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Spend without end, borrow and tax to the max

Obama's abysmal budget

The data for the forecast section of these charts is taken directly from Obama's FY 2011 Budget. The forecasts presented in this budget rely, as all forecasts ultimately do, on several critical assumptions. Together, these are among the most heroic and daring assumptions I have ever seen coming from the Office of Management and Budget. They are so off the charts that I don't think they will ever see the light of day. And that would be a good thing, because otherwise we will be facing a very unpleasant economic future.

To begin with, economic growth is expected to average about 4% per year over the next 5 years. That is quite a bit higher than the "new normal" consensus, which sees growth averaging about 2.5-3% per year. I don't really have a problem with that, since I think the "new normal" consensus is too pessimistic. But regardless of how optimistic 4% sounds, the growth projections the administration is using imply that it would take 10 years or more for the economy to return to its potential, or full employment growth. That would amount to a decade of very frustrated voters.

Next, we have the assumption that, thanks to 4% growth and higher tax rates, there will be a surge in tax receipts stronger than we have ever seen before in post-war history. Amazingly, the administration is making little or no allowance for the likelihood that rising tax rates (e.g., the expiration of the Bush tax cuts, the imposition of big taxes on cadillac health insurance policies, the limitation of deductions on high-income earners) and rising tax burdens might a) retard economic growth and/or b) result in lower-than-expected revenues (e.g., due to increased evasion). In other words, if the Laffer Curve asserts itself and/or the economy performs according to the "new normal" consensus, we would likely discover that tax receipts are significantly lower than the administration is projecting.

In the past, strong growth in tax receipts has been primarily a function of unusually strong economic growth, but the administration is not projecting unusually strong economic growth, as I have noted above. This is yet another reason to think it very unlikely that the economy would generate the spectacular growth in profits and incomes necessary to fuel the revenues projected in this budget.

Conclusion #1: it is very likely that the budget is seriously over-estimating federal revenues.

On the spending side, the administration is projecting a significant increase in the size and scope of government. The chart below, from Keith Hennessey's excellent blog post, shows that Obama's 2011 budget projects a substantial increase (on the order of 1% of GDP per year for the foreseeable future) in the size of government relative to what was proposed in last year's budget. Talk about daring assumptions! This alone is a very disturbing development, because it projects a permanently and much higher level of government involvement in the economy than we have ever before seen in peacetime.

I think it's safe to say that the projected level of spending shown in this chart is the absolute minimum that is likely to result if Obama's budget wishes become reality. Never in postwar history has any government program (and Obama is assuming the creation of quite a few new ones) not exceeded its initial cost estimates. Few if any programs are ever terminated, and most just continue to grow like Topsy.

Conclusion #2: it is very likely that the budget is seriously underestimating federal spending.

And from these conclusions, it follows that Obama's budget is very likely underestimating the federal budget deficit by an order of magnitude.

To think that U.S. federal deficits could end up being on the order of 7-10% or more of GDP for the foreseeable future is simply mind-boggling. The only precedent that exists in modern times for a developed economy with these kinds of deficits is Japan over the past 20 years, and that is not exactly an encouraging comparison—Japan has experienced an average real growth rate of only 1.1% per year since 1990.

Many will call me a starry-eyed optimist, but I simply can't accept the proposition that the voters will allow Congress and the President to lead us down a budget path such as is laid out in Obama's 2011 budget. Already it is becoming clear that cap-and-trade is dead, that card check is dead, and that healthcare reform is all but dead. The January Massachusetts Senate vote was the tipping point, as I predicted last month. Who would have thought, just one year ago, that Obama would now be on the defensive? That the only piece of legislation he championed would be an economic stimulus package that has completely failed to deliver its promised results? This is not the stuff upon which heroic and transformative budgets are built.

The Tea Party is now advancing, and the liberal agenda is retreating. This year will likely prove to be a very exciting time in the political and economic spheres. It still pays to be optimistic.

