Friday, August 5, 2011

Balanced Budget And Balance Budget Amendment: Dangerous Fiction

Sense or non-sense and will it ever happen?

First some ground rules. Both the idea of a balanced budget and a constitutional amendment are discussed in terms of an amendment. But, everything said applies to both. Also, this posting isn’t going to address the “right” size of government, nor the question of whether the right size of government changes over time. It’s also going to keep as much distance as possible between the posting and questions about what determines the right size of government. Now that all the people who stumbled onto the posting looking for a rant have left, let’s look at what is discussed.

Every effort is made to approach the issue as a budgeting and financial management question. Just in those terms, a balanced budget amendment isn’t a quick fix or silver bullet. In fact, it’s not even a quick fix for some other issues such as those the posting chose to ignore, and just from a financial management perspective the issue is more complicating than one might think.

The first question one should ask is: Could a balanced budget amendment work? Keep in mind we still haven’t addressed whether one is desirable or what it would be designed to accomplish. However, the starting point should be to acknowledge who makes the accounting rules that determine whether the budget is balanced. For all practical purposes, the government makes up its own accounting rules. So, in the strictest sense the answer is: A balanced budget amendment can’t force the government into a specific budgetary action.

The second question, one that follows directly from the answer to the first, is: Short of “control,” could a balanced budget amendment influence the government’s behavior? There can be little question that it conveys intent. Further, for good or bad, it could involve the judiciary in the process if someone decides to take the interpretation of the rules to court. That would make it necessary to change the rules, not just bend the interpretation. Bending interpretations is loophole government’s love.

Also, there is overwhelming evidence balanced budget amendments influence behavior at the state and local government levels. However, as many state pensioners and taxpayers are learning the hard way, the resulting behavior isn’t always what was envisioned. Unfunded promises and hokey forecasts are far too easy a response. They’re tricks every politician knows.

Finally, the consequences of violating the rules could be structured in a fashion that encourages compliance so that sanctions for violation are irrelevant. (An example using term limits will follow). So, the answer is clearly: Yes, a balanced budget amendment would influence behavior. But, not always in the way intended.

The third question is: Does a balanced budget amendment make sense? We’re still at a fairly abstract level since we haven’t defined a balanced budget amendment. Yet, even at this abstract level, annual budget balancing is a silly idea. People don’t do it, sometimes in folly, but often for good reason. People have capital accounts or balance sheets. Money is flowing in and out of those capital accounts making a balanced budget for any year unnecessary and often highly undesirable.

It is folly to balance cash flow accounts for any fixed period of time, certainly on an annual basis. That would make NO provision for the purchase of any asset with less than a one year payback period. There would basically be no fixed capital. Kiss the manufacturing base good-by if everyone does it. Similarly, it would preclude time-purchase of any consumer good where the value of the first year’s benefit of having the good was short of the purchase price. Basically, there would be no owner-occupied homes, few if any appliances, probably no cars, and probably no horse and buggy for that matter. Fortunately, people both acquire assets and borrow to invest and consume, but as discussed previously in “Truth In Lending” and “Borrowing For Investment,” not always for good reasons.

People do manage balance sheets as well as cash flow, although not always consciously or well. By contrast the Federal government does its accounting on a cash flow basis. It very conveniently ignores its balance sheet. That approach substantially increases the likelihood of errors – errors in each step and cumulative errors. To illustrate the risk on each step, both the initial Boehner and the Reid proposals to end the deadlock on the debt ceiling came up short when scored by CBO. For cumulative error, how have the forecasts of Medicare and Social Security faired?

The absence of a balance sheet seems to totally confuse some people. The Hedged Economist is of the opinion that some people in government don’t even understand a balance sheet. They’re expert cash flow managers, but wouldn’t have a clue about relating cash flow to a balance sheet. That’s not all bad. Others understand the relation, but intentionally use it to their short term advantage. Cash flow managers are important, but they aren’t enough.

The conspiracy theorists fabricate sinister motives for the absence of a balance sheet. It never occurs to them that the government can’t construct a balance sheet.

Why can’t the government construct a balance sheet? Well, what is the present value of the right to print the money? What’s the present value of the authority to collect taxes? You need those calculations since they are government assets. Think you’re getting close despite the obstacles? Well, what’s the present value of the ability to influence, some would say control, even set, the interest rate used to determine all those present values? Can’t be determined is the answer.

Some extremists resort to: “Well, the government shouldn’t be doing all those things.” Sort of, if I can’t figure it out, it should be illegal. But, then what’s the right to make it illegal worth? Furthermore, if they can make it illegal, they can decide to not make it illegal. What’s that worth? Note that we haven’t even broached the subject of the value of the exclusive right to make war or enforce laws.

