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Federal budget update: still a significant concern

Spending has slowed, and revenue has picked up, with the result that the budget deficit has shrunk from a high of $1.48 trillion (about 10% of GDP) last February to $1.3 trillion (about 8.8% of GDP) today. Although it's difficult to see in the top chart, spending has actually picked up a wee bit in recent months, and if and when new programs like ObamaCare kick in, spending is quite likely to reaccelerate, pushing government spending up to about 25% of GDP (or more) on a permanent basis; that would represent a 20% expansion in the relative size of government compared to the average of the postwar period. This is the part of the budget that weighs most heavily on the economy, since government spending is chronically inefficient, and transfer payments—which make up over half of the budget—create pernicious disincentives to work. Even though the deficit is likely to shrink a bit more as revenues continue to increase, the deficit is very likely to remain large enough to also weigh heavily on the economy, since it is absorbing a significant portion of our savings.

It is of great concern as well that the Federal Reserve is contemplating the purchase of a substantial portion of the deficit (thus monetizing the deficit, which is what economic textbooks refer to as a sure-fire way to create inflation) in coming months.

If not for promise of significant change as a result of the upcoming elections, this budget picture would all but guarantee disappointingly slow economic growth for the foreseeable future. If spending can be reined in as Republicans are promising, and if the Bush tax cuts can be extended, that would create a lot of light at the end of this otherwise dark tunnel. Fiscal austerity in this environment would, ironically, provide a significant boost to growth going forward.

Retail sales well on the road to recovery

Retail sales in September rose by more than expected, resulting in strong 7.3% growth over the past 12 months (top chart). The bottom chart zeros in on the level of retail sales to show how they have nearly recovered from the big collapse of late 2008. Taken together with the relatively strong showing from imports in August (see previous post), this confirms that consumers are doing fairly well despite the persistence of high unemployment.

As a supply-sider, I don't attach a lot of importance to measures of consumer demand such as retail sales. Instead I think this is more a barometer of the general health of the consumer sector, and as such it corroborates much of the evidence of an ongoing economic recovery. At the very least, it is solid evidence that there is no double-dip recession underway.

Trade slowdown

As the top chart shows, both exports and imports slowed down in recent months, with exports slowing a bit more than imports. The slowing in exports is confirmed by a more pronounced slowdown in outbound container shipments from the ports of Los Angeles and Long Beach, as shown in the second chart. The result of more imports than exports was a somewhat wider "trade gap," the traditional bugbear of politicians and others who fail to understand how international trade contributes to higher living standards.

Although it's true that a widening gap between imports and exports subtracts from GDP growth, it's not necessarily the case that a trade deficit is a sign of economic weakness. When foreigners sell us more goods and services than we purchase from them, as has been the case for decades, foreigners must at the same time put more money into our stock, bond, and real estate markets than we put in theirs. In other words, a trade deficit must always be matched by a capital account surplus of equal magnitude. The dollars we pay out for foreign goods and services must, at the end of the day, be spent on something here, whether it be a bank deposit, a stock certificate, or a bond. You might say that foreigners are more interested in buying dollar-based financial assets and real estate than they are in buying our goods and services. (I should add that foreigners have traditionally converted a decent portion of their export earnings into $100 bills, which cost us almost nothing to produce.) A trade deficit is not a problem, since it means that foreigners are willing to contribute to our pool of savings by investing in the U.S.

It's entirely possible that the slowdown in exports was a reflection of foreigner's heightened concern over the possibility of a double-dip recession and/or a European banking crisis. Instead of buying more of our goods and services, foreigners wanted to put some extra money into our financial markets for safe-keeping. With markets beginning to feel a bit better about the future, it's also entirely possible that we might see foreigners taking some money out of the bank to buy more of our goods and services in the months to come, thus fueling stronger U.S. export growth.

Whatever the case, the still-strong growth rate of U.S. imports (up at an annualized 12.6% rate in the three months ended in August) reflects healthy demand from U.S. consumers.