The bottom in employment is in sight

This chart shows two measures of the number of private sector jobs in the economy, one using a survey of known establishments, the other using a random telephone survey. Both are now saying that job losses are almost a thing of the past. The ADP survey of jobs is also in agreement, as shown in the chart below. Within one or two months we should see clear evidence of a net increase in jobs.

It may be awhile before we see any meaningful decline in the unemployment rate, however. The next chart shows the unemployment rate, which appears to have peaked. This is largely due to the fact that the labor force (those with a job and looking for a job) has declined by almost 2 million over the past 8 months (lots of discouraged workers leaving the labor force). If the economy gets back on its feet, the labor force is likely to start expanding as worker confidence returns. To keep the unemployment rate from rising we'll need to see jobs rising by 200,000 or so a month, and we aren't likely to see that until we get closer to the November elections.

High unemployment is thus going to be a major focus of the elections. With luck it will spur discussion of why the many hundreds of billions in "stimulus" spending have failed to stimulate. The correct answer, of course, is that the money should have been used to finance a cut in the tax rate on labor and capital.

Thoughts on Greece and PIIGS

The top chart shows the spread on 5-year Credit Default Swaps on Greek government bonds. Spreads have shot up to over 400 bps on fears that Greece's federal deficit is spiraling out of control (with a deficit of about 12% of GDP) with no fix in sight. Similar fears have surfaced in Portugal, with spreads today reaching 230 bps, Italy (153 bps), Ireland (172 bps), and Spain (170 bps), thus giving rise to the new acronym for fiscally challenged countries: PIIGS.

(Truth be told, the US should be included in the group of PIIGS, since an objective analysis of Obama's 2011 budget implies deficits of 10% of GDP or thereabouts for at least the next several years.)

For purposes of comparison, the second chart above shows the spread on generic 5-year Credit Default Swaps on speculative grade (junk) bonds. For all the fears of a Greek default, Greek government bonds are still trading better than junk bonds, and their spreads are still far below the worst we saw for junk bonds about a year ago. In other words, while the situation does look troubling, we are still far from standing on the edge of an abyss. Nevertheless, European sovereign debt risk has managed to infect the U.S. market, helping send stocks down 3% or so today. For further purposes of comparison, the following chart compares the performance of the German DAX index and the S&P 500, with the DAX priced in dollars. Both markets appear to be moving in lockstep of late, with German stocks made more volatile by swings in the dollar's value.


The problem of Greek deficits is multifaceted. On the one hand, the EU doesn't want any of its members to run large deficits, for fear that it could bring down the Euro. Greece has no authority to print Euros, so if it can't pay its debts it must default, and that could send shockwaves through the other PIIGS and destroy confidence in everything. This might result in great pressure on other EU member countries to effectively bail out the PIIGS, but no one is enamored of that solution. On the other hand, Greece's options appear limited, since it has a socialist government that loves to spend and wants to tax the rich to pay for it. This isn't exactly working out, and the economy is struggling and supposedly very vulnerable to any attempts to cut spending or raise taxes. (If this sounds familiar to US citizens, it should be.)

I'm having trouble with the idea that all of this represents an intractable and grave problem. Why are people so quick to assume that government spending can never be cut? That any attempts to reduce fiscal deficits via spending reductions will cause grave harm to economies? In my view, the deficits are big and awful already, and that is a major problem already. Big deficits imply expanding government intervention in the economy, the risk of major increases in tax burdens, and a less efficient and slower growing economy going forward. Increasing fiscal deficits is only stimulative if they are used to finance a significant and productive cut in taxes; otherwise, higher deficits, especially when they get to 10% of GDP or more, are bad (just look at what they have done to Japan). I believe it is never a bad thing to do the right thing; if higher deficits are bad, then lower deficits are good. Cut the spending, and watch the private sector take off; that's the best way to fix these economies.

