Tuesday, January 13, 2015

The end of fiscal nirvana

Over the past 5 years, the federal budget has improved dramatically. But the best part of that improvement—a zero net increase in spending which translated into a significant decline in spending relative to GDP—looks to be reversing. Federal revenues continue to boom, thanks to rising jobs and incomes, but federal spending over the past year is once again growing. We're no longer likely to see a significant, further decline in future expected tax burdens, unless and until Washington embarks on a more aggressive reform of tax and spending policies.

Federal spending has been essentially flat since the beginning of the current business cycle expansion, but it rose 5.8% in CY 2014 and is likely to continue increasing, thanks mainly to entitlement programs. Meanwhile, federal revenues have been growing steadily since the beginning of 2010, and rose 9.4% in CY 2014.

The net result of these trends has been a sharp decline in the federal budget deficit (see chart above), which fell from over 10% of GDP to just under 3%. In dollar terms, the budget deficit fell by two thirds. In five short years we went from "out of control" spending and borrowing to something that is eminently controllable. The future turned out to be far less scary than we once thought, and that is one reason the stock market is up.

The increase in federal revenues has been broad-based, as the chart above shows. The green line at the bottom of the chart shows the Fed's transfers of its operating profits (the direct result of QE) to Treasury. This added an impressive $98.7 billion to federal revenues last year. (HT: Mark Perry, who adds some interesting color commentary here.) But I think it's fair to say that those profits were in effect largely offset by "losses" suffered by Treasury. The net result of Treasury issuance and Fed purchases was in effect a wash, since the Fed benefited by borrowing short and lending long, while Treasury suffered from lending longer than it otherwise might have. The Fed profited because the yield on its bond purchases exceeded the interest it paid on bank reserves. Treasury, on the other hand, paid out more on its bond borrowings (Treasury was lengthening the maturity of its debt for most of this period) than it paid out on its short-term borrowings.

Once interest rates start rising (if they ever do), then the Fed will be suffering losses, while Treasury will benefit because it will have locked in long-term borrowing costs at relatively low interest rates.

In any event, the "profits" that accrued to the Fed from its QE activities, and ultimately to Treasury, represented about 3.2% of total federal revenues last year. Without them, the federal deficit would have been about 0.6% higher as a percent of GDP.

For the 46 years shown in the chart above, federal spending averaged about 20.2% of GDP, and I estimate it was about 20.5% last year. The extraordinary spending sparked by the Great Recession has now been reversed. That is excellent news, because government spending is invariably taxation. The reduction in spending in recent years, relative to GDP, translates into a significant decline in expected future tax burdens, and that has undoubtedly contributed to rising levels of confidence. A reduced relative level of spending also boosts the economy because it means the federal government is squandering fewer of the economy's resources. (Government spending is almost always less efficient than private sector spending.)

All of the extra spending, coupled with weak revenues in the early years of the recovery, created huge deficits which have boosted total federal debt held by the public from $5 trillion in 2007 to $13 trillion today. The chart above shows that the burden of that debt (i.e., total debt as a percent of nominal GDP) more than doubled from 2007 to 2014. The only other time we saw such a huge increase in debt burdens was during the WW II era. Fortunately, the growth in the federal debt burden has been effectively arrested for the past few years, as the chart above shows.

Conclusion: good news and bad news. The good news is that federal finances were brought back down to earth, thanks to mainly to spending restraint, new job creation, and rising incomes. The bad news is that the era of spending restraint appears to be ending. It remains to be seen just how the new Congress with a professed interest in continued spending restraint interacts with an executive that strongly favors more spending. Moreover, it remains to be seen whether increased spending can be offset by constructive tax reform which ends up boosting growth. I'm hopeful, but there are uncertainties.


William said...

Wells Cap, James Paulsen: Median NYSE Price/Earnings Multiple at Post-War RECORD

The S&P 500 begins the new year with a price/earnings (P/E) multiple of about 18 times trailing 12-month earnings per share. This represents a valuation higher than about 74% of the time since 1945. While a relatively high valuation, it remains far below its post-war record of
more than 30 times earnings in early 2000, and as recently as the 1990s, the stock market delivered nice returns from valuation levels at or above today’s P/E multiple.

Most U.S. stocks, however, are much more expensive than suggested by the S&P 500 Index. The median New
York Stock Exchange stock is currently at a postwar record high P/E multiple, a record high relative to cash flow, and near a record high relative to book value!

In the late 1990s, surging technology stock prices caused the overall S&P 500 P/E multiple to reach record highs even though the median stock’s P/E multiple never became excessive. Conversely, today, although the S&P
500 P/E multiple remains far below record highs, median valuations are at a pinnacle.


Scott Grannis said...

This is a very misleading piece that is missing a key fact. It's an apple vs. oranges comparison of PE ratios. The widely quoted PE ratio of 18 for the s&p 500 is a cap-weighted average, whereas the much higher median PE ratio comes from an equal weighted mix of stocks.

In an equal weighted index, small cap stocks receive much more weight than they do in a cap weighted index. Small cap stocks typically have higher multiples than large cap stocks, and that explains why the average of one can be so much lower than the median of the other. Plus, small cap stocks have hugely outperformed large cap stocks for years, so their multiples are not surprisingly higher than their large cap cousins.
In the end, investors cannot ignore the fact that the market is cap weighted. Thus, the 18 ratio of the S&P is a valid indicator of "the market."

Roy said...


"Once interest rates start rising (if they ever do)"

You no longer expect rising inflation?


Benjamin Cole said...

Some interesting fiscal and monetary times ahead.

If the GOP again controls DC (Congress, White House and Supremes), will we see balanced federal budgets and tight money?

The record of 2000-2008 suggests the opposite.

It may be that one-party control always leads to gushers of red-ink spending, as every Congressperson wants more spending in their state or district and lower taxes.

And with elections pending and the GOP in the White House, no GOP'er is going cry to tighter money. See Nixon, Reagan, Bush.

You know, between the 'Phants and the Donks, I think we need another party animal. Those species have become parasites.

How about a Buffalo Party?

Scott Grannis said...

Roy: I will worry about rising inflation as long as the Fed seems more worried about the health of the economy than it does the risk of higher inflation.

BamBamFunkhouser said...

How about the record of 1995-2001?

steve said...


so not only is crude in freefall, copper is also. I just cannot beleive this will end well. commodities and bond yields tanking portends poorly for worldwide growth.