by Calculated Risk on 4/18/2011 11:50:00 AM

As everyone knows, S&P issued a "negative outlook" on U.S. debt this morning. Although S&P has made plenty of recent rating mistakes, this is a reminder that there is work to do in the U.S.

Here is the approach an effective manager would take to analyzing the deficit.

The first step would be to divide up the deficit into several components and calculate the NPV (net present value) of each component. I'd divide the deficit into 1) cyclical portion, 2) General Fund ex-healthcare, 3) healthcare (Medicare and Medicaid), and 4) Social Security Insurance. This is nothing new - I've been pointing this out since I started the blog in 2005!

The cyclical deficit is due to the severe recession (and was predictable in 2005). As a result of the recession tax revenues declined, and there was more spending (both stimulus and automatic safety net expenditures). The good news is the cyclical deficit will decline as the economy slowly recovers. The bad news is recoveries following housing/credit bubbles and a financial crisis are usually sluggish and choppy. This is the portion of the deficit that gets the most attention, but from a long run perspective it is the least significant.

The General Fund ex-healthcare deficit is the most immediate problem. I've been writing about this for years. Back in 2006, Professor Samwick (who served as Chief Economist on the Staff of President Bush's Council of Economic Advisers) wrote: First Things First

CR writes:

Everyone should agree that the most immediate fiscal problem is the structural General Fund deficit. Excluding future health care costs, the structural deficit is around 4% to 4.5% of GDP. This serious problem has been caused almost exclusively by Bush's policies. And imagine if the economy slows next year, as many people expect, adding a cyclical deficit on top of the huge Bush structural deficit.

So isn't it reasonable to suggest that Mr. Bush and the GOP fix the structural deficit first, before addressing other long-term issues? Of course.

CR is correct in his diagnosis of the immediacy and the size of the problems of the General Fund deficit. As I have discussed in earlier posts ... the appropriate target for the General Fund deficit is for it to average to zero over a business cycle. A corollary to that is that the General Fund should be in surplus during the non-recessionary parts of that business cycle. (A slightly weaker target that I would also accept is that the Debt/GDP ratio not trend upward over time.)

In five years, nothing has changed. This structural deficit is still the most pressing problem.

Some politicians refuse to even address this issue, apparently because of a "no tax" pledge. This is silly and juvenile. Besides many of these politicians supported the policies that created the structural deficit, because they thought we were going to have surpluses forever. Since the forecasts for "surpluses forever" were inaccurate, reversing those policies should be a priority. There is no way to balance the General Fund ex-healthcare without gutting defense spending or reversing those earlier policies.

After this is resolved, the next step would be to address the long run healthcare issues. And the last step should be to address any Social Security shortfall.

As an experienced manager, I know that people will avoid the difficult choices and try to fix the wrong problems first. But an important role of management is to focus people on the more immediate and serious problem. And that is:

1) General Fund ex-healthcare, and
2) Healthcare.

So if we are serious about the deficit, we need to start by finally addressing the General Fund ex-healthcare structural deficit issue.