The incredible shrinking budget deficit

Since hitting a high of $1.478 trillion in February 2010, the U.S. federal budget deficit has plunged by 54% to a new, post-recession low of $679 billion in the 12 months ended August 2013. Two factors accounted for the bulk of the decline: federal outlays have declined (both in nominal terms and relative to GDP) and revenues have grown. Virtually no one expected the budget outlook would improve so quickly and so dramatically. Since the decline in spending is without post-war precedent, whereas the rise in revenues is fairly typical of recoveries, the real surprise here is the degree to which spending has declined.

As the chart above shows, there has been no growth in federal spending since the recession ended in mid-2009. Federal revenues, on the other hand, have been rising almost continuously since late 2009. 

Relative to GDP, spending has declined by over 15%, from 24.4% of GDP to 20.6%, while revenues have increased by almost 17%, from 14.2% of GDP to 16.5%. The budget deficit is now a mere 4.1% of GDP, down from a high of 10.2%. In less than 3 years, the federal budget outlook has gone from dire to almost normal. It's nothing short of astonishing.

And despite the unprecedented and almost completely unexpected shrinkage of federal spending, the economy has been growing and the unemployment rate has been declining. Far from precipitating another recession, as Keynesians would have argued just a few years ago, our incredibly shrinking public sector has coincided with a meaningful improvement in the economy. (Yes, I know that the employment situation is still miserable, but it's undeniable that things have improved.)

It's tempting to conclude that the massive fiscal "stimulus" of 2009 was bad for the economy, while the unwinding of that "stimulus"in recent years has been good. (We can't know for certain, of course.) But at the very least, this is a very important example of the Law of Unintended Consequences, which loves to thwart the best intentions of politicians: government spending doesn't always do what it is expected to do.

As I've explained before, this is very good news. As Milton Friedman taught us, spending is taxation, so the big decline in spending means that the expected burden of future taxation is far less today than it was thought to be just a few years ago. This is equivalent to a dramatic reduction in the headwinds facing the economy. It's also a big reduction in the level of uncertainty that has plagued the economy for the past several years. In a supply-side model, this is a good reason to be optimistic about the future, since declining tax burdens and reduced uncertainty should prove to be fertile ground for much-needed new investment.

It may be too much to hope for, given that the healthcare exchanges are supposed to open for business in less than 3 weeks, but I continue to believe that Obamacare will never see the light of day. It's terribly unpopular, more and more unions are against it, the exchanges aren't ready, and the deferral of the employer mandate opens the door to massive fraud unless the individual mandate is also postponed. Even if the exchanges open and the individual mandate takes effect on January 1st, it is inevitable that Obamacare will fail to achieve its objective, all the while creating unpleasant and unintended consequences for tens of millions of citizens. From the very beginning, it was clear that there was almost a zero chance that the government could re-engineer and restructure one-sixth of the U.S. economy in a way that would work to the benefit of the majority of the people. It was hubris to the max, and as such, virtually guaranteed to fail.

If the implementation of Obamacare is delayed, this would result in another boost (by reducing expected tax and regulatory burdens) for the U.S. economy.