Federal Deficit Reality
SUSPECTED BUT WERE AFRAID TO ASK!"
A Series Authored by Walter J. "John" Williams
"Federal Deficit Reality"
(Part Three in a Series of Five)
September 7, 2004
U.S. Treasury Shows Actual 2003 Federal Deficit at $3.7 Trillion
Deficit Moves Beyond Any Possible Tax Remedy
Could U.S. Treasuries Face a Rating Downgrade?
The U.S. government’s fiscal ills have spun wildly out of control and no longer are containable within the existing system. As detailed in this article, the actual annual shortfall in U.S. government operations for fiscal year 2003 (September 30) was $3.7 trillion. Put in perspective, that means if the U.S. Treasury had seized all wages and salaries in 2003 with a 100% income tax, there still would have been a deficit! The outlook for fiscal 2004 numbers is even worse.
Considering that the popularly reported 2003 budget deficit was $374 billion, one-tenth the number cited above, this installment on government reporting concentrates on where the incredulous $3.7 trillion number comes from, how and why the Treasury is reporting it, and why the financial press and federal politicians are ignoring it.
Nonetheless, some implications of the current circumstance are touched upon briefly, here, conditioned by the promise of a full and separate analysis at a future date.
As brief background, the $3.7 trillion number is from government financial statements prepared using generally accepted accounting principles (GAAP), and a large portion of the expanded deficit is from the annual increase in the net present value of unfunded Social Security and Medicare obligations.
The impossibility of this circumstance working out happily is why lame-duck Federal Reserve Chairman Alan Greenspan suddenly has urged politicians in Washington to come clean on not being able to deliver promised Social Security and Medicare benefits already under obligation. He suggests, correctly, that there is no chance of economic or productivity growth resolving the matter. The funding shortfall projections already encompass optimistic economic assumptions.
Even if the Administration and Congress heeded Greenspan’s advice, the unfolding fiscal disaster faces one of only two very unpleasant general solutions:
· The first solution is draconian spending cuts, particularly in Social Security and Medicare, even if accompanied by massive tax increases. This appears to be a political impossibility, at present.
· In the absence of political action, the second solution is the U.S. government facing some form of insolvency within the next decade or so. Shy of Uncle Sam defaulting on debt, the most likely outcome is the Fed eventually having to monetize U.S. debt heavily, triggering a hyperinflation. U.S. obligations eventually would be paid off in a significantly debased and devalued dollar.
Implications for the United States’ sovereign credit rating is discussed more fully in a later section, but the unfolding fiscal crisis also opens the possibility of a credit downgrade for U.S. Treasury securities. This could happen before either of the two broad solutions discussed above comes into play.
Accounting Gimmicks Mask Underlying Reality for Decades
Misleading accounting used by the U.S. government, both in financial and economic reporting, far exceeds the scope of corporate accounting wrongdoing that has received partial credit for recent stock market turbulence. The bad boys of Corporate America, though, still were subject to significant regulatory oversights and the application of GAAP accounting to their books. In contrast, the government’s operations and economic reporting have been subject to oversight solely by Congress, America’s only "distinctly native criminal class."
Nearly four decades ago, President Lyndon Johnson’s political sensitivities led him and the Congress to slough off some of the costs of an escalating Vietnam War through the use of accounting gimmicks. To mask the rapid growth in the federal government’s budget deficit, revenues from the surplus being generated by Social Security taxes were added into the general cash fund, without making any accounting allowance for the accompanying and increasing Social Security liabilities. This accounting-gimmicked reporting was dubbed "unified" budget accounting.
The government’s accounting then, as it is now, was on a cash basis, reflecting cash revenues versus cash expenditures. There were no accruals made for monies owed by or due to the government at some time in the future.
The bogus accounting understated the actual deficit for decades and even allowed for claims of budget surpluses in the years 1998 to 2001. While there were extensive self-congratulatory comments between the President, Congress and the Fed Chairman, at the time, all involved knew there never were any actual budget surpluses. There hasn’t been an actual balanced budget, let alone a surplus, since before Johnson and his cronies cooked the bookkeeping.
The doctored fiscal reporting complemented the short-term political interests of both major political parties. Additionally, the ignorance and/or complicity of Pollyannaish analysts on Wall Street and in the financial media-eager to discourage negative market activity-helped to keep the fiscal crisis from arousing significant concern among a dumbed-down U.S. populace.
U.S. Treasury Owns Up to a Financial Nightmare
In the mid-1970s, the then "Big Ten" accounting firms proposed setting up for the federal government an accrual accounting and reporting system similar to that used in the business community. Purchases of capital equipment, weapons and buildings would be booked as assets and depreciated, taxes receivable and accounts payable would better reflect near term cash needs. Accrued liabilities, such as Social Security payments due in the future, would reflect longer-term cash-flow needs.