The real problem faced by the PIIGS and by the U.S. is political in nature, not economic. The party in power never seems to want to cut spending, but ultimately that is the only solution. The spending is unproductive to begin with, so eliminating it should be a net benefit. It probably requires a near-crisis to cause such a sea-change in fiscal policy, but by the looks of things we are well on the way, both here in the U.S. (with the rise of the Tea Party), and in Europe (thanks to the discipline of the bond market).

One hiccup in claims doesn't mean anything

The market today is distressed over the unexpected rise in unemployment claims, among other things. But nothing ever moves in a straight line, as this chart should attest. What's happening today has happened before, without serious consequences. Consider the first half of 1992, when claims were averaging about 420K per week, and then briefly jumped to almost 450K. That didn't stop the economy from growing at an annualized 4.3% throughout the first half of 1992. In fact, if you adjust claims for the size of the workforce (which is 21% larger today than it was then), today's level of claims is about 5% lower than than the average level of claims in the first half of 1992. This is a tempest in a teapot, as they used to say.

Obama clueless on FX rates

This news item from Reuters is the latest example of how Obama, like most politicians, is utterly clueless about how economies work.
President Barack Obama said on Wednesday China and Asia would be a huge market for U.S. exports going forward but it would be important to address currency rates to ensure American goods were not facing a disadvantage. "One of the challenges that we've got to address internationally is currency rates and how they match up to make sure that our ... goods are not artificially inflated in price and their goods are artificially deflated in price," Obama told senators from his Democratic party.
Stripping aside the rhetoric, what Obama is saying is that the U.S. would be better off if the dollar weakened against the yuan. This is nothing but shoddy thinking. A weaker currency can never make an economy stronger. A weaker currency may make U.S. exports cheaper, but a weaker currency also makes imports more expensive. Devaluing one's currency is thus a fool's game, since it benefits one segment of society (exporters) but harms everyone else (consumers, who have to pay more for the imported goods they purchase).

China made a perfectly rational decision to start pegging its currency to the U.S. dollar in 1995. Targeting its currency is the mainstay of Chinese monetary policy, and that is perfectly acceptable, so long as you understand and accept that under a targeted exchange rate regime, the economy is forced to adjust if the exchange rate chosen is too strong or too weak. If the currency is pegged at a rate that is too weak (as Obama is alleging) then imports will be too expensive and inflation will tend to rise, and the price of goods and services will rise until the currency's artificial cheapness is offset. In the long run, pegging one's currency at a low level will only result in inflation and perhaps a temporary boost to exports.

The Chinese central bank first started targeting the yuan/dollar exchange rate in 1994; thus the economy has had 16 years to adjust. It's noteworthy that the Chinese have already revalued the yuan against the dollar significantly, by almost 28%, since 1994. It's highly unlikely, therefore, that the yuan is being pegged at a level that is artificially low. And even if it were, the passage of time will inevitably erode whatever "advantage" that is supposed to give to Chinese exporters.

The biggest problem the Chinese face with their exchange rate regime is that the currency they have chosen as a standard (the U.S. dollar) has suffered extreme changes in value against the other major currencies of the world. It does the Chinese little good to peg their currency to a standard that fluctuates, and in fact it only creates problems for its economy. For example, the dollar rose some 50% from 1995 to 2002, lifting the yuan with it, and that was the proximate cause of the deflation that China suffered from 1998 through 2002. The dollar subsequently lost over one-third of its value from 2002 to 2008, and this helps explain why Chinese inflation rose from zero in early 2003 to almost 9% in 2008. The main reason the Chinese have revalued their currency against the dollar is because the dollar has lost about 20% of its value against other major currencies since 1994.

The result of this so-called currency "manipulation" is a yuan that has been more stable relative to other currencies, and to gold, than the dollar. This stability, coupled with massive foreign currency reserves, has made the yuan a rock of stability. Revaluing the yuan would only make sense if the U.S. were to allow the dollar to continue to fall against all currencies. Is a dollar devaluation really what Obama wants? I hope not.

