Federal budget continues to improve

One of the great, largely-untold stories of the past three years is the ongoing and substantial improvement in the federal budget. Thanks to very slow growth in spending and a decent rise in revenues, the budget deficit has declined from a high of $1.47 trillion in late 2009 to $1.03 trillion in the 12 months ended January 2013. Relative to GDP, the deficit has dropped from a high of 10.5% to 6.7%. This was achieved despite no increase in tax rates (and in spite of a 2-year payroll tax holiday), despite no announced budget cuts, and despite the Senate not having once passed a budget. Three cheers for Congressional gridlock, and a hearty "well done" to an economy that has managed to grow despite all the headwinds it has faced!

Looked at another way, the burden of the federal deficit has dropped by a very impressive 36% in the past three years. More important, perhaps, is that the burden of government spending has dropped by 10% over the same period. These rank as significant improvements in the underlying economic fundamentals of the economy, since they allow the private sector to keep more of its earnings. The private sector is much better at spending money than the government, so getting government out of the way and out of our pockets is a good thing.

Over the past year, federal revenues have grown by over 9%, mainly because the economy has been adding jobs. Even taking into account the surge in revenues in December, which was driven in large part by accelerated income and dividend payouts designed to avoid the threat of higher taxes in 2013, revenues had been rising at a 7-8% pace for most of last year, while spending in the 12 months ended January 2013 was up only 0.4%.

If current trends were to continue, the budget would be balanced within 7 years or so, without the need for budget cuts or higher taxes.

The problem, of course, is that these trends are not likely to continue, unless we get real healthcare and entitlement reform. Healthcare costs are going to rise enormously if and when Obamacare is implemented, and social security benefit payments are going to outstrip receipts unless the retirement age is increased, benefit increases are limited to the increase in inflation, and payouts are means-tested.

But for the time being, things are getting better, and that's good news that is not widely understood.

The U.S. goes global

Trade data for December was somewhat better than expected. This, combined with stronger data on construction and inventories, will likely boost Q4/12 GDP from -0.1% to a small positive gain.  

But stepping back from the recent numbers, what stands out to me is the incredible progress that the U.S. economy has made in the past 20 years on the international trade front. In 1992, imports and exports of goods and services both represented about 7-8% of GDP. Since that time, exports have grown to over 13% of GDP, and imports to over 16% of GDP. Exports, in other words, have grown 75% more than GDP, and imports have more than doubled relative to GDP.

The U.S. economy is finally becoming globalized, like most of the world's other major economies. The growth of international trade is an unqualified good thing, for us and for the rest of the world. It makes economies more efficient and boosts standards of living everywhere. The more the better. This is one of the reasons why it doesn't pay to underestimate the ability of the U.S. economy to overcome adversity.

Lower productivity points to slower growth and higher inflation

Today we learned that productivity fell at a 2% annual rate in the fourth quarter of last year. From a peak of 5.6% in 2009, it is now up only 0.6% in the past year. This fits with the slowdown in growth in the past two years—companies have squeezed about as much out of existing resources as they can. Without a faster pace of hiring and more investment in productivity-enhancing equipment, technology, and training, the economy's growth is going to be constrained to the current growth rate in jobs plus productivity gains of maybe 1% a year, and that in turn suggests we could see only 2-2.5% annual real growth going forward.

The above chart compares the 2-yr annualized growth of productivity (to minimize the typical quarterly volatility of this series) to the year over year change in the GDP deflator, the broadest measure of inflation. There is a relative strong tendency for the two to be inversely correlated. Strong productivity tends to coincide with low inflation, and weak productivity gains with higher inflation. If the bloom is indeed off the productivity rose for the time being, then this chart suggests that we could see somewhat higher inflation in coming years. 

Looked at another way, the decline in productivity means that unit labor costs are rising and could now begin to feed through to higher prices.