It gets just as complicated when one starts thinking about the physical assets the government purchases. Does one carry an aircraft carrier at its acquisition cost, and how is it depreciated? Is it worth more if there is a war? Or, is its purpose deterrence? If so, should all defense expenditures be written off in the event of a war? Perhaps, written down based on the size of the war? What’s the value of the capital building, white house, Air Force One, the entire federal triangle, every military base, all public lands, mineral rights, and control of the offshore? How should they be depreciated?

Given the absence of a balance sheet, any balanced budget amendment would have to focus on cash flow. It would be flying blind in the same sense as people who borrow or invest without thinking about their balance sheet are flying blind. Thus, a balanced budget is almost guaranteed to lead to mistakes if based on annual fiscal years. So, a balanced budget amendment based on balancing the budget in each of the government’s annual accounting years would be financially irresponsible. It was put more bluntly in the earlier statement: Annual budget balancing is a silly idea, and as discussed in “The Only Truth About Finance,” it’s a sure fire way to always be broke.

Back in 1776 Adam Smith pointed out that the wealth of a nation is determined by the productivity of its people. If the wealth of a nation is the productivity of its people, it seems logical that the government which is, after all, a creation of those people, is somehow related. The relationship is fairly direct: the more productive the people, the higher the value of most of the government’s assets. What they’re worth is a guess, but they are worth more in a wealthy (i.e., productive) nation; that isn’t questionable.

So, while constructing a balance sheet for the federal government is impossible, the exercise of thinking in terms of balance sheet and cash flow is possible and desirable. It defines the appropriate accounting period. Since the value of the government’s assets, what it has that serves as collateral, is largely determined by the economy, the economic cycle is a reasonable accounting cycle. But, since policy influences the cycle, a policy error can influence the accounting cycle. Given the feedback, some “normal” cycle expectation is needed as a control.

As cycle analysts, the dreaded cycle theorists, have documented, there really isn’t one cycle. But, absent some substitute for a balance sheet and a defined accounting period, we have seen that the potential for cumulative errors mentioned earlier isn’t a potential, it’s a darn good forecast. In the US and around the world, governments make the same cumulative error. So, the logical question is, can the uncertainty and need for some control of cumulative errors (whether deliberate or mistakes) be addressed through a balanced budget amendment?

Fortunately, the founding fathers had some good ideas about how to structure a government. (No, there isn’t a question about the present value of the constitution even though it has great value). Let’s look at the structure and note a few things. First, they divided power between branches of the government and the chambers of the congress. Second, they set up different length of time in office for different institutions.

So, there isn’t a way to clearly link cycles, the appropriate accounting period, to everyone’s terms in office; the terms differ. But, clearly it is the people who are in office that a balanced budget amendment has to influence. Government is those people functioning within the framework of government. Perhaps the framework for a balanced budget amendment can be adjusted in a way that takes advantage of differences in periods of time in office, and takes economic cycles into account.

The separation of power and the different periods of time in office provide some levers that can be used. Here’s how. Link the balancing of the budget to the ability to run for re-election (i.e., term limits). This would be most important for the legislature. But, in order to accommodate the uncertainty associated with economic cycles, don’t make the limits the same for all chambers of the legislature.

For example, if a House member has served some number of terms, he or she can only run for re-election if the budget has been balanced on average during the most recent some number of terms of service. The Hedged Economist favors three terms or six years. That’s long enough to accommodate Keynesians who want deficits during economic slowdowns without being so long that it accommodates those pesky cumulative errors mentioned earlier. But, the key is that whether it three terms or four, it provides an incentive to run both deficits and surpluses.

The Senate doesn’t need incentives that are exactly the same. So, again, some number of terms seems appropriate; two terms or twelve years seems a good starting point for discussion. You may wonder: Why different periods? 1) The constitutional framers envisioned spending bills usually originating in the House. 2) Keynesian demand-driven cycles aren’t the only things that produce economic cycles. Having one chamber that could focus on longer cycles wouldn’t be harmful. (Granted that’s irrelevant if all politicians continue their short-run focus). 3) It would give the far left a focus. Face it; there are people like Paul Klugman who has never seen a deficit he didn’t like, except that he always feels they should be bigger. Yet, the term limits set at two unless the budget is balanced would keep their mistakes from becoming cumulative.

