How bad is fiscal policy?

It's no secret that federal debt is bigger, relative to the economy, than at any time since WW II, that deficits these days are measured in trillions, and that interest on the debt likely exceeds spending on defense. It's unquestionably bad. But is it out of control? Not yet.

To begin with, Federal Debt Owed to the Public is $27.7 trillion. It's not $34.9 trillion, as many will tell you. The latter figure is Total Public Debt Outstanding, but that includes $7.2 trillion of Intergovernmental Holdings. Those holdings are debt that one part of the government owes another (most of it is owed to Social Security). But to include that in the total is double-counting. Social Security surpluses are "invested" in Treasuries, and in this manner Social Security surpluses effectively reduce Treasury's need to sell bonds to finance the larger government deficit. 

Knowing how much the federal government owes to the world is one thing, but the burden of the debt is quite another. The burden of the debt depends on the level of interest rates and the nominal size of the economy. Today the debt is huge relative to the size of the economy, but interest rates are relatively low, with the result that the burden of the debt today is much less than it was in the 1980s, when federal debt was about 40% of GDP, thanks to interest rates today being much lower than they were in the 80s.

Here are some charts that put deficits and debt into perspective.

Chart #1

Chart #1 is a history of federal debt owed to the public from 1970 through July '24. It's plotted on a logarithmic axis, thanks to which a constant rate of growth shows up as a straight line. It's commonly thought that federal debt has been surging at unprecedented rates in the past 5 or so years, but that's not true. Debt grew at a much faster rate in the mid-1980s. For the past 75 years, our national debt has increased on average by about 8.8% per year, and recent years have proved to exception.

Chart #2

Another common misperception about our national debt is that more debt should push interest rates higher, and less debt should allow interest rates to decline. As Chart #2 shows, the relationship is often just the opposite. The peak in bond yields occurred in the early 1980s, when debt relative to GDP was very small and was growing rapidly. In the 2010s, debt was surging relative to GDP and interest rates collapsed. Lots of debt in the 1940s occurred during a period of low and relatively stable interest rates. As a general rule of thumb, interest rates are not determined by the amount of debt, but rather by the level of inflation and the strength of the economy.

Chart #3

Chart #3 shows the source of our national debt—the difference between spending and revenues. Is our deficit the result of it too much spending or not enough revenues? That, like beauty, is in the eye of the beholder. One thing for sure, however, is that the government chronically spends more than it takes in.

Chart #4

Chart #4 helps answer the question from another perspective, by comparing spending and revenues to the size of the economy. The dashed lines on the chart show the post-War averages for each. Since the mid-00s, spending has been much higher than its post-war average, whereas revenues have been generally closer to their long-term average. This suggests that spending is the problem.

Chart #5

Are revenues too low because tax rates are too low these days? Could higher tax rates boost revenues as a percent of GDP? Not necessarily! According to Chart #5, it seems that federal revenues are not at all a function of the level of tax rates. Reagan slashed tax rates in the early 1980s, but tax revenues proceeded to surge relative to the size of the economy in subsequent years—because the economy enjoyed a surge of growth. Isn't it better to achieve a given level of revenues with lower tax rates than with higher tax rates? Taxes distort behavior and weaken the economy. At the same time, government spending tends to be much less efficient than private sector spending. 

Chart #6

What about the source of federal revenues? As Chart #6 shows, the individual income tax generates about half of federal revenues these days. Payroll taxes account for 34%, corporate taxes about 11%, and estate and gift taxes 0.6%. If I could eliminate only one tax, it would without question be the Estate and Gift Tax. Last year it generated only $30 billion, which was about 0.6% of federal revenue. $30 billion is pretty much a rounding error when it comes to government finances. Yet the Estate and Gift Tax has a profound impact on the economy: the ultra rich spend massive amounts of money hiring accountants and lawyers to find a way around paying the tax, and very few pay anything in the end. But small business and family farms are often forced to liquidate in order to pay the tax. And of course it amounts to double-and triple and even quadruple taxation for many, since any money saved and invested must first pay income tax. 

Chart #7

Chart #7 shows the true burden of our federal debt: interest payments on the debt as a percent of GDP. The debt burden was 25-30% higher in the 1980s than it is today. True, the debt burden is likely to continue to climb, especially if interest rates rise. But if they fall, as the Fed has all but conceded they will, then our debt burden should remain within bearable levels for the foreseeable future.

