Thursday, October 18, 2012

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


WimpyInvestor said...

Great series of analysis on the recovery.

Would very much appreciate your unbiased analysis of the heated debate between John Taylor (Stanford) and Reinhart & Rogoff on the post-financial crisis (systemic failures) economic recovery.

Which side is right?

Scott Grannis said...

My money is on John Taylor

Mark Gerber said...

Another exceptionally well written explanation of our economic state of the union. Your ongoing efforts to explain our economy are an invaluable contribution to our nation and all of humanity -- I truly mean that.

I just can't see how you can believe "There is still time to avoid disaster." As I'm sure you recall from our exchanhes going back to 2000, I can't see how disaster is avoidable. Now that we are in the "crisis," as you so aptly wrote, what makes you think we will take the difficult steps to "avoid disaster?"

William said...

Your simple solution is very wise:

"continue to exercise spending restraint, avoid increasing taxes, and broaden the tax base by reducing deductions and loopholes."

Get this to the next President of the US fast!

Scott Grannis said...

Mark: when what is needed to avoid disaster is relatively simple and painfully obvious, and there is still plenty of time to do it, I find it very difficult to believe that disaster is unavoidable. I also have an abiding confidence in the ability of the U.S. economy to overcome obstacles, and in the ability of the average person to choose the proper course of action when it is adequately explained.

Bob said...


Thank you very much for these three installments. For a lay person like myself they are priceless. I can't say as I undertand all of it, but I certainly understand more than I did before. Your entire blog, along with the commentary section (well most of it) is a terrific resource.

I direct people to your site as often as possible. Thanks again and keep up the good work.

God Bless,


Scott Grannis said...

Thanks very much Bob, it's nice to be appreciated.