Our highly progressive tax code, illustrated

This chart (recently updated with 2008 data) needs wide distribution, especially now that Obama has rekindled the debate over whether the rich are paying their fair share of taxes. What it shows is that the top 1% of taxpayers (when ranked by income) pay about 40% of all Federal income taxes; the top 5% (which includes all those whose adjusted gross income exceeded $160K) pay about 60% of total taxes; and the top 10% pay fully 70% of all income taxes. You can find the data and commentary from The Tax Foundation here.

Those whom Obama would label as rich—those with incomes greater than 250K—and thus deserving of higher tax rates, paid (based on my interpolation of the data) about 50% of all Federal income taxes in 2008. Is that not enough of a burden?

There are other goodies here. Note that despite the 50% reduction in top marginal tax rates since 1980, the rich have paid progressively more and more of total income taxes. If that's not the Laffer Curve at work, I don't know what is. Plus, this shocker: the top 1% of income earners paid almost as much (92%) as the bottom 95%. We are deeply in a situation in which the few are supporting the many: the bottom 50% of income earners paid only 2.7% of total income taxes in 2008, and 52 million taxpayers paid no income taxes at all. This leaves the Federal government in the precarious position that has already crippled California: since only a relative handful of taxpayers pay the lion's share of taxes, government revenues are highly dependent on the health of the economy. The rich lose far more income in a recession than the poor, and that results in a huge drop in revenues whenever the economy hits a rough patch. The rich also have a greater ability to change the amount of income they earn, and to simply take their income somewhere else if they feel overly burdened.

Our tax code does not need to be more progressive. Instead, tax rates should be flatter and lower, and we should eliminate as many deductions as possible in order to broaden the tax base. The result would be a more efficient and stronger economy, and a more equitable distribution of the burden of government. Give more people some "skin in the game" by requiring them to share the cost of government, and we might find it easier to reduce the size of government. Allowing the burden of government to be borne by only a small portion of the population is not only inherently unfair but dangerous to the economy's long-run health.

QE2 is not only unnecessary but foolish (cont.)

Even as there appears to be an overwhelming consensus that the FOMC will commence a second round of quantitative easing following next month's meeting, the evidence is mounting that this is not a good idea. As this chart shows, the bond market is getting more and more worried about inflation. 10-yr Treasury yields are anchored by the Fed's pledge to keep short rates low for a long time, and by the evidence that suggests that economic growth is not accelerating and unemployment will thus remain high for a long time. But 30-yr Treasury bonds have no such constraints. They have risen 35 bps since the end of August, while 10-yr yields are essentially unchanged. Meanwhile, 10-yr real TIPS yields have fallen almost 70 bps over the same period as demand for inflation protection has increased. All this adds up to an 80 bps rise in 5-yr, 5-yr forward inflation expectations (as shown above in red), the Fed's preferred indicator of the market's inflation expectations.

This one chart should be held up at the FOMC table, with the following admonition: "Gentlemen, the market is clearly telling us that to move ahead with QE2 would increase inflation expectations beyond what is consistent with our mandate to seek relative price stability. Meanwhile there is little or no evidence that economic growth has been constrained by a lack of liquidity. I vote to tell the world that we remain disposed to avoid deflation at all costs, but to make no changes to monetary policy for the time being." What would be very exciting to hear—but highly unlikely, unfortunately—is at least a few words to the effect that fiscal policy (e.g., extending the Bush tax cuts) is the more appropriate policy lever to be pulling at this juncture.

Credit default swap spreads point to improvement

After jumping in May in the wake of the concern over a European credit crisis and expectations of a double-dip recession, CDS spreads have settled back down and are now only modestly higher than their lows early this year. I think this shows that financial markets are healthy and liquid, and there has been no deterioration in the economic fundamentals so far this year. The problem, of course, is what appears to be a reluctance of businesses to invest in new jobs and productivity enhancements.