Finally, since the executive branch proposes rather than enacts, either leave it out or link a re-election run to executive budget proposals. Theoretically the executive is administering a budget set by the legislators. Letting a president serve two terms regardless seems reasonable. But, we can’t just ignore the veto. Yet, two terms doesn’t seem too long. Hopefully the judiciary can be left out of it.

Now let’s look at what’s left to consider. What’s been discussed so far only addresses the cyclical issue. The entire discussion originated from the implications of the economy for the assets on the government’s balance sheet. The economy doesn’t just fluctuate; it tends to grow from cycle to cycle. One could argue that as GDP grows, the assets increase in value creating greater debt-carrying capacity. It’s a legitimate balance-sheet-based argument.

However, debt carrying capacity also involves cash flow. One can easily envision expenditure and tax responses to changes in income that could make balanced budgets a disaster under either a growth assumption or during contractions. It involves speculating about the elasticity of asset value, revenue (cash income), and expenditures.

There is, however, a saving grace in the term limits approach. The parties involved have the control to change the structure before the consequences force them from office. For example, if economic growth produced expenditure growth that accelerated too rapidly, the legislators could change either the revenue structure or the expenditure structure. In this respect, previous periods under a balanced budget regime would make the process easier since simultaneous disequilibrium on the balance sheet and in revenue or expenditures would be less likely, not impossible but less likely.

Finally, once one broaches the subject of the response to long-run trends, it is impossible to avoid all the issues this posting tried to avoid. But, contrary to the belief of many people on both sides of the balanced budget debate, a balanced budget doesn’t address the size of government. If both revenue and expenditures grow faster than the economy, the government could grow to include most of the economy. The opposite is also true. People forget that many expenditure and revenue-related government items are indexed because of the funky way they respond to changes in nominal income.

So, back to the question of could a balanced budget amendment be structured in a way that makes sense? The answer is: Yes, a balanced budget amendment can be made sensible in the US. But, it sure wouldn’t look like what most people think of when they say balanced budget amendment, and it would accomplish few to none of the objectives of either advocates or those who oppose it.

So, that brings us to the real concern: Is a balanced Budget amendment desirable? Here’s a unique answer. A balanced budget amendment is an embarrassing admission of the failure of our governing system as currently designed to automatically generate responsible budgetary behavior. In that respect, one answer is: It seems just having to ask the question is undesirable.

There is a broader negative associated with a balanced budget amendment. First, if the US starts out in disequilibrium, a balanced budget provides no mechanism for restoring equilibrium. To illustrate, after World War Two, the war effort had created a debt-to-GDP ratio similar to the current ratio. It had also created tremendous pent-up demand (for investment in plant and equipment to retool from war to civilian production and for consumption after a period of rationed consumer goods and forced consumer sector saving). While growth was the major mechanism for bringing equilibrium to the GDP-to-debt ratio, surpluses, not balanced budgets also contributed. While the example uses a high debt to GDP ratio, the opposite situation can also exist.

Second, a balanced budget amendment ignores the real issue which is, in fact, the balance sheet. While the debt-to-GDP ratio provides some guidance because GDP bares a rough relation to asset value, debt has become a lousy proxy for liabilities. The reason is exactly the same reason some states are in a fiscal crisis mode. Politician have long since learned that promises of future “entitlements” are a more effective way to buy votes than current expenditures. More effective because the absence of a current cash cost and no balance sheet on which the liability appears make it possible to deliver more goodies for less. Basically they get more bang for the buck. Thus, governments have shifted from resource allocators to entitlement allocators.

So, a balanced budget amendment isn’t desirable because it ducks the important issues. It ducks the issues this posting intentionally avoided. Worse still, it ducks the issue of responsible debt management at the federal level. It perpetuates the myth that politicians can ignore the difficult and uncertain (and yes indeterminate) chore of thinking realistically about the government’s balance sheet.

So, that leaves the question: Will it happen? This last question is the point where the issue of an amendment to the constitution has to be separated from the question of whether the budget will be balanced.

The second question is addressed first because the answer is easier. Yes, at some point the budget will be balanced. More than likely it will occur temporarily on a path from deficit to surplus. If not, a balanced budget will be forced on us by an absence of lenders. On the question of an amendment, let’s hedge the bet. Probably enough people will recognize that a balanced budget amendment is financial mismanagement to keep it from happening. If it does, it will be repealed faster than prohibition. But, the entire discussion of linking it to term limits was a hedge. People do the darnedest things, especially when it comes to financial management, and The Hedged Economist is never surprised when, collectively, politicians do dumb things. Smart individuals can do increditably foolish things when they become a crowd.

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