As the project progressed, GAAP accounting was applied to the government’s operations and prototype annual statements were published beginning in 1974. The appropriate accounting for Social Security liabilities, however, was discarded during the Reagan administration as being politically untenable.
Under the eventual mandate of Congress, the accounting project culminated in the U.S. Treasury publishing its first formal Financial Report of the United States Government for fiscal year 2000, consistent with GAAP, except for Social Security and similar accounts such as Medicare, Medicaid and the Railroad Retirement Fund.
To the credit of the Bush administration, later reports, published in April 2003 and April 2004 for fiscal years 2002 and 2003, indicated for the first time since the 1980s what the Social Security and related numbers would look like if they were included in the accounting, just as corporations need to account for pension and retiree health benefit liabilities.
The gimmicked accounting standards, as established during the Johnson era, and as used today for official, unified budget reporting, show a 2003 deficit of $374.3 billion. Using GAAP reporting (without Social Security reporting), the official GAAP deficit for 2003 expands to $665.0 billion. Including accounting for Social Security and related areas, the 2003 deficit balloons to $3,702 billion, or $3.7 trillion. The accounting reflects no adjustment for the new, more expensive Medicare program.
As an aside, if you download a copy of the financial statements, the GAO’s auditor’s letter as to why they won’t certify the statements is an exposé of significant financial mismanagement within the federal government.
Beyond the $3.7 trillion deficit in 2003, however, the numbers get even worse, because the shadow deficit has been taking its toll ever since the Johnson era. According to the Treasury’s 2003 financial statement, the U.S. government has a negative net worth of $34.8 trillion. That $34.8 trillion reflects $36.2 trillion in financial liabilities offset by $1.4 trillion in assets, of which only $0.4 trillion are liquid.
Part of the underlying reality-the actual operating cash shortfall-is reflected in the growth of the federal debt. During fiscal 2003, for example, gross federal debt increased from $6.2 trillion to $6.8 trillion, or by $600 billion, against the unified $374 billion deficit. As of the end of August 2004, the debt had increased to $7.3 trillion.
While gross federal debt is at a record, relentlessly pushing against borrowing ceilings, the markets, press and politicians generally ignore that portion of the debt borrowed from Social Security and similar programs. So, the September 30, 2003 debt level commonly is reported as only the $3.9 trillion owed to the public, instead of the total $6.8 billion. Again, the more accurate GAAP estimate of total government liabilities is $36.2 trillion.
Results for the official 2004 deficit will be published in the next several months, and the numbers are projected by the Bush administration to be significantly worse than in 2003, $445 billion versus $374 billion, with the actual deficit likely to near $4.3 trillion (my estimate). The 2004 GAAP financial statements on the government will not be published until March/April 2005.
GAAP-Based GAAP-Based Fiscal "Official" Deficit Without Deficit With Year Deficit Soc. Sec., Etc. Soc. Sec., Etc. ————————————————————
2004 est. $445 Billion $800 Billion $4.3 Trillion
2003 $374 Billion $665 Billion $3.7 Trillion
2002 $158 Billion $365 Billion $1.5 Trillion
The credit markets were rattled slightly by the early official projections of an increasing shortfall in government finances, but only the surface problems have gained any market recognition. The full magnitude of the difficulties ahead is not recognized by the markets, yet.
With 2003 gross domestic product (GDP) (annual average for the government’s fiscal year) at $10.83 trillion, that places the annual budget deficit and total government obligations at respectively 34.2% and 334.3% of GDP, negative extremes never before breached outside the environment of third-world, net-debtor nations.
Is "AAA" Rating of U.S. Treasury Debt Sustainable?
The major U.S. credit rating agencies, S&P, Moody’s and Fitch, issue credit ratings to sovereign states. The United States enjoys the top "AAA" rating, but that could change if the rating agencies apply their sovereign credit rating methodologies to the GAAP U.S. financial statements, instead of the gimmicked accounting accepted for decades.
As an example of part of the ratings approach, Fitch notes in its Sovereign Ratings Rating Methodology:
Sovereign borrowers usually enjoy the very highest credit standing for obligations in their own currency. If they retain the right to print their own money, the question of default is largely an academic one. The risk instead is that a country may service its debt through excessive money creation, effectively eroding the value of its obligations through inflation.
Such risks will come into play in the future article on possible hyperinflation. The question at hand is the top "AAA" credit rating held by the United States, home base of the U.S. dollar, the world’s primary reserve currency.
