The Fiscal Us

News everywhere seems to be blaring about the fiscal cliff that we'll supposedly go over unless something is done about it. Let me begin by saying there is no cliff, keep calm and carry on.

Before diving into the fiscal cliff, let's examine why 'fixing it' could become a problem. For a moment, ignore that we're already $16 trillion in debt.

As a nation we have a GDP of $15 Trillion, that means, we produce that much value per year in dollar terms.

Per person then, our value creation is roughly $50,000 per year. 

Let's put it in real terms of a Joe.

Our Joe is earning 50,000 a year. Banks love Joe, an honest and law abiding person who means to repay every single penny with interest. Joe's got a great credit profile, so he enjoys rock bottom interest rates of 2% as well. Life is great. Joe takes on new debt every year to the tune of  $3,666.67. This not a big number Joe thinks. Joe's income is near stagnant, growing at about 2% a year.

Joe thinks he's pretty well off and doesn't do anything about this debt. In 20 years, Joe's earnings have increased to roughly $75,000.00 per year. He's done nothing about his debt over the years and his debt now stands at roughly the same amount of $75,000.00. 

Suddenly, Joe doesn't look as low risk to banks as he did 20 years ago. What's more, he now needs to borrow 5000 a year, because a sizable amount of his borrowing goes to pay interest on the already existing loans. But wait, banks decide that if Joe wants to borrow more, given his addiction to accumulating debt, he's become a lot more riskier, they charge him 4% interest now on his loans. Now when Joe renews his debt, his new interest payments stand at $3000.00 a year, plus the $3,666.67 he needs a year to finance his lifestyle.

Things go rapidly downhill from here. Banks still lend him money, as Joe is honest and pays back interest even if that means he has to borrow more. In five years, his earnings stand at $83000.00.

At this point, Joe owes his bank $109,000.00. Joe is horribly underwater, with no sign of escape.

His bank refuses to renew his debt till he brings it down to acceptable levels.

Joe has two stark choices in front of him. Reduce his spending immediately and live a leaner life style or, declare bankruptcy. Declaring bankruptcy would be easy, but he would ruin his standing in the financial world, and he would not be trusted for a long time to come. Cutting spending is not an easy choice either, it would mean a huge change in Joe's quality of life.

This is our story as a nation. The fiscal cliff is an early call to action to avoid the ultimate cliff that Joe had to face. We as a nation will become Joe in 10 years. The world loves us and wants to give us money for very cheap because there is nowhere else to park capital. This will change. There will be other places. The price of inaction now will be far steeper in the future.

We're already in as much debt as we produce in value every year as a nation. We spend a big amount of money every year paying interest to our debtors. 

The government has two more options that it can legally pursue that Joe can't. It can print more money or it can tax people more.

Printing more money reduces the value of the outstanding debt, but it also makes our debtors sour.

Taxing people more just takes a bigger percentage of value produced by the population. 

However, these two tactics do work in the short term. But neither of these have any value till we cut our expenses.

Will it hurt in the short run? Sure. But, if and only if we curtail expenses in the long run, taxes and printing money in the short run will put us on a sustainable path for the long term.

The fiscal cliff does two things. It reinstates the tax rates from 10 years ago and the payroll tax holiday from 2 years ago, and it cuts spending a little bit too.

Honestly, there is no cliff. It's a made up notion. It's very clever political marketing by Washington to be able to kick the can down the road some more, AND look like heros doing so.

There will be pain, I'm not suggesting otherwise. But pain today will be tolerable to disease tomorrow.

Unbalance this!

Now that the Cricket World Cup is behind us and मेरा भारत has won, the humdrum of daily economic news that had taken the back seat in the past few weeks has now started to come back to the forefront.

Not much has changed, we're still fighting over how much to spend this year (even though half the year is gone). The sad part is that the amount both sides are squabling over is not nearly what needs to be cut.

So we will have a shut down. Going by the last shutdown, non-essential workers will be fuloughed only to be provided back pay after budget issues are resolved. This game of political chicken is not to save the heart of America, no, this stalemate hurts us even more. How long will the world keep funding our debt if instead of doing business and running a nation, we are reduced to a bunch of squablers, the only goal of whom is to throw the other party out of office.

Yes, but can we really do something about it? One can surely dream about it?

Take a look at the largest spending items below

We can't really touch the Net Interest on our debt, so that's gone regardless. Let's leave Social Security out of the equation as, even though we owe a staggering 700Billion, payroll tax as seen in the revenue figure, brings in a little north of 800Billion making up for that annual liability for now (one fight at a time!)

The budget that can be touched purely from a theoretical standpoint is roughly 2.1Trillion dollars. The problem is, almost all of this spending is mandated in existing laws.

No political party worth their salt will ever try and tackle these. Sure Rep. Ryan (Wisconsin (R)) has suggested that Medicare be made a premium program, curtailing it from becoming the 78Trillion dollar monster in the future, but he also wants to cut taxes, across the board for Individuals. What a guy!

How about cutting taxes down to 20%, not 25% as he suggested, but, also removing every single tax exemption (e.g. Mortgage interest deduction, Child credit, etc.), eliminating all credits.

By some estimates, this will bring in a trillion dollars more in revenue. Currently, Individual income tax revenue is just short of a trillion dollars, even if reducing the tax bracket to 20% reduces that in half, you're still better off by about 500Billion dollars.

Let's mandate that defense be just that. Stop funding all wars. Recall the troops, defend America - that's all that matters. Reduce that budget by 30%, yielding about 200Billion dollars.

Cut Medicare/Medicaid benefits by 30%. Is it painful? Yes. You are the government, force industry to accept 15% less for their services to you. The remaining 15% will have to be absorbed by us, painful as it may be, it will be better than the program going insolvent in the future. This 30% cut will save 250Billion dollars.

Income security needs to be cut 15% along with Federal Pensions liability taking a 30% haircut.
This will save another 100Billion dollars.

All this adds up to just over a Trillion dollars of savings. This will leave us with a deficit of about 250Billion dollars. If we attain these fabulous cuts, we can address the rest by letting the USD weaken a bit more to lessen the impact of the debt burden - plus revenues realized by US companies overseas will marginally increase revenue coming in.

Of course, this is just idealogical talk.

Meanwhile, please make sure you don't go to any National Park on the weekend of 4/8/2011.