The U.S. Annual Budget Deficit and Cumulative Debt in Historical Perspective

While the U.S. budget deficit seems likely to be large for the foreseeable future, the situation doesn't look particularly grim in comparison with other times in U.S. history.

Robert Kiyosaki - Rich Dad, Poor Dad There is a story of a snail who was walking through New York 's Central Park . A tortoise attacked the poor snail and stole his money. When the police asked the victim what had happened, he said, "I don't know, offi­cer, it all happened so fast."

Like the speed of slow-moving creatures, most things are relative. Accordingly, the U.S. financial position should be compared with the size of the overall economy (GDP). Using this comparison, the current fiscal position is not as bad as at previous extremes in U.S. history. Figure 7.3

shows total U.S. federal government debt as a percentage of the overall size of the economy for a few selected years.

The three years shown in Figure 7.3 are the extreme points of their eras. During World War II, the United States ran up enormous debts. By 1946, just after the end of World War II, the U.S. federal debt had risen to 122% of the overall economy. Using the current projections, the most extreme figure over the next decade will occur in 2011 when the U.S. federal debt is projected to reach 74% of the size of the overall economy. Not only is this figure far below World War II levels, it is not substantially different from where we stood in 1996.

When we move from the cumulative federal debt to the annual budget deficit, the current projections look even better. While $600 billion is an enormous sum, when scaled against the size of the economy, our current deficits are tiny compared with those during World War II. Figure 7.4 shows the annual deficit as a percentage of the overall size of the econ­omy for a few selected years.

FIGURE 7.3 The U.S. 's Cumulative Debt Is Below Historical Highs Sources: Office of Management and Budget, Congressional Budget Office

Jim Cramers Real Money Sane Investing In An Insane World In 1943, the government's one-year deficit exceeded 30% of the

FIGURE 7.4 The U.S. Annual Deficit Is below Historical Highs

Sources: Office of Management and Budget, Congressional Budget Office

overall economy! The CBO projects that over the next decade, 2004 will have the largest deficit when measured against the size of the economy. The projected 2004 figure of 5.6% of GDP is smaller than the 6.0% of GDP figure that occurred in 1983 (the largest of the Reagan era deficits).

Is it possible to have $500 billion deficits as far as the eye can see without harming the economy? The answer appears to be a resounding yes. In fact, throughout the early 1980s, the United States ran large deficits every year while the economy prospered. Specifically, in spite of large deficits, interest rates fell during the 1980s. While we can't know what would have happened in the 1980s with smaller deficits, the U.S. economy seems able to handle deficits in the range of 5% of the size of its economy.

So what is the likely effect of deficits on interest rates? With current projections, the deficits look to provide some upward pressure on interest rates but with no cause for panic. The projected U.S. federal deficits and debt are well within historic ranges. The key will be to watch as the deficit and debt figures change. If annual deficits and cumulative debt swell beyond current projections, they could cause interest rates to rise substantially.

Three Ways to Lose Money in Ultra-Safe U.S. Government Bonds

The federal government deficit, as currently projected, does not seem to spell doom for bonds. Those who argue that the deficit will cause prob­lems have been making their bearish case for decades. In fact, Professor Tobin's quote regarding the crowding out effect was made in 1986. Eighteen years later, Alan Greenspan said, "One issue that concerns most analysts, especially in the context of a widening structural federal deficit, is inadequate national saving." 5 Those who fear that the large U.S. federal deficits will eat up all the available savings might eventually be proven right, but there is no evidence of a problem yet.

Even though U.S. government bonds are among the safest investing for dummies in the world and there is no imminent risk from deficits, there are three ways investors can lose money: (1) You never get your money back, (2) you get worthless money back, or (3) you get much less money back than alternative investments.

The most extreme risk is that the U.S. government defaults on its bonds. Many corporations and other countries have defaulted on their bonds. It is almost impossible to imagine the U.S. federal government defaulting. In the most extreme circumstances, annual U.S. government deficits could reach trillions of dollars. Even in such circumstances, the govern­ment has unlimited ability to create dollars so there is essentially no risk of default.

A U.S. government default is almost impossible. Those who worry about such a default ought to be investing heavily in items such as guns and food. I am not saying that it is impossible for the U.S. government to

default on its bonds, just that this is extremely unlikely, and if it happens we will have much more to worry about than our investments.

