Wednesday, October 15, 2014

$3 trillion in taxes trumps Ebola risks

At a time when the Eurozone is flirting with its third recession in the past six years, the Chinese economy is slowing down measurably, and the Ebola virus has leapfrogged the Atlantic, investors are naturally nervous that the five-and-a-half-year-old equity party could be coming to an end. Fear is entering the range of panic proportions, in fact, with the Vix Index today spiking to 31 today and the 10-yr Treasury yield sinking to almost 1.85% at one point. The Vix/10-yr ratio thus attained its fourth-highest value (16.7) in history today, behind the Lehman collapse ((27), and the two Eurozone debt crises (24 and 18).

I don't pretend to be an expert on pandemic diseases, but I note that Nigeria, Africa's most populous state, located not too far from the Ebola hotspot of Liberia, has not had any new cases of Ebola in over 42 days. (HT Don Luskin) This is not necessarily the pandemic disease that promises to wipe out civilization as we know it, even though it's premature to rule out that possibility. But the mere prospect of a virus that could theoretically mutate and kill 70% of the population of the world in 2 years or less understandably has investors nervous. 

(Might I suggest that if indeed the world population were to collapse in short order, most of those who managed to survive would face bleak prospects at best; the machinery of the global economy would be effectively broken, and modern civilizations would be hard-pressed to survive. What good would it do to sell everything you own today? Investing in anticipation of the "end of the world as we know it" is a questionable exercise at best. If you are convinced we are faced with an inevitable global catastrophe, then buying plenty of guns, ammunition, food, and a private, isolated island is probably your best strategy. Nevertheless, it is worthwhile noting that the world has managed to survive quite a few end-of-the-world-as-we-know-it events: The Cold War, the Crash of '87, Y2K, AIDS, bird flu, the 2008 financial crisis, and the PIGS debt crisis.) 

In any event, the massive size and momentum of the U.S. economy is a force to be reckoned with. Despite all the world's problems, the federal government in the 12 months ended September 2014 collected just over $3 trillion in taxes, mainly because the economy managed to grow just a little over 2% a year. That's an increase in revenues of about 50%, or $1 trillion dollars, in just the past 4 ½ years. And because federal spending has not grown at all in the past five years, the federal budget deficit has collapsed from a high of $1.5 trillion to less than $0.5 trillion, from a max of 10.5% of GDP to only 2.8% of GDP. It wasn't too long ago that the world quaked at the prospect of trillion-dollar federal deficits for as far as the eye could see, yet today the federal deficit is unquestionably manageable and many years from potentially spiraling out of control due to unchecked growth in entitlement programs. 

We have managed to avoid yet another end-of-the-world-as-we-know-it event, and almost totally unexpectedly.

This is not a defense of the Obama administration. I think the good things that have happened have occurred in spite of all the mistakes that have been made (e.g., the ARRA faux-stimulus, Obamacare, Dodd-Frank). This has been the slowest recovery on record not because the government hasn't spent or stimulated enough, but because the government has spent and regulated way too much. My point is that it never pays to underestimate the U.S. economy's ability to overcome adversity. It's probably fair to say as well that one shouldn't underestimate the ability of modern science to check the spread of Ebola.

Some charts to back up the points made above: 

Federal spending has not increased at all in over five years. This is simply amazing, completely unexpected. Excellent news, also, since it means the government is shrinking relative to the economy.

The chart above documents the virtual collapse of the federal deficit. Again, completely unexpected and a cause for celebration. Keynesians have a hard time dealing with this, however, since they view big declines in budget deficits to be contractionary. Supply-siders, in contrast, view declining deficits which result from spending freezes to be a positive force, since the government is consuming fewer of the economy's scarce resources. Moreover, most of the increase in revenues has been due to an expanding tax base (e.g., higher incomes, more profits, more capital gains), not to increased tax rates. The U.S. compares very favorably to the Eurozone on this score, since, as Brian Wesbury notes in today's WSJ, Eurozone public sector spending is about half of GDP, whereas total public sector spending in the U.S. is only 36.5%.

Federal spending relative to GDP is now back to its long-term average (over the period shown in the above chart), as are revenues. Five years ago, nobody would have believed that progress like this was possible. There is now no reason to raise tax rates, another reason for cheer. Indeed, slashing and flattening tax rates (while eliminating deductions and subsidies) would likely have very powerful and positive consequences—exactly what is needed to "jump-start" the economy and get it back to its long-term trend.

The chart above is further proof that big declines in government spending relative to GDP do NOT weaken the economy.

