demand

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Shrinking Deficit

We have been bombarded for the past few years by an endless stream of analyses, diatribes, and invectives about the horrors associated with the Federal deficit. The tide of red ink that began to flood Washington at the end of the Bush administration and which has abated only slowly under Obama became a feature of the great political stand-off that has frozen policy making and disrupted Congress since 2009. In response to the yawning gap in the nation’s finances politicians, academics, the media, think tanks, and sundry hangers-on all felt the need to opine on the merits and demerits of a deficit that peaked at 10.1% of GDP back in the darkest days of 2009.

We have been treated to a variety of sober plans to slash it back in the name of preserving the nation, avoiding a burden on future generations, and restoring the full faith and credit of the government. Folks like Alan Simpson and Erskine Bowles have re-emerged from obscurity to become stars amongst the cognoscenti the membership of which was limited to those who saw the dangers of debt and advocated astringent urgent remedies.

We became used to being told that we could no longer afford the goodies we wanted. That Social Security needed “saving”. That Medicare was a looming disaster, and that in our newly diminished state we all had to tighten our belts, forgo nice things, and suffer the consequences of austerity. This was the new America, austere, harsh, but with balanced books. Our creditors would love us. Confidence would flow, and eventually the tide of red ink would be replaced by one of business, industry, and – perhaps – a recovery in employment.

Perhaps the most enduring images of this discussion were the various budget proposals put forward by Paul Ryan. He shot to fame from nowhere because his ideas were deemed a serious conservative alternative to the left’s older, and deemed tired, economics built largely on a Keynesian foundation. Since the right’s leading economic ideas were the root of the crisis, conservatives and self-styled centrists alike were desperate for a new hero who could be the anti-Keyenes. Ryan adroitly fit the bill. That his plans were a sham and didn’t even add up was never a concern. What mattered was that he advocated a solid dose of puritanical, morally uplifting, austerity designed to wean us all off of the government’s largesse.

So the deficit debate turned into one about the size and scope of government. The Republicans managed to exploit the gloom and angst over the rising debt by using it as a bargaining chip. They threatened to shut down the government. They threatened to renege on the national debt. They opposed all and every measure proposed to lift the economy, unless said measure was attached to the introduction of “vital” austerity. As a result, Washington lurched from one political crisis to the next. The economy languished. And we became stuck in a surrealistic stand-off with each and every offer advanced by Obama being rebuffed, even if it embodied austerity measures hated by his own supporters.

And then …

Something funny happened.

The deficit began to melt away. Not completely, but enough. Just like some of said it would. The vast drop in revenues and the equally vast jump in spending that happened because of the drop in economic activity in 2008 was cyclical. It was always going to go away if, and when, the economy came back to life. Which it has done. Just enough to make a big difference in the deficit.

Yesterday the Congressional Budget Office (CBO), the bipartisan referee of Washington facts and figures, published its revised budget outlook. It makes for startling reading.

The deficit is expected to shrink to a mere 2.1% of GDP by 2015. That’s below the 2.4% average for the forty years ending in 2008 before the crisis erupted. Not only that, but the deficit is now projected to be only 4.0% of GDP this year, weighing in at $642 billion. This means that the rapid upward tilt in the debt to GDP ratio that we had been warned would ruin us all is now set to sputter to a halt and even turn down a little. Instead of hurtling across the dreaded 90% cliff of doom – recall Reinhart and Rogoff’s infamous paper – the debt ratio will hover around 71% for the foreseeable future.

In short the panic is over. The deficit is under control. The debt ratio is high but just fine. We can relax.

We have no deficit problem.

This should make us all happy, right?

Well not really.

I think the deficit is too small. We have shrunk too fast too soon. We have drawn too  much demand from the economy before it was able to hum along without government help.

But that’s for another day.

The fun result of the CBO report is to watch all the austerity advocates scurry around to find new things to worry about, and new ways to justify inflicting pain on the poor, the sick, the young, and the less well off. After all, what’s a conservative to do if there’s no budget war to fight?

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Growth, But Barely?

Today’s headline is that the economy grew, just, in the fourth quarter last year. GDP rose at an annual rate of 0.1%, down from 3.1% in the third quarter and at the slowest pace in almost two years.

But things aren’t that bad. On the contrary the report is quite encouraging. this is one of those occasions when we need to dig a little deeper into the numbers.

Here are  the basics, broken out by primary economic sector:

  • Personal consumption grew at a 2.1% rate; this contributed 1.47% to the total
  • Private investment slumped, declining at a -1.5% annual rate; this reduced the total by -0.2%
  • Exports and Imports both declined, at annual rates of -3.9% and -4.5% respectively; this added 0.24% to the total
  • Government spending declined sharply, at an annual rate of -6.9%; this subtracted 1.38% from the total

Now here’s the good news:

There are some major quirks inside those numbers.

