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Federal budget outlook continues to improve

Thanks to April's stronger-than-expected gains in federal tax revenues and weaker-than-expected growth in federal spending, the 12-month federal deficit has shrunk to $1.15 trillion, down significantly from its high of $1.48 trillion in early 2010. By my estimates, the federal budget deficit now has dropped from a high of 10.4% of GDP to 7.4%. This is very good news that I imagine most people are completely unaware of, and it's come about in the best possible way: government is slowly shrinking relative to the economy, and this is allowing the private sector to grow, with the result that tax revenues are rising even though tax rates are not. If these trends were to continue, our spending and deficit problem would fix itself without the need for any political haggling or agonizing.


Here's the big picture. Note that spending has been almost flat since the end of the recession, while revenues have increased by $350 billion. Congressional deadlock can be a wonderful thing: by not increasing spending in recent years, Congress has managed to get federal spending as a % of GDP down from a high of 25.3% to 22.7%.


How many people realize that the federal budget deficit as a % of GDP has declined by almost 30% in the past few years? It's now comfortably below the 9% of GDP level that studies suggest is the tipping point beyond which an economy begins to destabilize.


This chart highlights the progress that has been made in federal revenues. Tax receipts have been much stronger this year, thanks to more people working, rising incomes, rising corporate profits, and increased capital gains realizations. Looked at another way, since government is consuming a smaller portion of the economic pie, the private sector has been able to put those resources to more efficient use, and as a result the pie is growing.

As I've long argued, and as Robert Barro points out in his op-ed in today's WSJ, declining budget deficits are not "austerity," and in fact can be stimulative. Keynesian "stimulus" spending just doesn't work—trimming the size of government and allowing the private sector to expand is a far better way of encouraging economic growth. Here's a key excerpt:


Despite the lack of evidence, it is remarkable how much allegiance the Keynesian approach receives from policy makers and economists. I think it's because the Keynesian model addresses important macroeconomic policy issues and is pedagogically beautiful, no doubt reflecting the genius of Keynes. The basic model—government steps in to spend when others won't—can be presented readily to one's mother, who is then likely to buy the conclusions.
Keynes worshipers' faith in this model has actually been strengthened by the Great Recession and the associated financial crisis. Yet the empirical support for all this is astonishingly thin. The Keynesian model asks one to turn economic common sense on its head in many ways. For instance, more saving is bad because of the resultant drop in consumer demand, and higher productivity is bad because the increased supply of goods tends to lower the price level, thereby raising the real value of debt. Meanwhile, transfer payments that subsidize unemployment are supposed to lower unemployment, and more government spending is good even if it goes to wasteful projects.
Looking forward, there is a lot to say on economic grounds for strengthening fiscal austerity in OECD countries.

We can only hope that more and more policymakers and politicians around the world begin to understand the fallacy of traditional "stimulus" policies. What most countries need these days is less public sector spending, not more, and lower and flatter tax rates. Government needs to get out of the way and let the private sector work its growth magic.

Trade update: continued growth a positive



Imports rose more than exports in March, causing the trade deficit to increase, but that is not necessarily a sign of weakness. The more important thing is that both imports and exports continue to increase at a healthy rate, since that means the U.S. economy is growing and dynamic, and the rest of the world is also growing and dynamic.


This chart focuses on goods exports over a shorter time frame, and here we see how export growth has picked up in recent months after a period of sluggish growth in the latter half of last year. This is especially encouraging, since it suggests that the weakness in the Eurozone has not had a significant impact on demand for U.S. exports. The export sector of the U.S. economy is doing quite well (goods exports are up 57% in the past three years!), in part because of the weak dollar, but also because the rest of the world is growing and consuming more.


This chart illustrates just how much the U.S. trade gap has narrowed over the past decade, thanks mainly to strong export growth. Note also the huge impact that increased international trade has had on the U.S. economy in recent decades. Since 1980, when we imported and exported about 5% of our GDP, trade has roughly tripled in importance: in the first quarter of this year, exports were equal to 13.5% of GDP, while imports were 16.5%. Today, the U.S. economy is far more integrated with the rest of the world than ever before, and there is every reason to think that this trend will continue.

Claims back on track


Weekly claims for unemployment came in as expected, and as this chart shows, the seasonally adjusted level of claims and the 52-week moving average both still appear to be trending down. On an unadjusted basis, claims last week were almost 15% below the level of a year ago, which is actually quite impressive. Taken together, these numbers confirm that the downtrend in this series is still intact, and the upward surprise of a few weeks ago was the result of faulty seasonal adjustment factors.


It is also impressive that the total number of people receiving unemployment insurance has declined by 1.2 million, or 16.8%, over the past year. This means that more people are finding jobs, and also that more people have a greater incentive to find and accept jobs. On the margin, the dynamics of the labor market are still positive.