The federal deficit has now shrunk to a size that is manageable, because—at the current level of interest rates—the burden of the federal debt (i.e., total debt relative to GDP) is no longer increasing. Even in a rising interest rate scenario, the increase in the federal debt burden would not likely prove to be exponential, given how relatively small the deficit is today.

As the chart above shows, the Obama administration has overseen the largest post-war increase in the federal debt burden of any administration in history. Thank goodness it is no longer increasing. (Red bars in the chart signify that the debt burden increased over the presidential term, while green bars signify the debt burden fell.) There is hope for the future.


Grechster said...

Scott: I recently read an article that claimed the govt's deficit numbers were bogus. It claimed that the true way to assess what the deficit actually was - rather than the hocus pocus churned out by the govt - is to compare the nation's total debt from one fiscal year to the next. The difference is the real deficit. (Makes sense to me.) In any event, in the fiscal year cited in the article (I believe FY13), the delta was $1.085 trillion. This occurred in a year in which the govt claimed the deficit was a mere few hundred billion.

I have no agenda in my comments. Indeed, I don't even know what's true and what isn't. Any thoughts on the subject?

Scott Grannis said...

I've compared the deficit resulting from the monthly revenue and spending numbers released by Treasury to the Treasury's report of total debt held by the public for several periods, and the results are pretty close. The deficit in one year does not exactly equal the increase in outstanding debt, but it is pretty close.

For example, the FY 2013 deficit was $680 billion, and the net increase in total debt held by the public during that same period was $709 billion. The difference is probably due to the fact that Treasury holds periodic auctions and estimates how much will be needed to fund future debt, but they can't always be right.

I've heard many claim over the years that the government's numbers are bogus (for CPI, etc.) but I have never found evidence to support those claims.

Benjamin Cole said...

The real problem is that the Federal Reserve is asphyxiating the economy. You cannot judge central bank policy by interest rates. Otherwise you would conclude the Bank of Japan was very stimulative from 1992 to 2012. Instead you had deflation and gloom in Japan in those years.

The Federal Reserve needs to sustain its quantitative easing program for many years.

Things look ugly---long-term rates sinking. The tight-money crowd is fighting the last war.

Scott Grannis said...

Benjamin: can you give us one—just one—example of exactly how the Fed is asphyxiating the economy?

Banks hold $2.7 trillion of excess reserves, and they are increasing their lending at a healthy pace.

The dollar is still well below its long-term average, which suggests there is an abundance of dollars in the world relative to other currencies.

Gold and commodity prices are way above their 2001 lows, suggesting again that money is abundant or at the very least is not scarce.

Real interest rates are extremely low, which suggests monetary policy is accommodative (tight money that kills the economy is always accompanied by very high real rates, reflecting a shortage of money).

Inflation is running around 1.5%.

It's not good enough to observe that the economy is weak and therefore the Fed needs to add more money to the system.

W.E. Heasley said...

“The chart above is further proof that big declines in government spending relative to GDP do NOT weaken the economy.”

Who’d a thunk it?

This news is not going to go over well with a particular ex-economist/current columnist at the NYT.

Benjamin Cole said...


Of course, you make a lot of strong points, and I cannot "prove" what I say.

This is my view: We have been hearing that the Fed has been "accommodative" for six years, and during that time many darkly warned about inflation, even galloping or runaway inflation.

I think today 10-year Treasuries sank below a 2% yield, or close. After six years of Fed "easing" we get 2% yields on 10-year Treasuries?

Volcker never even came close to this!

Milton Friedman said low interest rates are a sign of tight money and a sign people have confidence money will stay tight. We have sophisticated institutional investors buying 10-year treasuries at 2% yield (and falling).

Essentially, sophisticated institutional investors are saying they believe inflation is dead, and for at least 10 years. That is a sign that money is way too tight.

True, commodities indices are above 2001 levels, and there was a great commodities bull run---but we also had enormous buying of commodities by Chindia in that time frame, and China is the largest buyer of commodities in many categories. China was (and still is) booming---one would expect commodities prices to rise, and they should, the alleviate bottlenecks.

There was and is also the dubious US ethanol program, which boosted corn prices, a feedstock for many other products. Not monetary policy, but federal policy. Great timing too.

I would even say I "like" rising commodity prices, as they are a sign of prosperity, and that the market is working to resolve those bottlenecks (oil is bad market due to all the thug states involved from Venezuela to Russia to Iran). There may have been some speculative spiking and manipulation in commodities markets too.

I think the free market did what it does so well, and created new supply in the commodities sector, while reducing demand. I suspect commodities are soft for a long time. At $100 a barrel, I suspect we never see oil demand increase much. At $80, maybe.

