The Reluctant Recovery: Part 3

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes the key points of the presentation, and is the third in a series (see Part 1 here and Part 2 here). In this third part, the main focus is fiscal policy. I argue that Congressional deadlock has allowed the growth in federal spending to slow significantly, with the result that there has been a welcome decline in spending relative to the economy; and that economic growth has increased federal revenues without any increase in tax rates. This has combined to reduce the burden of the deficit substantially. From this it is easy to see a simple and straightforward solution to our trillion-dollar deficit nightmare: continue to exercise spending restraint, avoid increasing taxes, and broaden the tax base by reducing deductions and loopholes.

To begin with, it's important to understand that we are indeed in the midst of a fiscal debt crisis. As the chart above shows, the burden of the federal debt (measured by comparing outstanding federal debt held by the public to nominal GDP) has increased by much more during the Obama administration than it has during any previous post-war administration. By early next year the federal debt burden will be over 70% of GDP, having risen from 46% in early 2009. The impact of the rapidly increasing debt burden has been muted by the fortuitous fact Treasury yields have fallen to their lowest levels in history. This could change dramatically for the worse, of course, if the economy and/or inflation picks up in coming years, since higher interest rates combined with the relatively short maturity of existing federal debt could make federal debt service payments soar even if deficits were to decline meaningfully.

The first chart above shows federal spending and revenues as a % of GDP, while the second shows the nominal level of each. Government spending has declined relative to GDP mainly because the growth in spending has slowed sharply as the economy has grown. Slower growth in spending owes much to a gridlocked Congress, and also to improvement in the labor market, since 6.8 million people have dropped off the unemployment insurance rolls since early 2010. Revenues have increased much more than spending has declined, thanks mainly to the growth of the economy, which in turn has generated more jobs and more corporate profits. We didn't need to raise tax rates to increase tax revenues, because economic growth caused the tax base to expand. In fact, tax revenues have risen even though social security contribution rates have been reduced for most of the past two years (i.e., the "payroll tax holiday"). Unfortunately, liberals seem to be dug in on the need for higher tax rates on the rich and more income redistribution, both of which could weaken the economy and aggravate the budget problem. 

Thanks to slower growth in spending and a moderate increase in the size of the economy, the federal deficit has shrunk rather dramatically from a high of 10.5% in late 2009 to about 7% today. The 2012 fiscal year deficit came in at $1.089 trillion, however, which is still mind-boggling. The bad news is that the deficit is still very large; the good news is that it's declining. 

Tax revenues are likely to rise further if the economy continues to grow, so that side of the ledger will likely take care of itself. But on the spending side we have two looming problems: payments to individuals and net interest expense. Both are likely to rise meaningfully if and when Obamacare is implemented and if and when Treasury yields rise. Payments to individuals (aka transfer payments) already consume a huge portion of the budget (over 70%), and this category has been growing like Topsy for the past 50 years. Social security, medicare, medicaid, food stamps, etc.; are all non discretionary items that could continue to expand without practical limit unless Congress reforms the underlying programs and their eligibility requirements. As for net interest expense, it is very hard to see how this won't increase significantly; only a continuation of painfully slow growth could keep interest rates from rising, and the deficit is going to be very large no matter what for at least the next several years.

So although the budget picture has definitely improved in the past few years, we are not yet out of the woods. The deficit is still very large, as is the burden of federal debt. But the most important part of the budget, as Milton Friedman taught us, is spending. Spending is the best measure of the burden of government, and it is still at very high levels relative to the economy. Government at the federal, state, and local levels still consumes a huge share of our nation's output, and that is like a ball and chain to economic progress, because government simply can't spend money as efficiently as the private sector can. The only hope for stronger growth and rising prosperity in the years to come is a substantial shrinkage in government spending, and that can come only from fundamental reforms to our many entitlement programs.

In the meantime, it is easy to see how investors and corporations are reluctant to believe that there won't be a big increase in future tax burdens, and reluctant to believe that there will be significant relief from the overall burden of government. Fiscal policy is like a big storm cloud on the horizon. There is still time to avoid disaster, but there are many obstacles on the road to prosperity.

Next installment: the economy

Labor market update

The weekly claims data has been exceptionally volatile of late, which strongly suggests that seasonal factors are at work, distorting the reported numbers. This is when you look at the 4-week average of the data for clarity. As the chart above shows, not much is going on beneath the surface noise—claims are about flat so far this year.

The one area of the labor market that is not receiving the attention it deserves is the number of people receiving unemployment insurance. This has been steadily declining since early 2010: in fact, 6.8 million people have stopped receiving unemployment insurance since the peak in early 2010. Just over 2.3 million so far this year have dropped off the unemployment insurance rolls. Compare that to the 4.2 million new jobs since early 2010, and the 1.3 million new jobs so far this year, and you realize that this represents a significant change on the margin, since it means that there are millions of people out there who now have a stronger incentive to look for and accept a job offer, and who are now much more interested in the health of the economy and the size of the jobs market.