Supply-siders like me keep insisting that the problem with slow growth can be traced to a lack of "supply; the economy can't grow if our productive capacity doesn't grow and if new jobs aren't created. Demand-siders (aka Keynesians) keep insisting that the problem is a lack of "aggregate demand;" if only everyone would spend a little more then we would be back on the road to recovery. It's a chicken-and-egg argument that to my mind is very simple to resolve using simple logic: you must first produce more before you can spend more. The supply-side solution to today's sluggish economy is to increase the incentives to work, save, and invest, while lowering the barriers to working more and investing (e.g., regulatory burdens, reducing the threat of higher taxes, and generally increasing confidence in the future). That is precisely the opposite of what Obama and the Democrats did early last year, and that's why the economy has, predictably, been very slow to recover.

Pulse of Commerce Index weak but not likely a threat

The September UCLA-Ceridien Pulse of Commerce Index was weak, and it has been weak for a few months now. After healthy growth over the previous year, this index suggests the economy took a pause in the third quarter, and that seems consistent with other indicators that suggest the economy slowed down somewhat. The important thing is whether this presages further weakness. I seriously doubt it, and the folks at UCLA make this sensible observation:

This unfavorable news could be taken by the Cassandras of the double-dip as an alarm of a coming decline in GDP and another spike up in unemployment. The slowing growth of the PCI this year is similar to the behavior of the PCI in 2007 which presaged the recession that began in January of 2008. That recession produced major declines in the volatile cyclical components of GDP — residential investment, consumer durables and business spending on equipment and software. With all three of these components at or near record lows relative to GDP, it seems unlikely that any of them could contribute much to an outright GDP decline, and the other components of GDP do not have histories that suggest they could produce an outright decline either.

Claims still point to very gradual and modest improvement

Weekly unemployment claims came in a bit higher than expected, but as the first chart shows, this counts as a minor blip; claims are going nowhere this year. But as the second chart shows, the number of people receiving unemployment benefits has dropped to a new low for the year. Undoubtedly there are folks who are still out of a job and hurting, but on balance, fewer people receiving claims means a) more people working, and b) an increased incentive for some to find and accept jobs on the margin. Yesterday, while walking around the South Coast Plaza in Costa Mesa, I noticed quite a few "help wanted" signs in shop windows. I'd bet that those jobs don't pay more, after tax, than unemployment benefits, but I could be wrong.

Producer Price Inflation still alive and well

The September report on Producer Prices shows no sign of deflation, but rather an ongoing rise in prices. Over the past year, the Producer Price Index rose 4%, while the core rate rose 1.5%; the core rate has actually risen at 2% annualized rate for most of this year. Both are registering more inflation (2-4%) in recent years than the 1.6% average annual rate of producer price inflation we had in the disinflationary 1990s. Since the Fed first started easing policy in earnest in 2001, there has been a notable pickup in the pace of inflation at the producer level that continues to this day. Not coincidentally, commodity prices have in general been very strong for past 9 years. With commodity prices continuing their rise, we have every reason to expect that producer inflation will remain elevated—and possibly rise—in coming months.

This is not an environment that begs for further quantitative easing. On the contrary, this report should be high on the list of reasons why QE2 is not necessary at this time.

I suspect that if the FOMC were to announce next month that they remain committed to doing whatever it takes to ensure that the economy is expanding and deflationary risks are minimal, but that it thinks the economy is healthy enough not to need further QE at this time, that the market might be briefly disappointed. But I also suspect that after a selloff, reason would take over and risk prices would again rise. Nobody wants to see the Fed try to push inflation higher. Nearly everyone has a stake in the dollar retaining its purchasing power. Higher interest rates and a stronger economy are in everyone's best interest.

The $1 trillion lesson

In an article to appear this Sunday in the NY Times Magazine, titled "The Education of President Obama," you'll be able to read that President Obama "realized too late that 'there’s no such thing as shovel-ready projects' and perhaps should have 'let the Republicans insist on the tax cuts' in the stimulus."

U.S. taxpayers only had to fork out $1 trillion or so to educate Mr. Obama and the congressional Democrats on how an economy really works.

HT: Drudge

Global equities mark a post-recession high

The market cap of global equities has reached a new post-recession high this past week, thanks in part to the weak dollar. (U.S. equities are still about 3% below their April highs.) What's propelling things upward is anybody's guess, of course, but from my perspective this rally is in large part about things that were feared that didn't happen—like a double-dip recession or a deadly bout of deflation or more policy mistakes. The fundamentals—strong corporate profits, abundant liquidity, strong commodity prices, lower swap and credit spreads—have been looking good for quite some time.