Private investment looks rotten on the surface until we realize that the entire decline can be attributed to a major inventory adjustment. Without inventories investment actually grew at its fastest pace in over  year. That big shift in inventories is typical. Businesses periodically realize they have overstocked and try to compensate in the next period. There is nothing particularly abnormal about the swing in the fourth quarter, and it has little bearing on the sustainable rate of growth we have carried forward into 2013.

The other real oddity in the figures is in defense spending which dropped a remarkable -22.0% in the fourth quarter after having jumped up 12.9% in the third. Obviously the data needs to be smoothed out to accommodate such shifts, and even with a tighter budget there is no way that we will see a repeat of the fourth quarter any time soon. Setting aside defense, spending at the federal level rose 1.8% which was mostly offset by a continued decline – of -1.3% – at the state and local level. So without defense total government spending was a nearly neutral factor for the economy late last year.

In terms of looking forward into this year it is encouraging to see personal consumption continuing to contribute a healthy amount to activity. That 2.1% growth rate is vital as we seek to keep the recovery on track. Consumption has grown steadily, but not outrageously, in every quarter for three straight years, the last decline coming in the third quarter of 2009.

Without the quirks I noted above the economy would have grown at a healthy 3.0%, virtually identical to the 3.1% of the third quarter, so it safe to say that the recovery remains on a decent trajectory.

That, however, may end soon as the sequester eats into government spending. My original thought for 2013 growth was in the range of 2.0% to 2.5%. With the upcoming budget cuts that has to be reduced by at least 3/4%, so instead of a decent year in 2013 we will get minimal growth and thus will prolong the rotten employment outlook much further than we ought.

I find it strange that Congress actually is proposing a slower economy, one that might even totter on the edge of recession, but that’s exactly what the House seems to want. The dominant thought in the House is that cutting government spending will magically release a surge of confidence in the private sector and thus more than offset the negative effects of the cuts. It won’t. It never has. It never will. Private sector confidence is a function of a pragmatic assessment of the future. The outlook for demand is the largest single contributor to that assessment. Government tax policy and spending is a much lesser component. So even if businesses and households perk up at the thought of lower future tax bills – which is what right wing theory says happens – that extra optimism will be overwhelmed by the simultaneous realization that demand will ebb as government spending is cut. It is, after all, entirely rational to take into account all the effects of austerity and not just those the right wing prefers us to focus on.

If you disagree take a look at Europe. They tried the austerity-leads-to-growth idea. It has produced nothing but longer deeper recessions, and now is producing a populist backlash. It is an unequivocal failure. But we are about to follow.

That’s just stupid. It’s also where the House wants to go. I haven’t a clue as to why.

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Simpson-Bowles: They’re Back!

Yes. Simpson and Bowles are back at it.

Erskine Bowles, former Clinton aide, and Alan Simpson former Republican Senator from Wyoming, are back in the headlines. Motivated by the onrushing sequester crisis – how we all love our crises nowadays – and infused with loads of cash from big business, our dynamic austerity duo snatched the headlines on more time today.

According to their website they have a new, modified, approach to deficit reduction. The urgency is greater, so is the pessimism. They say the need is greater because, well, umm, it is. And their pessimism is greater because, well, partisan bickering is getting in the way of deficit reduction.

If you’re like me and think that the deficit is just fine right now and needs attention only when we have a healthy economy so it can withstand the shock of cutting government spending, then there is no present urgency. Other, of course, to avoid any cuts. I suppose that puts me and the dynamic duo on the same side on that score. We both want to avoid the sequester cuts – they are just awful for the economy.

The problem is that any cuts in government spending will be awful for the economy. No matter when they occur. So I suggest that we go about that cutting, if at all, when we have growth robust enough to sustain a few hits.

Simpson-Bowles see things differently.

They say we need those cuts in order to get to robust growth. They don’t articulate why this is so. They have no theory to back up their thinking.

Well, that’s not true. they do. Let’s give them their due.

They subscribe to the view that we will get the economy going by reducing the deficit. This, their website tells us, will encourage private investment and mitigate the risk of a fiscal crisis. Here’s the relevant paragraph:

Promote, Don’t Disrupt, Economic Growth. The United States must pursue a growth agenda. As the economy recovers, one of the best ways to promote economic growth is to bring our debt under control, which will both encourage private investment and mitigate the risk of a fiscal crisis. However, sharp austerity could have the opposite effect by tempering the still fragile economic recovery. In order to protect the recovery, the sequester should be avoided and deficit reduction should be phased in gradually. At the same time, tax and spending reforms should be designed to strengthen current economic conditions, promote work, encourage innovation, improve productivity, and bolster investment in our future.