Inflation is running at 1.5% you say. Egads Scott, you might even be older than me. You must remember when Volcker got inflation down to 4% and was considered a hero.

Now 1.5% inflation is considered a sign of easy money?

I will believe the Fed is doing its job when we see real growth above 3-4% a year and sustained. No, the Fed does not "create" growth, but it can suffocate growth.

All that said, I totally agree with that almost anything the federal government tries is dubious and that federal spending could be seriously cut.

I would go even further than most, and say not only is the federal government unsuccessful in trying to make the USA a better place, it is even less successful when it tries to make Afghanistan, Iraq, Syria, Palestine or Vietnam a better place.

So, print a lot of money and cut taxes to the bone!

netbacker said...

The funds to pay taxes and buy government securities come from government spending. Not the other way around.
Under the current fiat currency system it is the economy that needs government money to pay taxes. -

McKibbinUSA said...

Federal spending has been out of control now for almost 15 years -- that's depressing for me -- I advocate that either the US cuts Federal spending immediately by at least 40%, or that the US folds and we start a new country that outlaws deficit spending -- I detest deficit spending with a passion.

Vespasianus said...

I am a bit puzzled by the fact that Reagan's Administration witnessed an increase of the federal debt.

I can only guess that fact was more than offset by other supply side policies, or maybe the money spent by the public sector was more productive then that nowdays.

Grechster said...

Thanks, Scott.

steve said...

all this discussion of federal spending is hocus pocus. neither party will cut spending to the point where we'll have a surplus AND why so celebratory about a $500B deficit? the DEBT increases by $500B and we're supposed to be content?

bond yields are where they are for one reason-FEAR! fear of economic slowing if not recession (I know, there are no signs in the US-yet) and fear of stocks continuing to sink. could be the 10 year gets to where the 10 year bund is trading, sub 1%! why not? these things are anything but rational.

Benjamin Cole said...

PPI shows deflation and retail sales down in September. Not pretty.

Grechster said...

Steve: The deficit numbers aren't good, at least by your personal definition of "good." But I know I'm in good company when I say that I never thought, four years ago, that we'd be in this position. At that time we were running a $1.3 trillion deficit and coming off a period in which a Republican president had completely torpedoed the debt numbers. Hope had seemed to be lost.

I, and many others, were also wrong in HOW we got to where we are now. Congress basically flat-lined spending. Didn't think it was possible but it did happen - and for several years now. Imagine how good the numbers would look right now if we hadn't gotten involved in Iraq/Afghanistan. Or maintained a thousand bases across the globe. Or shoveled money at "intelligence" services that don't even submit budget numbers to the public. Even now, I estimate the "defense" budget is too high by about the size of the current deficit, about $500 billion. (I estimate the total cost of "defense" as $1 trillion, not just the low $600s that you see in the DoD budget.)

Don't get me wrong; our leadership is pitiful and I don't see much cause for budgetary optimism going forward. But we should celebrate this shockingly good progression of events over the last few years.

What we need is growth, growth, and growth!

Scott Grannis said...

Re the decline in retail sales and the PPI. It is not unusual at all for these two series to show monthly declines during periods of rising prices and rising sales. These two series are notorious, in fact, for their month-to-month volatility. Nothing can be inferred from last month's decline in retail sales and the PPI. On the contrary, it is highly likely that sales continue on an uptrend and producer prices are also trending higher.

McKibbinUSA said...

Observation: The only asset moving up in value right now is the dollar. Comments...?

Johnny Bee Dawg said...

"Congress" didnt flatline spending....the TEA PARTY did. God bless em.

The Tea Party did something no Congress has been able to do since WW2: they actually reduced government spending in one year vs. the previous year. We The People rose up, beginning with the Town Hall protests of 2009, and put the brakes on government, and that's why we've gotten as much growth as we've gotten.

We will just have to see if America wants to continue these reforms, come November.

Bob said...

Johnny, I agree.

Mathew, why no mention of sequestration? This was a Republican initiative that is responsible for the reduced deficit.

How did a Republican president torpedoe debt numbers? That's a statement that makes no sense. Prior to the economic collapse brought on by federal government involvement in the private sector, i.e. houses for everyone, the deficit in Bush's last year had shrunk to $250bil and was projected to be a surplus within two more years.

I am no lockstep conservative. Nor am I an adamant Bush fan. But Bush inherited a flatline economy from the Haloed Clinton and during his 8 years we added over $2tril. in GDP with consistently low unemployment, somewhere in the 4.5% range.

As Grannis points out many times, it is the resiliency of the economy, based on free market principles that has gotten us the meager growth we have, inspite of the roadblocks and speed bump policies that have been put into place by the current administration in the name some false altruism.