One important thing is missing from almost every discussion of debt and debt burdens: the burden of the debt from the government's perspective is equal to the payouts received by all those who have purchased Treasury securities. One man's debt is another man's asset. Paying interest on our national debt is not like flushing money down the toilet. In fact, the true cost of the debt can only be calculated by considering the benefits the country has obtained by issuing debt. A business can issue tons of debt and still grow, provided it is using the money raised for productive purposes. But governments—especially ours in recent years—are notoriously inefficient in that regard. (As I noted here, our government is spending an enormous amount of money on transfer payments, which for the most part only fund spending, not investment.)

And this leads to another conclusion: the problem with debt and deficits is not the borrowing, it is the spending that created the deficits in the first place. 

Who spends money better: the person who spends his own money, or the person who spends other people's money?

Chart #8

Chart #8 shows the federal budget deficit as a percent of GDP over time. The nominal amounts at key points are highlighted in green text. Note some amazing things: today's deficit is just about as much relative to GDP as was the deficit in 1983, but in nominal terms, today's budget deficit ($1.6 trillion) is 8 times larger than 1983's deficit!

The door is wide open to multiple Fed rate cuts

The evidence supporting multiple Fed rate cuts is now solid. 

As I've been documenting for at least the past year, shelter costs, as calculated according to the BLS's flawed methodology, have been artificially raising reported CPI inflation. Abstracting from shelter costs, the year over year change in the CPI has been less than 2% for 10 of the past 13 months, and in June it was 1.8%. This clearly meets and exceeds the bar that Powell set this week, thus opening the door to multiple Fed rate cuts that could begin as early as the July '24 FOMC meeting, and will almost certainly occur at the September 18th meeting and at subsequent meetings. 

I'm thinking multiple cuts, more than the 2 ½ cuts that are now priced to occur by the end of this year. 

Chart #1

Chart #1 is the one that cements the case for multiple rate cuts. Owners' equivalent rent makes up about one-third of the CPI index, and as the chart shows, this has been adding significantly to the rise in the CPI index until this month. The annualized rate of change in this index for the month of June was 3.37%, which is the lowest rate we have seen April '21. 

Chart #2

I've shown Chart #2 repeatedly for the past year or so. The relationship between the year over year change in Owners Equivalent Rent and the year over year change in housing prices continues: 18-month old housing price changes effectively determine today's shelter costs, according to the BLS methodology. The only good news here is that the deceleration in housing prices which began two years ago dictates that the OER component of the CPI will continue to decelerate at least through October of this year.

Chart #3

Chart #3 compares the year over year change in the CPI to the same change in the CPI ex-shelter. Note that two typically move together, but over the past year there has been a substantial difference between them. That gap, which has persisted for over one year is completely explained by the OER (shelter) component. Absent shelter costs, the year over year change in the CPI has been less than 2% for 10 of the past 13 months, and it fell to 1.8% in June. The overall CPI is very likely to close the gap by moving lower as shelter inflation continues to decline.

Chart #4

Chart #4 compares the year over year change in the CPI ex-energy (which I have chosen mainly because it is a more stable index and thus provides an easier comparison to interest rates) and the level of 5-yr Treasury yields. Treasury yields tend to track inflation but with a lag that can approach one year or so. With the CPI ex-shelter now down to 1.8% (see the green asterisk in the lower right hand corner of the chart), we might reasonable expect Treasury yields to move substantially lower over the next year or so.

In sum, the Fed has no reason to not lower rates soon. The market fully expects the first rate cut to come at the September FOMC meeting, and another 1 ½ cuts to come by year end. I don't see why the Fed can't move sooner and more forcefully. Inflation has been licked, and interest rate sensitive sectors of the economy are really hurting. Lower rates would provide welcome relief, and it would take a whole lot of cuts to add up to any meaningful stimulus. 

Cutting rates now would not be playing politics, since it would not boost the economy by any reasonable measure before the November elections; it would instead be a responsible move to avoid further damage to the economy.

With a little luck we'll survive Biden's departure

This is one of those times when it's easy to find things to worry about, and right now they add up to a big deal. Figuring out what that means for the world of investments is the tough part.

To begin with, for years the federal government has been spending way too much money on non-productive things, thus sapping the economy's inherent strength. The federal debt is now almost 100% of GDP, and debt service costs are rising rapidly. The Fed is most likely too tight, holding short-term interest rates uncomfortably high relative to current and expected inflation. Meanwhile, the economy is growing at a modest pace that is unlikely to pick up anytime soon. Interest-sensitive sectors (particularly housing) are really being squeezed.

