The incredible shrinking budget deficit continues

As I noted two and a half years ago, the best way to get the federal budget back in balance was to cut the growth of spending and pursue policies that helped the economy to grow. I'm not sure Washington has done much to pursue the latter point, but Congress has exceeded all expectations on the former: federal spending has not grown at all since the recovery started in June 2009. 

The most important thing about all this progress on the deficit is that it was totally unexpected. Those are the kinds of things that move markets. Federal spending in calendar year 2013 was only slightly above its post-War average of 19.1% of GDP, by my calculations. Federal revenues were only slightly below their post-War average of 17.2% of GDP. Nobody on earth expected this to happen back in mid-2009. This achievement was brought about largely by a combination of a) no growth in spending and b) the recovery, which boosted the tax base. (Message to Obama: the economy can grow best when government does the least to "stimulate" it with transfer payments and make-work projects.)

The chart above makes it clear: spending has not increased since the recovery started (and it has even declined in the past few years), while tax revenues have surged—and most of the surge happened well before tax rates went up a year ago. I credit a gridlocked Congress and the economic recovery for this tremendous and welcome achievement.

As a result, the budget deficit has plunged from a high of 10.2% of GDP to now only 3.3%. This is less than the budget deficit during most of the Reagan years, and does not present any problem going forward. The deficit has ceased to become a serious problem almost overnight. That's great news, because it means that the argument for higher taxes has all but evaporated, and because a smaller government has resulted in a huge reduction in expected future tax burdens. This is very bullish for growth going forward.

Keynesians would have told us four years ago that freezing government spending would almost certainly doom the economy to another recession and higher unemployment, but they would have been dead wrong. As the chart above shows, the huge decline in the budget deficit has coincided (not necessarily caused, mind you) with a huge decline in the unemployment rate. The latter has a lot to do with the decline in the labor force participation rate, but at the very least it should be clear that this massive "fiscal contraction" (as the Keynesians would term it) has not damaged the economy one whit. Sure, it may have slowed the recovery, but it did not kill the economy. On the contrary, the economy has managed over four years of an ongoing and meaningful recovery. Maybe, just maybe, it's the case that getting government out of the way (by shrinking spending relative to the economy) allows the private sector more room to breathe, and that in turn is what generates growth. I raised this possibility almost exactly three years ago.

This is not a fragile recovery

When I see members of the FOMC saying that the U.S. recovery is "still fragile," I wonder if we're looking at the same economy. Sure, this recovery is the weakest ever and the most risk averse, but it looks pretty broad-based to me. The improvements are numerous and significant: total employment is only a few months away from hitting a new all-time high; auto sales are only about 10% below their highest sustained levels; industrial production is at a new high; real retail sales are about 5% above their pre-recession high, as is real GDP; personal income is up 17% since 2007; housing starts have jumped almost 130% from their recession low; corporate profits are at record highs, both nominally and relative to GDP; equities are more than 10% above their pre-recession highs; jobless claims are only 10% above their pre-recession lows.

As I see it, recoveries are "fragile" if confidence is high; when optimism about the future is abundant; when the majority of forecasts predict robust growth for as far as the eye can see. That was the case back in early 2000. Real yields on TIPS were 4%, and PE ratios were on the moon—it was common to hear people predicting that the economy would enjoy 4% real growth or more for as far as the eye could see.

This recovery, in contrast, continues to be met by a healthy degree of skepticism, and the Fed's own cautious stance is an excellent example. Today, we're more likely to read articles explaining why this recovery's sluggish growth rate is likely to persist, than we are to read articles about why the good times should continue to roll. Instead of characterizing the current recovery as "fragile," I think it makes more sense to simply label this a sub-par recovery (as it has been for a long time), while wondering why it's not stronger.

Slow growth does not necessarily increase the risk of recession. Slow growth is best thought of as symptomatic of some underlying problem that, if fixed, would result in stronger growth. Comparing the economy to an airplane flying at just above stall speed—and thus at risk of a crash—is simply not a valid analogy (though it remains quite popular). What causes an economic collapse is not slow growth, but major mistakes in fiscal and monetary policy whose consequences are poorly understood and for which markets are almost totally unprepared. The housing bust was a good example.

