How to Really Fix the Federal Budget

Families and businesses count and add the numbers honestly. They invest and plan for the future, and borrow when it makes sense. Washington could take a lesson.

The US budget is broken.

No, no, I don’t mean that the US is deeply in debt, so deeply that some wonder if we can ever dig ourselves out. And I don’t mean that our annual deficit, an estimated $1.65 trillion for fiscal 2011 year, threatens to soar even higher.

I mean that the actual federal budget, the mechanism that’s supposed to tell us whether our finances are in good or bad shape, and whether they’re getting better or worse, is broken.

It doesn’t give us an accurate picture of our financial health. And as for giving us guidance for where we’re headed, well, it’s like using a meat thermometer to gauge the weather, like timing a soft-boiled egg with a sundial, like deciding what to wear by looking at average daily temperatures, like . . . .

Don’t get me started.

As a result, the entire battle over raising the debt ceiling, cutting the annual federal budget, and even, maybe, raising taxes (excuse me, enhancing revenue) someday is a battle fought between two armies blundering across the landscape wrapped in the deepest Scots haar fog and whacking about with their claymores at friends, foes, and innocent sheep alike.

And a balanced budget amendment? Nobody can possibly decide whether it’s a good idea, a disaster, or a harmless joke, given the present state of our governmental budgeting. To start, what do the terms “budget” and “balanced” even mean in Washington?

OK, enough of a rant. Let’s get down to brass balance sheets. We can start with those definitions for “budget” and “balanced.”

On- or Off-Budget?
Look at the scorecard constructed by the Congressional Budget Office (CBO) for President Barack Obama’s fiscal 2011 budget. Revenue, estimates the CBO, will come to $2.27 trillion. But note that only $1.7 trillion of that is “on-budget" revenue according to the CBO. The budget office calls the additional $570 billion “off-budget" revenue.

The same terminology turns up on the spending side. On-budget spending amounts to $3.2 trillion, with off-budget spending adding up to $497 billion.

If you’re looking to balance the something called the budget, what numbers do you look at? And what is off-budget spending anyway?

Turns out most of what’s off the budget comes from the collection of Social Security taxes—revenue—and payment of Social Security benefits. That money goes into (and flows out of) the Social Security Trust Fund and doesn’t get counted as part of the budget. Although, as you know, if you’ve been following the current debate about the debt ceiling, Social Security checks do seem, strangely enough for an off-budget item, to come out of the US budget. (Another off-budget item is the US Postal Service. And some spending moves between off- and on-budget. The costs of the Iraq War were initially covered through special emergency appropriations, for example, and weren’t "on budget.")

NEXT: Is Balanced an Unbalanced Approach?

Is Balanced an Unbalanced Approach?
Let’s say you define what you mean by budget, maybe by putting all the off-budget items into the budget to create what’s called a unified budget. You’ve still got another problem definition. What do you mean by “balanced”?

Let’s say it’s the 1990’s and the Social Security Trust Fund is taking in more than the government is paying out. That was true during much of the Clinton presidency (and, in fact, until relatively recently). But you know that this is a temporary situation. As the baby boomers continue to age, the time will come when the trust fund is taking in less than the government is paying out. So considering the absolutely predictable future obligations, when is the budget balanced?

That’s a problem with the expected. Now, how about the unexpected? Hurricane Katrina made landfall near New Orleans at the end of August 2005. By October 2005, Congress had appropriated $62.3 billion in supplementary spending for disaster relief and recovery. Even then, voices in Congress argued against that spending because it would increase what was seen at the time as a large deficit.

Or how about the expected unexpected? By this, I mean the business cycle. We know—or at least everyone except Alan Greenspan knows—that the economy will go through boom and bust cycles. During the booms, tax revenues will soar and expenditures for some things—unemployment benefits, for example—will fall. If the government does nothing to change spending—such as passing a huge tax cut—the budget will move toward surplus. During the bust years, tax revenues will fall as the economy slows and the costs of things such as unemployment benefits will climb. The budget will move toward deficit, especially if the government decides that the downturn is severe enough to justify increased spending on infrastructure projects, say, or tax cuts, or credits to spur hiring.