First let’s acknowledge that they admit ‘sharp austerity’ would not help matters at all. Good for them.

It’s their basic premiss that sucks.

How will less government spending encourage private investment? This, presumably, is a variant of the old idea that government borrowing sucks money out of the economy thereby less for business. There is no evidence to support this. There is, however, a lot of hot air. The credit markets seem quite capable of providing enough money to finance both government and the private sector. If that were not true we ought to be seeing some form of rate increase because limited supply favors creditors. This isn’t happening. Plus monetary policy has been lax to put it mildly driving down rates and making borrowing very cheap. The consequence has been that investment has been muddling along at a decent if not spectacular rate since the recovery began. Besides big business is sitting on an almost unprecedented hoard of cash. If it wanted to invest it could even without borrowing. And bank balance sheets are not so constrained that they cannot lend. Indeed the most frequent complaint I hear from the banks is that they have too few credit worthy opportunities.

Why is that?

Because business, and especially small business, has a very unsure revenue outlook. Yes, things a getting better, but not that much better.

We have too little demand. More demand means more revenues. More revenues means stringer balance sheets. Stronger balance sheets means better credit. And that means more lending.

All roads lead back to getting demand to rise.

I think Simpson-Bowles must agree: that’s why they argue, as I do, that austerity now is a bad thing. It would depress demand even more.

Their second point in support of austerity is the ‘fiscal crisis avoidance’ idea.

This is also nonsense. Again: where’s their evidence?

Were we on the brink of a fiscal crisis interest rates would be moving up as creditors become ever more wary of lending. This is just not happening. The claim of imminent rate increases has been a steady mantra of the austerity folks since 2009. You would think that after four straight years of being wrong they would re-think their ideas. But no. They simply repeat them more loudly. This is absurd. Not to learn form an error is the worst kind of mistake an analyst can make. It is to put ideology before thought. Simpson-Bowles have fallen into such a trap.

Then there’s the small matter of the fiscal crisis that caused the melt down. It wasn’t a government debt crisis. It was a private sector debt crisis. Over indebtedness on the part of business and households led to an over-reaction once asset values were exposed as fictitious. The subsequent furious saving has depleted demand so much that it has become self-fulfilling drag on growth. It is abating now, but has a long way to go before it is played out. And as long as the private sector is saving and reducing its indebtedness, the government needs to supply demand.

Once more I need to acknowledge that they are clear: any austerity now is a bad thing.

So why is ever a good thing?

Well. Umm. It just is.

At its heart the Simpson-Bowles argument is the usual supply side one. Bolster the supply side and good things will happen. How? It’s magic.

This is not an economic theory. It’s a political position. They are at pains to tell us that immediate and heavy handed austerity is a very bad thing, but then are very vague as to why it should ever be a good thing. Instead they resort to obscure and hopeful statements rather than solid analytical reasoning.

The only explanation I have for their continued argument is that they just like the idea of spending cuts. No reason. Just cuts for the sake of cuts. They wrap this all up in little homilies, big warnings, and subtle suggestions, but they give no reasons. They say they want to protect the disadvantaged and then urge entitlement cuts. They want to burn the village to save the village. They want to encourage productivity growth but are silent on how to divide the fruits of that gain. Is it all for capital as it has been in recent decades? In which case demand will flounder some more. Or do they advocate wage increases? Unlikely I would say since Simpson-Bolwes are funded by big business.

There is one thing we can agree on, though.

They are clear that health care costs need to be reined in before they crush the economy. I agree. America’s antiquated health are system is a disgrace. It needs through renovation.

Good luck with that.

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The Market Gets Queasy

As we approach yet another of our self-inflicted crises, the ‘sequester cliff’, I find it amusing that the markets are reacting with surprising unanimity. Cutting government spending, apparently, is a jolly bad thing to do.

Why else would the stock market be in the beginnings of a panic?

Why else would the financial media obsess over the potential loss of business?

And why on earth would the Wall Street Journal be concerned at all?

The paradox and contradictions are acute.

On one hand big business lashes into Washington for running up debt and spending too much. On the other it gets vexed when it realizes that those cuts mean less business revenues.

On the one hand big business really, truly, wants supply side economics to work – it gets all the hand outs in that case. On the other it knows that it loses big time if demand stays depressed.

The acid test for anyone trying to figure out which side of the argument – austerity or stimulus – is correct is simple: follow the money. Or, rather, follow the lead of those who want to make a profit.

Business is sitting on scads of dollars of unspent profits. Corporate cash hoards are at historically high levels. It isn’t getting spent or invested. Why not? There’s no point. There is no point in investing in an economy where demand is already too low to keep our existing factories and workforce humming. We have excess capacity. That’s why we have high unemployment. We have lots of idle people and lots of idle factories.

