• Joshua Konstantinos

An In-Depth Look At The US Budget — And The Accounting Tricks That Understate The Deficit

Moving into election season there is a lot of discussion about spending, taxes, tax cuts, budget deficits and the like. But very rarely is the entire federal budget shown in sufficient perspective to make the numbers discussed meaningful. Even more rarely is the data shown over a long enough timeline to understand the trends. The numbers are further obscured by political partisans cherry-picking data to support their positions and by bipartisan accounting tricks which Congress has foisted into the official budget projections.


While the country will certainly be discussing federal spending going into 2020, the issue of the federal budget deficit has fallen sharply in importance to Americans. According to Gallup polling, the issue has fallen from its high in 1996, when 28% of Americans said the federal budget / budget deficit was the most important problem facing the country, to only 2% who felt that way in 2018.


Concern for the federal budget has not dropped because of better fiscal management. Since 1996, the federal government has passed significant tax cuts, increased entitlement costs substantially with Medicare part D and the Affordable Health Care Act, all in addition to spending somewhere between four and six trillion dollars on wars in Iraq and Afghanistan.


The Federal Budget

Spending has largely outpaced revenue for decades, with a combination of defense spending through the Cold War and entitlement programs contributing the bulk of expenses. With the end of the Cold War and the aging of the baby boomers, the growth of entitlement programs, (essentially Medicare, Medicaid, and Social Security), has increasingly driven spending.



Overlaying the total revenues of the federal government as a percent of GDP shows that taxes have remained in a fairly tight range of ~15-20% of GDP. It also shows the persistent deficits since the 1970s, as entitlement spending more than replaced defense spending.



When the baby boomer generation retires, government obligations for pensions and healthcare will soar. In the United States the large millennial generation will stabilize the tax base. But in much of the developed world there was no analogously large millennial generation. In many countries the tax base will dramatically shrink with the concurrent increase in mandatory spending. Even in the United States, with relatively healthy demographics, the ratio between working-age adults and the elderly will increase significantly.



However, aging populations will be even more of an issue in many other countries.



As a result, mandatory entitlement spending and interest on the debt alone will soon take 100% of tax revenues, according to Congressional Budget Office (CBO) projections.




Accounting Tricks Used to Understate the Deficit

The projected spending and revenues are the official estimates and projections from the CBO. However, CBO projections forecast no recessions or substantial increases in interest rates in the foreseeable future. Also note how the estimate for future defense spending is cut significantly in the coming decades. This is not because the defense budget is going to be slashed, but rather it is an accounting trick perpetrated by the Congress. Instead of planning to maintain the military budget at current levels, Congress says that it plans to cut it but then simply revises it's spending every year — forcing the CBO to project deep and sustained cuts in discretionary spending (largely defense spending) into the future that no one thinks are truly likely.


Another accounting trick, mandated by Congress, is ignoring fair-value accounting. Fair value accounting takes into account the risks to repayment. For example, currently the CBO is mandated to treat all loans as having the same risk as Treasury Bonds — essentially no risk. A mandate that forces the CBO to estimate, for example, that the Federal Student loan program will bring in $184 billion in profit over the next decade. Fair-value accounting takes into account the risk that some students will default and would project a $95 billion loss. The CBO has long been in favor of the more realistic fair-value approach, recently arguing that:


In CBO’s view, a fair-value approach would provide a more comprehensive measure of the costs of federal credit programs to the government than what is currently reported because it would fully incorporate the cost of market risk.


In a recent edition of National Affairs, Jason Delisle and Jason Richwine argue, in The Case for Fair-Value Accounting, that:


In nearly every government credit or insurance program — from student loans to public pensions to green-energy subsidies — the government makes risky investments without recording the full price of the risk. The government, at both the federal and state levels, exploits this accounting flaw to generate dishonest financial schemes — and some would even be illegal if they occurred in the private sector.


Even with all of these accounting gimmicks, rosy economic expectations, and the predicted perpetual low-interest rates, the budget deficit is projected to be an incredible ten percent of GDP by 2047. Moreover, total debt will rise to 180% of GDP in the CBO’s baseline projection —with little hope that things will improve beyond the end of the projection period.


One of the more dangerous ways that the scale of the US budget deficit is understated is the short-term nature of the US debt burden. This is not an accounting trick — it is more dangerous than that. In order to get even lower interest rates on US debt, the Treasury department relies heavily on short-term rather than long-term debt — continually rolling over massive amounts of debt every year. Steven L. Schwarcz writing in Rollover Risk explains:


The U.S. government relies heavily on short-term debt funding. As a result, some estimates suggest that the U.S. government has to roll over half of its debt every two years. A recent article estimates that the U.S. government will have to roll over seventy-one percent of its privately held debt over the next five years. Additionally, the government depends on short-term debt to finance the federal budget deficit—which was $1.1 trillion in 2012.


While the government saves hundreds of billions of dollars by rolling over short-term debt rather than using longer-term bonds which would charge a slightly higher interest rate, this creates the risk of a political stalemate over the debt ceiling or a future interest rate shock. Any such unforeseen event would substantially increase the cost for the US to roll over the national debt. It was this risk that led S&P to downgrade the US AAA credit rating to AA+ in 2011.


Key Takeaways

The aging of the baby boomers means that costs for healthcare and social security will swamp all other spending categories in the coming decades. At the same time, defense spending is unlikely to be cut significantly, as is currently projected, given the pentagon's renewed focus on great power competition and China's military buildup. Moreover, even with today’s low interest-rates, interest on the debt is an increasing share of the budget because of the growing size of the national debt.


Moreover, the true US debt burden is significantly underestimated because of the accounting tricks and optimistic projections mandated by Congress. One of the most significant costs that are not recognized is how the government will have to bailout pension funds when because Pension Funds Are Going To Be Destroyed In the Next Recession.



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About the Author Joshua Konstantinos Founder and Global Macro Strategist at Cassandra Capital LLC and author of Sleeping on A Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications, Joshua has been obsessively following global trends and collecting data for over a decade. His analysis takes into account not only the larger view of the rapidly changing global economy but also the longer demographic and geopolitical trends.

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