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.