We know from the history of the Depression—from the budget-balancing efforts of President Herbert Hoover and in the very earliest part of President Franklin D. Roosevelt’s administration—and from the 1937 relapse into Depression—that balancing a budget during a downturn, which requires cutting government spending, makes the downturn worse. When the bust in the cycle produces what some economists call a demand recession, marked by falling private demand for goods and services, increased government spending on goods and services can lessen the depth and duration of the downturn.

So is your definition of a balanced budget one that is always in balance no matter what strikes the economy? Or is it one that says “emergency” spending is OK, even if it puts the budget into the red? (And if the latter, you still have to define “emergency.”)

Let me throw one more element into the soup.

NEXT: The Need to Invest

The Need to Invest
Not all government spending is the same, although the current budget treats it as such. There’s a huge difference between spending money to pay salaries for government workers, for example, and spending money to build a highway or to expand the port of Charleston so it can handle the bigger ships coming through an expanded Panama Canal.

One is spending—however good and noble the cause—that covers a temporary cost. Once the money is spent, the government has to turn around and spend more tomorrow. The other is an investment that will likely pay dividends if not to the government then to the economy as a whole. Nobody argues that when General Electric (GE) or ExxonMobil (XOM) invest in a new factory or a new refinery, they shouldn’t do so if they have to borrow the money. As long as the return on the investment is higher than some hurdle rate, then borrowing the money makes sense.

How the Budget Needs to Change
I’d say the changes that our budget needs, at the least, are a division into investment and general expenditures; a countercyclical scoring system that defines “balanced” in the context of the economic cycle; and a unified budget that gets rid of the deceptive practice of pretending that some expenditures of taxpayer money don’t count because they’re off-budget. I’d call these pie in the sky, except that a few other countries around the world have created budgets like these.

Chile, for example, has dealt with the harsh realities of being one of the most cyclical economies in the world—that’s what happens when your economy is dependent on copper—by creating a government trust fund, financed by a tax on copper that rises and falls with global copper prices, that is available during years of economic bust. Independent panels of independent economists rule on when the economy has entered such a bust, and their decision authorizes the government to dip into the economic stabilization fund.

Norway, faced with the reality of a huge surge in revenue from North Sea oil and the realization that this resource wouldn’t last forever, created a sovereign wealth fund designed to take some of the cash flow from that resource and invest it for the future, either in projects that would produce income in coming years or in investments designed to create new jobs or improve the competitiveness of existing Norwegian industries. This prepares the country for the day when the oil runs out.

It’s hard for me to see why Chile and Norway can create budgets like this and the United States can’t. (A few more weeks of watching Congress in action, though, and I might be willing to entertain the notion that Chileans and Norwegians are just smarter than we are. We did elect this circus, after all.)

How Real Families Budget
Americans make these kinds of decisions in their own budgeting. We borrow to put a kid through college, because that kind of deficit spending makes economic sense. I don’t buy season tickets to the Yankees, as much as I like baseball, because I’ve got a new business that needs all my capital…and then some. My upstairs neighbors have worked hard to maintain a great credit record and used that recently to refinance their mortgage, cutting their monthly interest payments by more than a third.

When I hear the politicians try to score points by creating some simple-minded cliché of the American family sitting at their kitchen table and deciding to “live within their means”—by not sending Johnny to college and by not helping Janie finance her business, I assume—I feel really angry. American families do better than that. They make distinctions between good spending and bad. They understand what it is to invest—even if it sometimes means taking on debt. And they put money aside for a rainy day—even if sometimes the rain turns into an unexpected flood that overwhelms those preparations.

The federal government should do at least as well. It should start by changing how it keeps track of the way it spends our money. Do that and then we can talk about what spending needs to be cut and how to balance a budget in a way that actually means something.