The fact that inflation remains very low, despite the Fed's herculean and unprecedented efforts to pump up the monetary base, is another example of weak confidence. I've argued many times that the main objective of the Fed's QE efforts was to supply a risk-averse world with risk-free securities, and not to stimulate the economy. Bank reserves, because they now pay interest, are a near-perfect substitute for T-bills, and the banking industry has shown every sign of happily amassing a significant position in them, while using only a minuscule portion to support new lending. Risk aversion—and a desire to bolster their balance sheets with high-quality, risk-free securities—has driven banks to accumulate reserves, and it has driven the private sector to accumulate over $7 trillion in retail bank savings deposits, even though they pay almost no interest. Households have reduced their leverage by one fourth (leverage as measured by the ratio of total liabilities to total assets) since 2008.

With it's QE bond purchases, the Fed has simply "transmogrified" notes and bonds into T-bill equivalents in order to satisfy the world's risk aversion and the very strong demand for cash and cash equivalents. Weak confidence has created strong demand for money, and that has kept the Fed's "stimulus" from turning into inflation.

Risk aversion and confidence are in effect two sides of the same coin. As risk aversion declines and confidence rises, the world will demand fewer and fewer safe assets like bank reserves and bank savings deposits, and the Fed would be remiss if it didn't react to increasing confidence by first tapering and then reversing its QE program.

As the charts below show, I believe that confidence is slowly but surely returning, and if this continues, then the Fed can and should proceed to wind down its QE program—sooner rather than later.

As the chart above shows, consumer confidence has been on the rise for the past four years. It's still relatively low compared to other recoveries, but it is increasing, albeit in fits and starts. Confidence can feed on itself, so the Fed should not wait until it is strong and pervasive, lest we get a "confidence bubble" that could later pop.

The chart above shows the price of gold and the real yield on 5-yr TIPS (inverted, in order to be a proxy for their price). Both of these are "safe" assets, and the decline in their prices is a good indication of a decline in risk aversion and, by inference, a return of confidence. The world is getting more confident in the future, so the demand for gold and the demand for TIPS (which are default free and immune to inflation) is declining. That makes perfect sense.

CDS spreads, shown above, are a highly liquid indicator of the creditworthiness of corporate bonds. CDS spreads are now at their lowest level since the recovery began, and are approaching the levels that prevailed one year prior to the recession, when optimism was generally abundant. The low level of CDS spreads today means the market has a good deal of confidence in the ability of corporations to service their debts in the next several years. That, in turn, infers confidence in the ability of the economy to grow. By this measure, things don't get a whole lot better than they are now.

The chart above provides another look at the creditworthiness of U.S. corporations: investment grade and high-yield corporate debt spreads, which encompass a wide variety of securities of all maturities. Here again we see that spreads are at very low levels, which means that confidence in the economy's ability to grow is substantial.

The PE ratio of the S&P 500 today is a bit above its long-term average (17.4 vs. 16.6), which suggests that the market is somewhat optimistic about the future of corporate earnings. But as the second of the above two charts shows, if we use a measure of true economic profits as calculated in the National Income and Product Accounts (see a full explanation here), instead of reported GAAP earnings, PE ratios today are still substantially below average. There is still a degree of caution among equity investors, but the outlook for the economy and corporate profits is improving on the margin.

The dollar is still very low when viewed from a long-term, inflation-adjusted basis (see chart above). This suggests that confidence in the Fed and confidence in the health of the U.S. economy (both of which help to determine the demand for dollars vis a vis other currencies) is still low. However, the dollar has appreciated by 5% or so in the past few years, suggesting that confidence is improving on the margin.

For all the Fed's efforts to "pump up" the money supply, M2 has only grown slightly faster in recent years than it has over the past 20 years, as the chart above shows. That's evidence of very strong demand for "money" from banks: they prefer to accumulate bank reserves than to accumulate loans. If making loans to the public were more attractive, on a risk-adjusted basis, than making loans to the Fed (in exchange for bank reserves), then the money supply would likely have increased dramatically by now, via our fractional-reserve banking system.

As the chart above shows, the growth of M2—arguably the best measure of easily spendable money in the economy—is closely tied to the growth of nominal GDP.