The unattractiveness of Treasuries

CPI data for September were unsurprising. Although the headline number was higher than expected (0.6% vs. 0.5%), the core number was lower than expected (0.1% vs. 0.2%). On a year over year basis, both headline and core inflation are running at 2.0%. Over the past 10 years, prices ex-food and -energy have risen at an annualized pace of 1.9%, while the total consumer price index has risen at 2.5%, with the difference being attributable almost entirely to rising energy prices (crude oil was $20/bbl 10 years ago, and is now $90/bbl). As the chart above shows, while there have been some deviations from the long-term trend, 2.5% per year on average for the CPI is still the norm. Ho-hum. Nothing to see here, move on.

But as this chart shows, Treasury yields are very low relative to inflation. The chart is set up to reflect the long-term difference between 30-yr bond yields and core inflation, which has been about 2.5%: the right-hand y-axis is offset by 2.5% relative to the left-hand y-axis. Note how yields were very high relative to inflation throughout the 1990s, a period in which the Fed was for the most part actively fighting inflation. That period culminated in falling commodity and gold prices—and the Feds' first panic over the possibility of deflation—when the core CPI hit a low of just 1% in 2003. Since then, bond yields have tended to follow inflation with the customary 2.5% difference, up until, that is, the past year, when bond yields have plunged while inflation has risen.

The difference between bond yields and inflation is now as low as at any time since the 1970s, when low real yields helped boost inflation. 30-yr T-bonds now offer only a 3% yield, at a time when inflation is running 2-2.5%. That's a very small premium to insure against the possibility that inflation could outstrip bond yields at some point over the next 30 years. 10-yr Treasury yields are even more unappealing, since at 1.8% they are already below the current rate of inflation. Thus, TIPS real yields (which are negative out to 20 years' maturity) and Treasury yields out to 10-years offer investors either a risk-free, U.S. government-guaranteed loss of purchasing power (in the case of TIPS), or the strong likelihood of a loss of purchasing power (in the case of Treasuries) over the next decade. Wow, what a deal!

It only makes sense to hold TIPS and Treasuries at current yields if a) one is obligated by organizational mandates to invest in risk-free notes and bonds, or b) one is so afraid of suffering losses in alternative investments (e.g., MBS, corporate bonds) that a guaranteed loss of up to 1% of one's purchasing power every year for the next decade sounds terrific. It doesn't even matter if you think that inflation will decline, because negative real yields on TIPS guarantee that you will lose purchasing power even if the rate of inflation declines significantly. (Technicality: If TIPS are held to maturity, investors are protected from negative rates of inflation, but not against receiving a zero inflation adjustment. This is comforting to some degree, but it doesn't help the investor who owns 10-yr TIPS if and when there is a bout of deflation that hits in the next several years.)

But isn't this all the result of Fed meddling in the bond market? Aren't yields artificially low because of QE? I don't believe so. The Fed may be buying a relatively large share of the new issuance of Treasuries (the current Quantitative Easing program only involves the purchase of $40 billion of Treasuries per month, which is a bit less than half the current $90 billion/mo. financing needs of Treasury), but Treasury yields are not set by marginal buying; they are set by the world's demand to hold the existing stock of Treasuries. After all, low yields on newly-issue debt must equal the yields on existing debt, since Treasuries are fungible.

Fed purchases of Treasuries these days are only a small fraction (less than 10%) of the non-Fed-held federal debt held by the public, which is almost $10 trillion. It strains credibility to think that $40 billion in purchases of new debt can massively distort the value and the current yields on $10 trillion of outstanding debt which is owned by individuals, corporations, and large institutional investors all over the world. And let's not forget that many tens of trillions of bonds all over the world are priced off of Treasuries (i.e., their yields are quoted in terms of a spread off Treasuries of similar maturity). Distorting the price on Treasuries means distorting the price on almost all of the bonds in the world. Yet there is no evidence that spreads on non-Treasury debt are unusually or irrationally wide. As an example, the chart below shows how tightly the yield on 5-yr Industrial bonds tracks the yield on 5-yr Treasuries over time. The current spread of 66 bps is actually lower than the average (89) over this same period.

From this I think it is clear that QE is not the driver of low Treasury yields. The real driver is deep-seated pessimism over the outlook for economic growth. The market believes the Fed when it says that it will keep rates very low for a very long time, because the market does not believe that there is much chance of enough growth or inflation in the next several years to sway the Fed from delivering on its promise.

If you agree with the Fed or are even more pessimistic, then you think Treasury yields are attractive at current levels. But if you think the Fed and the market are being too pessimistic about what the future holds, then, like me, you think Treasury yields are very unattractive.