The Agenda

Leveraged Governments vs. Leveraged Firms

David Stockman has drawn attention for criticizing the 2001 and 2003 tax cuts in an interview with the Fiscal Times:

The fact is, the Bush tax cuts were unaffordable when enacted a decade ago. Now, two unfinanced wars later, and after a massive Wall Street bailout and trillion-dollar stimulus spending spree, it is nothing less than a fiscal travesty to continue adding $300 billion per year to the national debt. This is especially true since these tax cuts go to the top 50 percent of households, which can get by, if need be, with the surfeit of consumption goods they accumulated during the bubble years. So Congress should allow the Bush tax cuts to expire for everyone. By doing nothing, the government would be committing its first act of fiscal truth-telling in decades.

This strikes me as a pretty defensible view. His criticism of fiscal stimulus in this environment is equally interesting, though it doesn’t seem to have drawn as much attention:

We are not in a conventional business cycle recovery, so stimulus is futile and just adds needlessly to the $9 trillion of Treasury paper already floating dangerously around world financial markets. Instead, after 40 years of profligate accumulation of public and private debt, and reckless money-printing by the Fed, we had an economic crash landing, which left us with an enduring structural breakdown, not just a cyclical downturn.

 

In effect, we undertook a national leveraged buyout, raising total credit market debt to $52 trillion which represented a 3.6X leverage ratio against national income or GDP. By contrast, during the 110 years prior to 1980, our aggregate leverage hugged closely to a far more modest ratio at 1.5 times national income.

I like this framing, but there is an important difference between a leveraged government and a leveraged business enterprise. In a concise and lucid paper on “Leveraged Buyouts and Private Equity” [PDF] that appeared in the Journal of Economic Perspectives last year, Steven Kaplan and Per Stromberg describe how private equity works. First, firms pay careful attention to management incentives. Third, there is an emphasis on governance and to a lesser extent operational engineering. Second, and most salient for our purposes, is the use of leverage to create spending discipline:

The second key ingredient is leverage—the borrowing that is done in connection with the transaction. Leverage creates pressure on managers not to waste money, because they must make interest and principal payments. This pressure reduces the “free cash flow” problems described in Jensen (1986), in which management teams in mature industries with weak corporate governance could dissipate cash flows rather than returning them to investors. In the United Statesand many other countries, leverage also potentially increases firm value through the tax deductibility of interest. On the flip side, if leverage is too high, the inflexibility of the required payments (as contrasted with the flexibility of payments to equity) increases the chance of costly financial distress. [Emphasis added.]

Interest and principal payments force a firm not to waste money because the only way to increase revenue is to sell more stuff. Firms can’t impose taxes that people must pay under penalty of law. That is, governments have an escape hatch that firms do not. So we’ve LBOed ourselves as a country, but instead of imposing spending discipline this has created almost irresistible pressure to raise taxes. This is the central challenge facing the U.S. public sector: how do we impose spending discipline before we’re truly on the brink of disaster? 

Stockman continues:

The only solution is a long period of debt deflation, downsizing and economic rehabilitation, including a sustained downshift in consumption and corresponding rise in national savings.

And a key element of the latter is a drastic reduction in government dis-savings through spending cuts and tax increases — and these measures need to start right now.  Keynesian policymakers who say wait for the midterms to address the deficit are like battleship admirals: They are fighting the last war with the same failed strategy that gave rise to our current predicament.

Stockman is a hard-core “Austerian,” and his work in the “real economy,” in the private equity business as it turns out, seems to have given him valuable perspective. Can’t say I agree with him in every detail of his story, but it’s certainly provocative:

TFT:  With the midterms just a month away, do you think the GOP will gain as many seats as some are predicting, and if so, will that doom Obama’s agenda?

 

DS:  The Republicans will undoubtedly gain a lot of seats, if not congressional majorities. But the main result of that will be not only to doom the Obama agenda, which deserves to be stopped, but also any chance of addressing the fiscal issue until April 2013 at the earliest. Unfortunately, since we are in a chronic debt deflation, the GDP deflator is heading toward zero and real growth may limp along at 1 to 2 percent. That means that money GDP is growing at the shockingly low rate of 2 to 3 percent, or not even $40 billion per month. By contrast, the built-in deficit will result in $100 billion of bond issuance each and every month — meaning that through at least the spring of 2013, our national debt will be growing two or three times faster than the economy. So we are rolling the dice big time in a global bond market which is now a volcano of leveraged speculation and massive front-running of the expected multitrillion quantitative easing 2.0 (i.e. debt monetization) by the Fed. In this environment, one hiccup and it’s game over.

And on that note!

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