Fiscal policy update

There's a wealth of information in these charts, and they speak volumes. I'll just highlight a few things:

The federal deficit increased marginally in the 12 months ended December, according to figures released today by Treasury, as revenues declined by more than outlays. Federal revenues as a % of GDP haven't been this low since 1943, even though the top marginal tax rate back then was 88%, and today it is 35%. Tax rates are thus not the major determinant of revenues—the health of the economy is. As a supply-sider, I believe the economy would be healthier today, and revenues would be higher as a result, if Congress and the Obama administration had focused their stimulus efforts on lowering marginal tax rates for individuals and businesses, rather than massively redistributing income and ramping up make-work projects.

Federal spending as a % of GDP hasn't been this high since World War II. If Obama's spending plans aren't cut back, spending is destined to remain at a level of GDP that we have only experienced during wartime. This would be a truly unprecedented (to use O's favorite word) expansion of the government's control of the economy. As Milton Friedman taught us long ago, it's not really the federal deficit that is bad for the economy, it's the level of government spending. The more government spends, and the more it takes out of one person's pocket and puts into another's, the less efficient the economy becomes. Roughly two-thirds of the $3.5 trillion spent last year by the federal government was entitlement spending. That's about $200 billion every month that the federal government collects from some people and hands out to others.

If these trends continue—permanently higher spending that focuses primarily on income redistribution—it is not clear at all that tax receipts can be raised sufficiently by raising tax rates. Our economy has never generated a level of of federal revenues sufficient to finance current spending projections, no matter how high tax rates have been.

As the bottom two charts show, we saw a huge reduction in top marginal rates since the mid-1960s, but tax revenues as a percent of national income have remained basically unchanged (with the exception of the recent recession).

I don't see impending disaster in these charts or in the numbers. But I do see that we are entering uncharted waters, and that the unprecedented expansion of the size and scope of the federal government, and its increasing focus on income redistribution, raise very troubling prospects. While these concern me greatly, I do believe that it is possible to reverse these trends, and I note some major shifts in the politicial winds this past year that are encouraging in that regard. Things look very grim, but I think the changes on the margin going forward will prove to be positive.

$2 trillion a month adds up

The market capitalization of the world's equity markets has risen 85% over the past 10 months. That works out to just over $2 trillion per month. It's still 22% shy of the all-time high, but from the looks of things, we'll get there, which means another $14 trillion of value is waiting to be captured.

Meanwhile there are many trillions of dollars sitting in money market funds around the world, owned by investors—mainly institutional—who would prefer to earn essentially nothing on their money in order to keep it safe. To prefer a safe zero interest rate to the market's potential to continue growing is to be incredibly concerned about the future. It has also been a terribly expensive proposition in the past 10 months, since anyone sitting on cash has underperformed the market by a significant amount.

The longer this goes on, the harder it is to invest that cash. I'm hearing a familiar refrain these days from the managers of large institutional funds that have significant cash holdings: "We're waiting for the next big correction to get invested." Ah, OK, good luck.

China looks good

China's central bank today announced it was raising its required reserve ratio from 15.5% to 16.0%. Is this a reason to fear that the Chinese boom may turn into a bust? Hardly.

China's monetary policy is largely determined by the Federal Reserve, because China pegs its currency to the U.S. dollar. However, the Chinese have been reluctant to be completely at the mercy of Bernanke and Greenspan's whims. As the next chart shows, they allowed the yuan to appreciate against the dollar from 2005 through 2008, largely in response to the fact that the dollar became seriously weak over that same period. Why stay pegged to a collapsing currency? Better to float the yuan higher.

Allowing the yuan to appreciate was equivalent to a tightening monetary policy that in effect helped counteract the extremely easy monetary policy coming from the Fed during that period. To complement this tightening the Chinese central bank also raised its required reserve ratio from 6.0% in 2003 to 17.5% in mid-2008. The Chinese, like the Australians, are proactively tightening monetary policy, and the Fed should be following their example. This is not bad news for China, it is good news. Sound monetary policy is an essential ingredient to strong growth. And to judge from the top chart, China is back on track to more double-digit growth.