In determining a sovereign rating, Fitch reviews, among other factors, "the orthodox indicators such as ratios of debt to exports and debt to Gross Domestic Product, providing a measure of the current and prospective ability to service debt."
The United States is the world’s largest net-debtor nation, has the world’s largest current account trade balance and has the highest level of debt or financial obligations ever seen, irrespective of relative measure, for any major country, by at least an order of magnitude.
As of August 2004, Fitch gave the "AAA" rating to only 15 countries, including the United States. The other 14 are Austria, Canada, Denmark, Finland, France, Germany, Ireland, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland and the United Kingdom. Of those 14, five ran budget surpluses in 2003, including Canada, Denmark, Finland, Norway and Sweden. The worst deficit as a percent of GDP was for France at 4.1%, followed by Germany at 3.5%. In contrast, the not-generally-recognized GAAP U.S. deficit in 2003 was 34.2%.
Similarly, the highest level of debt to GDP seen among the 14 other "AAA" countries is at 75.6% for Canada, followed by France at 71.1%, Germany at 65.1% and Austria at 64.9%, versus a GAAP ratio of total financial obligations to GDP of 334.3% for the United States. The low ratio among the "AAA" countries is Luxembourg at 4.9%.
Where most of the other "AAA" countries have significant unfunded social insurance liabilities that are not included in the debt-to-GDP ratios, consistent 2003 numbers are not available. As a rough estimate, the high ratios mentioned for Canada, France, Germany and Austria would increase by two-to-three times, still well shy of the U.S. extreme. The ratings agencies are well aware of these circumstances and have noted the generally deteriorating credit quality of the major Western economies, particularly the United States. S&P seems comforted by expectations that most countries "will step up their efforts to more effectively confront the fiscal ramifications of aging …"
Of the 15 "AAA" countries, all but Austria, Ireland, the United Kingdom and the United States run current account trade surpluses. As a percent of GDP, the Austrian, Irish and U.K. trade deficits are 0.2%, 2.5% and 2.8%, respectively, versus 4.8% for the United States.
At "AA," two credit notches below the U.S. (two notches taking into account the AA+ between AAA and AA), sits Japan. Japan’s deficit and debt levels as percentages of of GDP are 8.0% and 157.3%, respectively, worse than the "AAA" rated countries but still much better than the U.S. GAAP ratios. Japan also runs a current account surplus.
In searching World Bank data, I couldn’t find any nation with a debt-to-GDP ratio worse than the United States’ GAAP obligations ratio of 334%. The closest found is for the West African state of Guinea-Bissau at 224%, but Guinea-Bissau is not rated.
The twist here, of course, is the accounting method used in analysis. Based on the gimmicked, instead of GAAP, fiscal numbers, the U.S. deficit and debt ratios are a little high but relatively benign at 4.8% and 62.8%. Further, much more goes into a sovereign debt rating than the discussed ratios. Still, if any country but the U.S. had GAAP deficit and debt ratios of 34% and 334%, its debt most likely would be given junk-bond status by the rating agencies.
Accordingly, a case can be made that the risks of the United States "servic[ing] debt through excessive money creation" are high enough so as to be inconsistent with a "AAA" rating. Political practicalities, though, likely will forestall any formal downgrade of the U.S. credit rating. Since a downgrade would trigger global financial-market and currency turmoil, action even could be delayed until the last minute.
Nevertheless, Fitch had the United States on a negative rating watch in 1995, and there have been occasional rumblings by S&P and Moody’s when Congress has been slow to authorize raising the ceiling on federal borrowing limits. Minimally, a shift to a negative rating outlook by one or more of the major rating agencies is not out of the question.
Irrespective of any credit rating actions, the credit markets usually catch up with underlying reality. That suggests there will develop a long-term higher floor under U.S. interest rates than has been seen previously.
Financial Report of the United States Government, 2003, Financial Management Services, U.S. Treasury, page 4, "Overall Perspective" table. The $3.7 deficit is the difference between "Total Assets minus Total Liabilities & Net Responsibilities," otherwise known as "Net Worth," in 2003 versus 2002, deficit net worths respectively of $34.8 trillion and $31.1 trillion. The $3.7 trillion deterioration is the actual shortfall in 2003 government operations.
PDF available at: www.fms.treas.gov/fr/03frusg/03frusg.pdf
Fitch Ratings website.
Based on analysis of data available in the Central Intelligence Agency’s The World Fact Book 2004, the International Monetary Fund’s World Economic Outlook April 2004, and the OECD and World Bank websites.
"The Western World Past Its Prime—Sovereign Rating Perspectives in the Context of Aging Populations," Standard & Poor’s, March 31, 2004, available at S&P website.