What Are Your Assumptions?

That is the first question that always had to be asked and answered in my years as an engineer and manager at Eastman Chemical Company. “What are your assumptions?” Sometimes I was answering, and sometimes I was asking, but those assumptions were always required for any business plan put forth.

I just took a look at President Obama's most recent budget proposal, his “business plan” for the USA. You can find it here. Clearly there is a plan for how much to spend and how much revenue to raise through taxes, and that plan shows government spending and national debt shrinking as a percent of GDP over the next ten years. Those are comforting trends, if the assumptions on which the plan is based are reasonable.  (You can click on the charts below for high resolution views.)

The chart above illustrates the plan, and the interesting thing about it is that, of the three major components of government spending, most of the increase in spending is in the social entitlements and the rest is in interest on the national debt.  Both are projected to continue to grow throughout the next ten years.  Discretionary spending, including defense and security, is not projected to grow at all. Looking at this plan leads me to categorize the administration proposal as cowardly rather than extravagant. They are just projecting increases already legislated and demographically determined, holding discretionary spending pretty constant, hoping for low interest rates and robust GDP growth (rosy assumptions maybe), and avoiding the ultimate reckoning that will occur when it becomes obvious that Social Security and Medicare reform are required. Just don’t bring it up in an election year, or in a campaign year, which pretty much covers all the years.

But, back to the assumptions: There are two key assumptions on which these plans must be based and against which they must be evaluated. One is the inflation rate, reflected primarily in the interest on the national debt. The other is GDP growth.

The administration has assumed that interest rates on the debt will range from 1.5% to about 3.2% over the next ten years, very low by historical standards. I would categorize that as a “rosy” assumption.

The administration has assumed that GDP will grow at an average of about 5% per year, representing a reversal of the long term downward trend and also, in my opinion, a “rosy” assumption based more on hope than on realistic projections of economic activity. Clearly, plans to pull more resources from the private economy for government spending will be exerting downward pressure on GDP growth.

I don’t have time to do the numbers right now, but you can imagine what the situation will be in a few years if inflation and interest rates go back to 6% and GDP growth is only 2%. We will need a bailout and will do it ourselves by printing more money and inflating the currency. No riots in the streets in America. If only Greece could print Euros!

Of course we always had “rosy” assumptions at Eastman Chemical also, especially if we were champions of a project. Honestly speaking, few projects lived up to their projected levels of return on investment. If they had, Eastman would be one of the world’s largest and most profitable chemical companies today (instead of a small and moderately successful company). But there was always a reality check, quarter by quarter, as sales and earnings were reported and investors made decisions about whether to buy or sell our shares. Soon, if my less “rosy” assumptions are correct, the USA will face a reality check on government spending, actual GDP growth and interest rates and inflation, and will, I suspect, have to make a painful change.

The sooner that change is made, the more gradual it can be.