Federal budget outlook continues to improve

Thanks to April's stronger-than-expected gains in federal tax revenues and weaker-than-expected growth in federal spending, the 12-month federal deficit has shrunk to $1.15 trillion, down significantly from its high of $1.48 trillion in early 2010. By my estimates, the federal budget deficit now has dropped from a high of 10.4% of GDP to 7.4%. This is very good news that I imagine most people are completely unaware of, and it's come about in the best possible way: government is slowly shrinking relative to the economy, and this is allowing the private sector to grow, with the result that tax revenues are rising even though tax rates are not. If these trends were to continue, our spending and deficit problem would fix itself without the need for any political haggling or agonizing.

Here's the big picture. Note that spending has been almost flat since the end of the recession, while revenues have increased by $350 billion. Congressional deadlock can be a wonderful thing: by not increasing spending in recent years, Congress has managed to get federal spending as a % of GDP down from a high of 25.3% to 22.7%.

How many people realize that the federal budget deficit as a % of GDP has declined by almost 30% in the past few years? It's now comfortably below the 9% of GDP level that studies suggest is the tipping point beyond which an economy begins to destabilize.

This chart highlights the progress that has been made in federal revenues. Tax receipts have been much stronger this year, thanks to more people working, rising incomes, rising corporate profits, and increased capital gains realizations. Looked at another way, since government is consuming a smaller portion of the economic pie, the private sector has been able to put those resources to more efficient use, and as a result the pie is growing.

As I've long argued, and as Robert Barro points out in his op-ed in today's WSJ, declining budget deficits are not "austerity," and in fact can be stimulative. Keynesian "stimulus" spending just doesn't work—trimming the size of government and allowing the private sector to expand is a far better way of encouraging economic growth. Here's a key excerpt:

Despite the lack of evidence, it is remarkable how much allegiance the Keynesian approach receives from policy makers and economists. I think it's because the Keynesian model addresses important macroeconomic policy issues and is pedagogically beautiful, no doubt reflecting the genius of Keynes. The basic model—government steps in to spend when others won't—can be presented readily to one's mother, who is then likely to buy the conclusions.

Keynes worshipers' faith in this model has actually been strengthened by the Great Recession and the associated financial crisis. Yet the empirical support for all this is astonishingly thin. The Keynesian model asks one to turn economic common sense on its head in many ways. For instance, more saving is bad because of the resultant drop in consumer demand, and higher productivity is bad because the increased supply of goods tends to lower the price level, thereby raising the real value of debt. Meanwhile, transfer payments that subsidize unemployment are supposed to lower unemployment, and more government spending is good even if it goes to wasteful projects.

Looking forward, there is a lot to say on economic grounds for strengthening fiscal austerity in OECD countries.

We can only hope that more and more policymakers and politicians around the world begin to understand the fallacy of traditional "stimulus" policies. What most countries need these days is less public sector spending, not more, and lower and flatter tax rates. Government needs to get out of the way and let the private sector work its growth magic.