Energy price update

One month ago, I noted in a post that "the threat of higher gasoline prices is receding." Some readers as well as some economists and analysts noted at the time that energy prices appeared to be tracking the strength of the economy, and that therefore they would rise if the economy improved, and fall if the economy got weaker. My point, in contrast, was that higher gasoline prices were not necessarily a reason to worry about the economy, and in any event, internal market dynamics were already pointing to a decline in gasoline prices. I'm not sure if anyone can claim victory here (are gasoline prices driving the economy, or is the economy driving gasoline prices?), but the issue is important enough to warrant posting some updated charts.


As this first chart shows, gasoline prices at the pump peaked in early April at $3.94/gal. and have fallen since to $3.75, according to the folks at the Automobile Club.


This chart compares the price of gasoline futures (white line) with gasoline prices at the pump (orange line). My point a month ago was that pump prices naturally lag futures prices, and the decline in futures prices was already pointing to declining pump prices. That continues to be the case, so pump prices could fall another 15-20 cents in the next few weeks.


This chart shows the tight correlation between gasoline futures prices and crude oil futures prices. A month ago I noted that gasoline prices were unusually high relative to crude prices, and that this also argued for lower gasoline prices. That is still the case today. So once again, I think the conclusion is that "since pump prices are high relative to wholesale prices, and wholesale prices are high relative to crude prices, it is reasonable to think that pump prices are at least unlikely to rise further, absent a significant increase in crude prices, and could well decline."

In conclusion, to the extent that expensive energy represents a headwind to growth, this is one more reason to not worry about the U.S. economy suffering a relapse.

Eurozone banks: the sum of all fears



As these charts show, Eurozone financial conditions are still under a lot of stress; Euro swap spreads reflect a significant degree of systemic risk. The U.S. has largely avoided Eurozone contagion, but the threat of a banking collapses in Europe still weighs heavily on investor sentiment around the world.


This chart compares the S&P 500 Banks Index (white line) with the Euro Stoxx Banks Index (orange line). Here we see that the capitalization of Eurozone banks has been in sharp decline since October 2009, while U.S. banks have been roughly unchanged since then. Eurozone banks are now just inches from their crisis lows of March 2009, while U.S. banks have recovered significantly over the same period.


This chart shows the ratio of U.S. bank stocks to Eurozone bank stocks to put the divergence in performance into perspective. Since the panic lows of March 2009, U.S. stocks have outperformed their Eurozone counterparts by 235%. (The Euro/$ exchange rate is about the same today as it was then, so this is a valid comparison.) The relative performance differential is simply astonishing—U.S. banks are still 63% below their 2007 highs—and it highlights just how much the Eurozone banking system has suffered as the risk of sovereign defaults has surged.

Eurozone banks are bearing the brunt of the deterioration of sovereign debt prices because they have been the most significant holders of this debt. This illustrates how debt defaults are zero-sum games: Greece benefits from its debt restructuring because it is relieved of the need to make burdensome debt payments, while Eurozone banks (and their shareholders) are punished because their future cash flows are now much less than originally expected. Meanwhile, life goes on for most of the rest of the world. Debt defaults don't destroy the productive capacity of the world, they simply are the consequence of imprudent and unproductive investment decisions. The funds that were lent to Greece and other PIIGS were misspent (e.g., on lavish pensions for public sector workers) and there is nothing to show for it. The Eurozone's scarce resources were wasted and frittered away for years, and that has already been reflected in weak growth and high unemployment. The economic damage of lending to unproductive nations has already been done.

The main threat posed by Eurozone sovereign defaults is that the Eurozone banking system implodes, and the severe underperformance of Eurozone bank stocks and the still-high level of Eurozone swap spreads shows that investors are very much aware of this threat. But painful and frightening though this may be, it is not a reason to expect the end of the world as we know it. Eurozone banks can be nationalized and/or recapitalized, and the ECB can lend massively—which they've been doing. The vast majority of the people working in the Eurozone will continue to work even if more sovereign debt is written off. Debt defaults and restructurings are like an economic version of neutron bombs: they destroy the net worth of lenders, but they leave productive resources intact. Eurozone economies need not collapse, and the U.S. economy needn't suffer very much.

Meanwhile, the solution to Europe's problems is not all that difficult. As Mark Perry noted in a recent post, Sweden has made significant progress in recent years by eschewing the Keynesian solutions that have failed elsewhere in Europe. Cutting back on public sector spending while reducing tax burdens on the private sector is the perfect way to solve the problems facing Europe, and the U.S. for that matter. Most of Europe is still refusing to acknowledge this, but sooner or later more people will understand that growth-oriented policies such as are being pursued in Sweden and Ireland are the not only the least painful solution, but also the best solution for countries that are burdened by too much government spending and too much debt.

There is a way out of this mess, so there is no reason to despair.