Bond Risk #2: Inflation

The second risk to bondholders is that they will be repaid but that the dollars they are repaid with might be able to buy very little. On this subject, the science fiction legend Robert Heinlein (author of Starship Troopers, Stranger in a Strange Land , and many other classics) wrote, "$100 placed at 7 percent interest compounded quarterly for 200 years will increase to more than $100,000,000—by which time it will be worth nothing."

We already covered the risk of repayment with worthless dollars in the inflation discussion. As of right now, there is no sign of dangerous levels of inflation in the United States . Nevertheless, the risk exists and is one of the most serious risks for bondholders.

In most circumstances the interest rate on government bonds exceeds the inflation rate. While this has almost always been the case in the United States , the amount of cushion—the difference between interest rates and inflation—has varied dramatically. Figure 7.5 shows the interest rate on the 10-year U.S. Treasury bond minus the rate of inflation.

The extra return on bonds above inflation has been decreasing for the last 20 years. The 1983 bond investor received 7% above inflation while the 2003 investor received only 1% above inflation.

In comparison to current inflation, bond buyers today are getting the worst deal they have had in decades.

Bond Risk #3: Opportunity Cost

In 1989,1 was the chief financial officer of Progenies Pharmaceuticals, a start-up biotech company (now publicly traded with the stock symbol PGNX). For no good reason related to my job, I wrote an analysis of the RJR-Nabisco leveraged buyout. The Wall Street Journal published a short version of my analysis as an editorial. 6

FIGURE 7.5 Interest Rates Adjusted for Inflation Are Extremely Low

Source: Federal Reserve, Bureau of Labor Statistics

One of the consequences of this article was an invitation to give my first lecture at Harvard. I was honored by the request so I flew to Cambridge to present my analysis. How did my first Harvard lecture go? The short answer is that it went amazingly poorly. Early in the lecture, I asserted that RJR-Nabisco bondholders had lost $ 1 billion because of the leveraged buyout. My calculation simply added up the loss on all RJR-Nabisco bonds as quoted on bond markets on the day the deal was announced. (These bonds traded actively so it was easy to get an accurate measure of how much the price dropped because of the buyout announcement.)

A student objected by saying that the bondholders had lost nothing. She argued that the RJR-Nabisco bondholders were still going to get all their money back. Accordingly, she said that the current price of the bonds was irrelevant. I tried to argue against this view, but it was shared by most of the students. After about 20 minutes of incoherent verbal flailing, the professor had to intervene and say, "Please, let's just assume that Terry is right and move on." This intervention allowed the lecture to continue, but obviously I had lost all credibility.

Let's view this issue in the context of a $1,000 dollar investment into a 10-year U.S. Treasury bond. Assume that the bond is bought with an interest rate of 4%. The purchaser gives the government $1,000. In return the government promises to pay $40 a year for 10 years, plus return the original $1,000 at the end of the tenth year.

Now let's consider what would happen if, soon after the purchase, interest rates on 10-year treasuries jumped from 4% to 6%. What would happen to our investor? The investor owns a bond that still promises to pay $40 a year for 10 years and to return the $1,000 upon maturity. From this perspective, the bondholder doesn't appear to have lost any money (this is the student's argument from my lecture). On the other hand, the rise in interest rates means that the market price of the bond would have dropped by $150.

So how much money would our bondholder lose? Is it $0 or $150 or something else?

The economist's answer is that the bondholder would lose the full $150 even if the government makes all the payments as promised. Where does the loss come from? The loss is caused by the change in the "opportunity cost." By investing at 4%, the bondholder has lost the opportunity to earn 6% on the $ 1,000. And these are not simply losses on paper, these are real dollars that the investor could have in his pocket but never will.

In my first Harvard lecture, and many since then, I have learned that opportunity cost is a difficult concept to grasp. Even highly trained people who understand the idea tend to overlook opportunity costs.

While the opportunity cost in financial terms is often misunderstood, in other areas of life it is clear. A famous—and almost certainly fake— wedding toast goes as follows: "Sometimes at rare moments in human history, two people meet who are meant to be together forever. When such romantic lightening strikes, I hope that the bride and groom have the strength to say, 'I am sorry, I'm already married.' "

For those who are unwilling to divorce, the opportunity cost of marriage is the forgone opportunities with other potential mates. A similar theme is revealed in stories of a mythical culture where women were allowed to have up to three husbands, but where divorce was banned. It was said that women in this culture almost never had a third husband, and when they did, he tended to be extremely handsome. By some calculations, the third husband has the highest opportunity cost in this marriage system because he rules out all future possibilities.

So the bondholder who locks in a 4% interest rate for 10 years loses when the world changes to provide opportunities for 6% investments.