UPDATE: Just to be clear, I'm saying that the only way the Chinese are going to revalue the yuan against the dollar is if the U.S. first devalues the dollar against other major currencies. 

Service sector continues to improve

The ISM's index of business activity in the service sector has been 50 or above since last August, and that is consistent with a modest improvement. Nothing to write home about, but I would note that conditions today are about the same as they were in March and April of 2003, just a few months before the Bush tax cuts were enacted and the economy subsequently took off like a rocket in the second half of the year. Miracles can happen: what if Congress refused to allow the Bush tax cuts to expire? Since almost everyone expects tax rates on income and capital to rise beginning in 2010, it would be very bullish for the markets if they were instead held steady.

The jobs situation continues to improve

The jobs market continues to improve, according to ADP's job loss estimate (top chart). The ADP figures have been tracking the the BLS numbers pretty well, and from eyeballing the chart it looks like we are very close—perhaps just a month away—from seeing net job gains being reported in both series. The Challenger count of announced corporate layoffs jumped last month, but as the second chart shows this is very typical even during times of strong economic growth (e.g., 2003-2005). A healthy economy is always experiencing some form of "creative destruction."

Auto sales still rebounding nicely

Auto sales were a little weaker than expected in January (Toyota's massive recall was a big factor), but they are still up at a 17% annualized rate from their low of last February. With the U.S. car fleet aging steadily, a sales rate this low (by far the lowest level relative to the size of the population since records were first kept beginning in 1967) is very unlikely to be sustained for much longer, especially if the economy as a whole continues to expand. From my perspective it looks like auto sales are following their typical pattern of rebounding after the end of a recession, and could even enjoy a very strong rebound in the years to come. Even from a pessimist's standpoint, it's clear that autos stopped being a drag on the economy about one year ago.

Credit spread update

The first chart shows spreads on generic 5-year Credit Default Swaps, and the second chart shows the difference between high yield (junk) and investment grade credits. CDS spreads are a nice, liquid proxy for generic credit risk with 5-year maturity. We've seen all three lines wiggle a bit to the upside in recent weeks, and that wiggle has coincided with an uptick in the VIX index, which is shown in the third chart, alongside the S&P 500 index. These wiggles are the market's way of climbing walls of worry. I doubt that they signal the end of the rally in corporate bonds or stocks.

As all three charts show, measures of risk and uncertainty have come down hugely, which is good, but they are still above the levels that tend to prevail during periods of tranquil markets and a healthy economy. No where can I spot any sign of irrational exuberance or a failure to appreciate that there is still plenty of risk and uncertainty out there in the world. Credit spreads are still fairly high relative to historical averages, and the VIX is still quite high as well. These are signs that the market is appropriately cautious, and worried that things might not continue to improve.

The threat of anti-business sentiment and higher-tax policies coming out of Washington seems like the likely catalyst for the market's latest bout of nerves. Bad policies can derail a recovery, so the market is reacting rationally to Obama's populist attacks on banks and big business. But meanwhile, the wheels of recovery continue to turn, and the economy has undergone some tremendous adjustments that open the door to continued improvement. You can't keep the U.S. economy down.

And as Obama is discovering, you can't impose a far-left agenda on the American people. The pushback has been huge. Free markets are not going to disappear anytime soon, and as long as this remains largely a free market economy, growth and rising prosperity are the default option.

Consumption has recovered, jobs will follow

As a supply-sider, I don't believe that consumption drives economic growth. The driver of growth is supply, and supply goes up when people work more, when the factors of production become more productive, when investment goes up, and when risk-taking goes up. I show this chart of real personal consumption expenditures merely to show that what has happened in the economy over the past year is typical of every business cycle recovery. With almost all economic indicators confirming a decent recovery, with productivity up strongly, with business capital spending up strongly, with risk appetites increasing (e.g., the 60% rebound in the S&P 500 and the dramatic narrowing of credit spreads) and with consumption up as well, it is only a matter of time before we see an increase in the number of jobs. Jobs are the last place that a recovery will show up.

