Even Warren Buffett Can Think Fuzzily; Maybe Keynes Also

Here is a proposal by Warren Buffett from his recent interview with Charlie Rose:

“Well, I think -- I think if we get back on more or less the formula we had which was getting 18.5 percent or 19 percent of our revenues from taxes, we can spend 21 percent then. We can run a deficit of a couple percent of GDP on average over time because our -- our country will grow and we have a lot more debt capacity than we had back in 1790, just like I’ve got more paying capacity than I had 50 years ago. 

So as your income grows, your population grows, your wealth grows you can handle more debt. But you can’t let it keep increasing as a percentage of your income or wealth and which is what we’ve been doing like -- like crazy lately.

So I don’t mind a couple of percentage point gap; 18.5 percent or 19 percent on revenues, 21 on thereabouts on expenditure but that means we have to hit both sides. And we can’t put ourselves on a trajectory that takes the expenditure side up automatically as the years pass, which is what we’ve done with entitlements.”

(Note: I'm taking the liberty of assuming what Mr. Buffett really meant by his puzzling first sentence above was that we could get back to taking 18.5 to 19% of GDP as federal government revenue.)  Here is an illustration of Mr. Buffett’s targets in historical context. They look pretty aggressive in terms of deficit reduction, but are not good enough.

Buffett’s suggestion is a formula that served him very well as he built his fortune of $50B, but it did not serve the country well because the targets he suggests are almost exactly what we have averaged for the last 45 years, federal receipts of 18.4% of GDP and federal spending of 20.8% of GDP. A major variable he omits is the interest rate that has to be paid on the accumulated debt.

I worked up a simple model showing the effect on accumulated debt as a percent of GDP with a range of inflation rates, real GDP growth rates, and interest rates on the debt. Examples are below, and they show that unless the interest rate is less than half the total of the inflation and real GDP growth rates, the debt keeps growing. I’ll be glad to provide the spreadsheet if anyone wants to check it out.

If a country has a robust real growth rate and little or no inflation, it is pretty easy to borrow at half the real growth rate. Three percent long bonds in an environment of 6% real growth and no inflation would be quite achievable. However, if a country has robust inflation and little or no real growth, the interest rate is going to have to be greater than the inflation rate. Six percent inflation and no growth is probably going to require 8% or 10% on the bonds.

I understand that Mr. John Maynard Keynes, British economist of the last century, came up with the idea of deficit spending by government in order to stimulate the economy when things get sluggish and that that particular proposal became very popular because it was fun, made the people happy, and got the politicians re-elected. I've never studied Mr. Keynes but, if he was as smart as people say he was, he must have also pointed out the need for government to spend less than it takes in when times are good in order to pay down the debt accumulated during the bad times. Doing so would be good use of the old “saving for a rainy day” principle, would help keep interest rates low, and would possibly help prevent those irrational exuberance-based booms and bubbles which always seem to end badly. If he didn't include that in his proposal, then I am not really interested in anything he said.

We missed a great opportunity during the George W. Bush administration to skip the infamous "Bush Tax Cuts" and instead pay down the debt, or at least avoid its rapid expansion, and possibly avoid or mitigate the housing bubble which ended in disaster in 2008. All we had to do was continue the surpluses generated under the leadership of Bill Clinton (D), Trent Lott (R), and Newt Gingrich (R). Cooperation of those three led to the only three years in recent history in which federal revenues exceeded federal spending.

In the quote at the beginning of this post, Mr. Buffett got pretty close to the truth in the second paragraph, but the first and last paragraphs have some statements with fuzzy mold growing on them.

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