comply while shrugging off those who might compromise.  Gerrymandered districts ensure that many representatives are accountable only to the more rigid ideologies of their district;  their sole challenge comes from extremists in their own party. 

Maybe this time is different.  Maybe not.  Slowly and finally, the social, economic and political order cracks; the public votes in the most extreme elements who promise to restore order and principle or their version of fairness.  What they bring is despotism.

But that could be many years in the future.  For now, we salute the New Year!

Defense Spending

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The conservative philosophy believes that government’s roles should be few.  Conservatives are often accused of being for Big Government in defense spending at the expense of programs for social welfare.  That government has a role in national defense is one recognized by both conservatives and liberals.  In defense spending, some conservatives do think that bigger is better.  During the 80s, conservative philosophy routinely touted 25% of the Federal budget as a minimum target for defense spending. 

After the Vietnam war, the Carter administration reduced the size of spending on the military from 30% of federal spending to 23% of spending (2010 Budget, PDF p. 127).  By 1987, the Reagan administration had bumped up defense spending to 28% of outlays but in dollar amounts, Reagan’s administration doubled the amount of spending on defense. (p.127)

After the collapse of the USSR in the late 1980s, George H.W. Bush’s administration reduced military spending to 22% of total spending.  Continuing the reduction, the Clinton administration held defense spending to under 20% of federal spending.  If conservative philosopy shows a predisposition to a strong defense, liberal philosophy shows an equal or more passion for strong social spending.  From 1973 to 2000, social programs grew from 48% of federal spending to 62% of spending.  Democrats touted this increased spending on public welfare as the “peace dividend” while the Republicans attempted to curtail a trend that in time could cripple the federal budget.

After 9-11, defense and homeland security spending increased but, during Bush’s tenure, did not exceed 21% of federal spending. (p. 129 – 130)  As a surprising comparison, the Bush administration spent less than the Carter administration on national defense.

Spending on social programs continued to eat up ever more federal dollars.  By 2008, it had grown to 66% of federal spending and by 2014 is estimated to be almost 70% of total spending.  Interest on the national debt, which had hovered around 15% of spending during the nineties, dropped down to 7% in the early 2000s and below 4% after the credit crisis in 2008, as interest rates plummeted and investors worldwide flocked to the safety of U.S. debt.  In essence, we have been spending our “interest dividend” on social programs.  2014 estimates of this country’s interest payments are almost 12% of total spending, heading back to the percentages of the late 80s and 90s.  Social spending or military spending will have to be cut to make up for the additional percentage of spending in interest payments.  The more probable scenario is a reduction in both types of spending and higher taxes in the coming years.