True, the prospect of further central bank accommodation has been much-discussed of late and that could be a factor behind the rally as well. But I prefer to think that markets don't react well to impending policy errors, such as would be the case for QE2. Instead I think that in addition to cheering the bad things that didn't happen, markets also are reacting to the prospect of fewer policy errors going forward, and the elections to be held in 20 days are very likely going to make that possible. The Bush tax cuts have a good chance of surviving. Federal spending is very likely to slow down. ObamaCare could suffer arrested development. Cap and trade is a creature of the past. Washington is very likely to become less anti-business and with a little luck might even become a bit pro-business. The people are going to give a raft of new politicians a strong mandate to fix the economy, and that can only be done by turning loose the energies of the private sector.

There are lots of reasons to be optimistic these days.

Blogging may be light

We've got some more visitors from Argentina this week and next, so blogging may be light at times.

QE2 is not only unnecessary but foolish

You can count on Allen Meltzer to offer sound and sensible advice on economics, and his article, "The Fed Compounds Its Mistakes," in today's WSJ is one more reason why. It would be very hard for any economist worth his salt to disagree with anything Meltzer says here, so why in the world is the Fed so hell-bent on proceeding with QE2? Excerpts follow, but read the whole thing:

The Federal Reserve seems determined to make mistakes. First it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. 
Then the press reported rumors about plans to raise the inflation target to 4% or higher, from 2%. This is a major change from the Fed's quick rejection of a higher target when the International Monetary Fund suggested it a few months ago.
Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman's analysis is now a standard teaching of economics. Surely Fed economists understand this.
Adding another trillion dollars to the bank reserves by buying bonds will not relax a constraint that is holding back spending. There is no shortage of liquidity in the economy.
The most important restriction on investment today is not tight monetary policy, but uncertainty about administration policy. Businesses cannot know what their taxes, health-care, energy and regulatory costs will be, so they cannot know what return to expect on any new investment.
The only lasting solution for housing is to let prices fall to a new equilibrium. Painful, yes, but necessary. Temporary palliatives such as lower interest rates delay that adjustment.
Once the economy does begin to heat up, the Fed will urgently need to reduce excess bank reserves lest they stoke inflation. The Fed has talked about policies it can use to do so, such as raising the interest rates it pays to banks to hold their reserves. It has not offered a coherent, credible program to do so since it does not say, and probably does not know, how high the market interest rate would have to be.
Yes, a sustained deflation would be a big problem, but it is unlikely in today's circumstances. Countries with a depreciating exchange rate, an unsustainable budget deficit, and more than $1 trillion of excess monetary reserves are more likely to inflate. That's our problem today, and it's another reason the Fed should give up this nonsense about more stimulus and offer a credible long-term program to prevent the next inflation.

Financial conditions in the U.S. are back to normal

As a follow up to my previous post, the Bloomberg index of financial conditions in the U.S. is now essentially back to the average of the 1992-June 2008 period after a brief Greek-related dip.

Financial conditions in Europe are on the mend

Financial conditions in Europe are gradually becoming less anxious, as these two charts show. The yield on 2-yr Greek government debt has dropped more than 400 bps since August, reflecting a much-reduced chance of a Greek default. Meanwhile, 2-yr yields on German government debt have risen 20 bps, suggesting less concern that Greek woes will drag down Germany.

Swap spreads (see my primer on swap spreads here) in the U.S. have been trading at very low levels for most of this year, which is a very good sign that financial conditions here are essentially back to normal. Counterparty risk, according to swap spreads, is actually rather exceptionally low, which is one anticipated effect of very accommodative monetary policy. European 2-yr swap spreads have dropped 25 bps since their early-June peak in a sign that the risk of a Eurozone financial meltdown (presumably triggered by a Greek, Irish, or Spanish default) has dropped considerably.

It shouldn't be surprising that the improvement in European financial conditions has largely coincided with the rally in U.S. equities, since it was the fear of a Greek default back in April that triggered the market's selloff that lasted through early July.