Things could have been a lot better, unfortunately, if it weren't for all the government "stimulus" spending. The bulk of that spending consisted of transfer payments which, because they take money from one person and give it to another, do nothing to create new growth. And the massive deficit that resulted from all the "stimulus" spending has sopped up a huge portion of the economy's savings that could have been directed to truly productive activities instead.

The recovery skeptics keep insisting that the economy is on "stimulus life support," and that any move to cut back on fiscal or monetary stimulus would threaten a double-dip recession. I don't believe it for one second. On the contrary, I keep insisting that the economy is recovering despite the government's best efforts to suppress growth. It never pays to underestimate the strength and dynamism of the U.S. economy.

Inflation risk is heating up

This chart shows the market's 5-year, 5-year forward expected inflation rate. Today it is making a new multi-year high. Gold has perked up today as well, gaining $23 to $1104/oz. These facts square with the ISM's January price index reading of 70. Deflation is history, inflation is making a comeback. None of this squares with the skeptics' call for a double-dip recession or even 2-2.5% growth. The key inflation fundamentals are very accommodative monetary policy coupled with declining money demand. Money demand, in turn, is falling because confidence in the economy is returning; money that was hoarded when the outlook was disastrous is now getting put back into the economy. Check out my post last Friday on money velocity for more details. Every day the Fed delays a reversal of its quantitative easing is another day that inflation risk rises.

The market is not entirely unaware of this, as this next chart shows. Despite the Fed's continual assurances that short-term rates will not budge for a long time, the yield on 3-month T-bills has been rising. I don't want to make too big a deal of this, because the rise in yields is still miniscule, but all important changes happen on the margin, and this one looks like it's just getting underway. If bill yields continue to rise, the Fed will eventually get the message that it's time to tighten.

Energy conservation doesn't require a federal mandate

Here are two charts that illustrate how effective free markets can be in the conservation of energy. As the first chart shows, consumers spend less of their income on energy today than they did in in 1970, despite the fact that the price of oil—the source of most energy—has risen some 600% in the intervening years in real terms, as shown in the second chart.

But here's a more accurate description of what has happened: since oil prices have risen 600% in the past 40 years, consumers now spend 13% less of their income on energy. Rising oil prices have spurred conservation and technological advances that have drastically reduced the amount of oil we need to run our lives and our economy. As this next chart shows, the U.S. economy today uses 57% less oil per unit of output than it did in 1970.

Free markets have thus accomplished the task of greatly reducing our energy dependence. We don't need any federal mandates or new programs or new spending to develop "green" energy. It's a process that is already well underway.

ISM indices are very bullish

The Institute for Supply Management's indices of manufacturing activity are full of V-shaped recovery signs. To be sure, these are diffusion indices, so they don't measure the strength of the rebound in manufacturing conditions; they measure instead the breadth or scope of the improvement. For example, the first chart tells us that 58.4% of those surveyed reported seeing increased activity. In an historical context, this is quite an impressive number, and it has coincided with GDP growth of 5% or more—which is exactly what we saw in Q4/09. But whereas recovery skeptics dismissed the Q4 growth as mainly due to a decline in the pace of inventory liquidation, the ISM numbers are saying that the strength of the recovery is more impressive than the latest GDP statistics suggest.

It's noteworthy also that the prices paid index has jumped to 70, which means the vast majority of businesses are paying higher prices these days. That's not exactly the sort of stuff of which deflation—still a popular theme among the recovery skeptics—is made.

I'd say the economy is in classic recovery mode, and deflation is history. This is reason for great cheer, even if Obama's $3.8 trillion budget proposal is an abomination. More on that later.

Tea Party update

The Tea Party movement is alive and well. I remember attending my first Tea Party gathering last April 15, and now the movement is organizing and preparing to announce its Contract From America this coming April 15th. Glenn Reynolds has a good article that explains what's going on here. You can vote on what you think should be the elements of the Contract From America here.