The ratio of M2 to GDP, shown in the chart above, is a measure of the demand for money. Money demand has increased dramatically in the wake of the 2008 recession, as individuals, banks and businesses took steps to increase the amount of money they held (in the form of currency, checking deposits, and savings deposits) in relation to their annual expenses. For some, this meant deleveraging, and for others it meant accumulating higher money balances, and for others it meant building up their savings deposit balances. When all was said and done, the $2.7 trillion the Fed "injected" into the economy by buying notes and bonds found its way into bank savings accounts (which have increased by over $3 trillion since 2008), and banks, in turn, lent the deposit inflows to the Fed in exchange for reserves. No unusual amount of money was created in the process.

But things are changing on the margin. As the chart above also shows, there has been almost no increase in the demand for money over the past year: the ratio of M2 to GDP only increased by 0.5% in 2013, after increasing 22% from mid-2008 through the end of 2012. In addition, the annualized growth of bank savings deposits has slowed dramatically from the strong double digits throughout most of the 2008-2012 period, to less than 6% over the past three and 12 months. The growth of money is slowing, which means that confidence is increasing.

Commercial & Industrial Loans are a good proxy for bank lending to small and medium-sized businesses. As the chart above shows, they have been increasing steadily for the past three years. This can only mean that banks have become more willing to lend, and borrowers more willing to borrow, and that is an obvious result of increasing confidence. C&I loans are still a bit below their previous high level, however, but at the current pace they should soon break new high ground. With banks absolutely flush with reserves, there is virtually no limit to how much they could expand their lending activity if they felt confident enough.

What all this means is that the only thing standing between us and an explosion of new money and higher inflation is more confidence. Confidence is the Fed's nightmare, and it's making a comeback. Rising confidence is the reason the Fed should be moving to taper and then reverse QE. Tapering and reversing QE is not what markets should fear. Markets should instead worry about the return of confidence and the Fed's inability to react decisively to that by reversing QE even faster.

Weak December jobs report likely a fluke

Every now and then there are jobs reports that are way out of line with other data, and the December 2013 report released today is very likely one of them. Bad weather was almost certainly a factor, and faulty seasonal adjustment factors could be another. Whatever the case, the jobs numbers are notoriously subject to significant revisions way after the fact, so when faced with a one-month outlier like this one, it's best to ignore it.

It's ironic that the ADP report for December was stronger than expected, while the BLS report today was much weaker than expected (+74K vs. +197K). As I read the chart above, whenever the two reports diverge meaningfully in one month they almost always come back into line the following month. And as the chart also shows, the BLS jobs number can be very volatile from month to month, and December's number was actually less volatile than many others we saw back in the mid-2000s when the economy was doing just fine.

Even though the unemployment rate has fallen much faster than expected in the past year—tumbling 0.3% in December—the decline has been driven mostly by increasing numbers of people deciding to "drop out" of the labor force, rather than by an increasing pace of hiring.

Over the past five years, the labor force has grown only 0.2%. This is unprecedented: throughout history, the U.S. labor force has typically grown by about 1% a year. As the above chart suggests, there are roughly 10 million people "missing" from the labor force. If they were to decide to look for a job, the unemployment rate would be much higher—possibly as high as 11-12%.  

A one-month surprise such as we saw today hardly registers if you look at the big picture in the chart above. Jobs continue to expand, and we are only months away from seeing total employment reach a new all-time high.

The chart above shows the six-month annualized rate of growth of private sector jobs. The December shortfall mainly offset stronger numbers in prior months, leaving the growth rate roughly unchanged.

 
As I've noted before, the much-ballyhooed growth in part-time jobs is a myth. As the chart above shows, part-time employment (the number of people working 35 hours or less per week) has not changed at all since the recovery began in mid-2009. As a percent of total employment, part-time jobs have fallen significantly during the current recovery, just as they have in prior recoveries. Part-time employment remains relatively high however, and that likely reflects the new regulatory burdens (e.g., Obamacare) that have been piled on businesses in the past 4-5 years.

Two enduring questions about the jobs market remain in force: why have so many dropped out of the labor force, and why haven't businesses expanded faster? The FOMC is delusional if it thinks that interest rates or the supply of bank reserves are the answers to those questions. If policymakers want to pump up the job market they are going to have to look for different incentives: e.g., ones that increase the after-tax return to working and investing, and ones that reduce the regulatory hurdles to new business formation. I continue to believe that we are in a slow-growth recovery mainly because of the headwinds emanating from Washington.