But the elephant in the living room is HUGE. The press and the DNC can no longer hide the fact that the president of the United States is mentally and physically unable to perform the duties of his office, and he's getting worse by the day. There is no question that he will not be the Democratic candidate for president on the November ballot (for proof of this, see this editorial in the NY Times). By all rights, and since he is unqualified to run, he is also unqualified to serve. It is thus quite likely that he will depart the Oval Office well before November, since he is now the DNC's worst nightmare. Worst of all, he poses a threat to global peace; nature abhors a vacuum, and the vacuum that pervades the White House is intolerable.

When you consider all this in the context of an equity market that has reached new highs in both nominal and real terms, it is troubling to say the least.

One way to make sense of all this is to conclude that the market is looking across the valley of despair to better times ahead. Biden's vow to allow the Trump tax cuts to expire at the end of next year and to instead raise taxes on the economy's engines of growth is now off the table. Happily, Biden will no longer be able to make foreign policy mistakes (he's been on the wrong side of every foreign policy issue for the past four decades, as Robert Gates once said). The Supreme Court recently issued decisions which will drastically curtail the power of the administrative estate, long Biden's ally, and Trump is likely to do even more in that regard. Green Energy subsidies are now an endangered species, as demand for electrical vehicles crumbles and the nation's power grid struggles to compensate for unreliable wind and solar power generation.

The charts that follow highlight some of the problems the economy is facing, as well as some of the indicators that suggest all is not yet lost.

Charts 1 & 2

Chart 1 shows government transfer payments (e.g., social security, medicare, medicaid, welfare) as a percent of disposable personal income). Since 1970, transfer payments have swelled from 10% of disposable income to now over 20%. Chart 2 shows the percentage of people of working age who are currently working, which began to collapse right around 2008-2009, when transfer payments surged in response to the Great Recession. Transfer payments essentially give money to people who aren't working. To paraphrase Art Laffer, when you pay people who aren't working, don't be surprised to find that fewer people are willing to work. 

Chart #3

It's not surprising, then, that the economy can only muster sub-par growth, as Chart #3 demonstrates. The 3.1% trend growth line (green) began in 1965, only to finally break down in the wake of the Great Recession and its avalanche of transfer payments. 2.2% per year seems now to be the new norm, as the red line illustrates. Had 3.1% prevailed, the economy today would be about 25% bigger. What a difference a 1% annual shortfall in growth can make after 17 years!

Chart #4

Chart #4 is one of my long-time favorites, since it shows two variables that have, until recently, foreshadowed the onset of every recession in my lifetime (with the solitary exception being the Covid black hole). When the Fed raises short-term rates to levels significantly higher than inflation—otherwise known as monetary tightening—and the Treasury yield curve inverts (red line), recessions typically follow. We are now very close to seeing both of these variables manifesting: real rates (blue line) are 3% and rising (still a bit shy of past peaks however), and the yield curve has been inverted for several years. If the economy avoids a recession it will likely be due to the Fed's policy of abundant reserves, an argument I've been making for the past 15 years. Abundant reserves all but guarantee that liquidity remains abundant, and that has the effect of inoculating the economy against credit busts and related recession. I've been making this argument frequently in the past 18 months.

Chart #5

Chart #5 reminds us that interest rates tend to follow inflation, albeit with a lag. (I've chosen ex-energy inflation to illustrate this since energy prices are by far the most volatile of all prices.) Note the asterisk on the lower right-hand side of the chart: inflation ex-shelter prices has been a mere 2.1% for the past year. Given the past behavior of housing prices, headline inflation is very likely to continue trending down. See this post for more information on why this is a valid point to make.

Chart #6

My no-recession-for-now call is not without risk, as Chart #6 suggests. The recently-released Small Business Optimism survey of employment intentions has deteriorated markedly in recent months, approaching levels associated with past recessions. 

Chart #7

Chart #8

Fortunately, financial markets to date show no sign whatsoever of any deterioration in the outlook for corporate profits. That's the message of Charts #7 and #8. Credit spreads on corporate bonds remain quite low.

Although the Fed's tight monetary stance is applying unnecessary pressure to the economy, it has not yet reached critical levels. And given that all signs point to a continuing disinflationary process (see my last post for more details), the Fed essentially has only one choice to make: when and by how much to lower interest rates. They are dragging their feet, but eventually they will figure this out. 

In the meantime, I think we'll need to worry more about external threats to global peace than about the US economy. Unfortunately my crystal ball holds no special insights into the minds of Vladimir Putin and Xi Jinping.