The austerity folks imagine that by cutting government spending we will magically conjure a burst of business activity. They argue that less government means more private stuff. It doesn’t. In an economy where the average person pays more in payroll tax than in income tax, cutting income tax means nothing. Absolutely nothing. Worse, cutting government spending means cutting wages and cash flows. Those cuts mean fewer customers for business. So, faced with fewer customers and therefore even less demand, business will have no choice but to reduce activity further. Austerity will make the economy worse. Take a look at Europe to see how much worse.

Business executives know this. It annoys them no end.

They tend to be a conservative bunch. They would love it were right wing politics and right wing economics to work in unison. But they don’t. The economics sucks. It is bad for business. That throws business into a quandary. It makes the markets queasy.

With profits already sucking out a larger percentage of our national annual wealth than ever before – I know small business people have a hard time thinking that’s true – the only way to increase future profits is to make sure we have a population with money to spend. We need higher wages. And we need government spending to stay where it is.

That may no agree with your politics. But it ought to agree with your pocket book.

In fact, I know it will.

No wonder the market gets queasy: it has its politics and its economics in a muddle.

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The Economy Trips Up – Or Does It?

Oh dear. Two days ago I suggested things were looking up. Today we hear about fourth quarter economic growth. GDP – the measure we use, rightly or wrongly, as a yardstick for economic growth – fell very slightly, by 0.1% at annual rates, in the fourth quarter last year. The brouhaha Monday, if you recall, was because durable goods orders rose sharply last month suggesting a stronger economy.

How do we reconcile these things? And what is actually going on?

It isn’t as difficult as it appears.

Let’s look at GDP:

The fourth quarter was disappointing because it followed what appeared to be a strong third quarter – remember that GDP grew at a 3.1% clip in the third quarter last year. The truth, as is often the case, sits somewhere between these two poles. So here’s the way in which each sector of the economy added or subtracted to the total:

  1. Personal consumption added at an annual rate of + 1.5%
  2. Business investment added + 0.8%
  3. Residential investment added + 0.4%
  4. Inventory changes subtracted – 1.3%
  5. Net exports subtracted – 0.2%
  6. Government spending subtracted -1.3%

Under normal circumstances I would report the three investment categories – business, residential and inventories – as one item, but this time we need to break them apart to get at the underlying story.

Personal consumption, which still amounts to about seventy percent of the total economy, grew well. That 1.5% rate of growth adds to a string of decent quarters and is a sign of good, but not great, economic activity.

The puzzle lies in investment. Both business and residential investment are going at a decent pace. Again neither is very strong, but neither is weak. The recovery in housing has been consistent throughout the past few months and shows no signs of diminishing. Business investment tends to be more erratic, and there were concerns in the third quarter that it was weakening as businesses waited for the fiscal cliff mess to be sorted out. Looking deeper into the data though we can detect that some of the quirkiness of the third quarter was due to the same trends that boosted that durable goods report we all got excited – sort of – over on Monday. Transportation equipment is the key. In particular aircraft orders. As I noted on Monday aircraft orders are sufficiently large in dollar terms, that when an airline announces a big order, it can shift the data about considerably. The same thing goes for production and sales of the aircraft later on. Much of the odd movement in investment over the past six to nine months stems from this volatility. So a more considered view is that the third quarter was not quite as strong as the 3.1% seems to indicate, and the fourth quarter was not was weak as the – 0.1% shows.

This same factor shows up in the wild swings in inventories. The last five quarters have seen the following inventory changes: +2.53%; -0.39%; -.046%; + 0.73%; and now – 1.27%. That’s a wild ride and one that can shift the total GDP numbers about quite a bit if the other sectors of the economy are only mediocre, which is our current case. So this is another instance of where we need to look beyond this volatility and focus on the trend, which is still showing modest growth.

The other two major categories of GDP, trade and government spending, detracted from growth also.

Trade, reported as exports net of imports, was a modest drag on the economy mainly because exports slipped for the first time since the economic crisis was at its peak. A slight hesitation in worldwide growth slowed both service and goods exports and a smaller decrease in imports was not large enough to offset that slowdown. Trade is not a huge factor in the US economy and is rarely enough to alter total growth. In order to get our economy moving we need to focus on domestic spending and regard better exports as icing on the cake not a substitute for good local growth.

Government spending continues its recent restricting action on the total economy. After a quirky increase in the third quarter last year when a surge in defense spending stopped a string of quarters of contraction, government spending returned to its steady decline. This may come as a shock to some of you so it’s worth repeating: government spending has been declining steadily since late 2010. This is because the Federal stimulus has gone away and spending on social programs to do with the recession have ebbed as the crisis itself waned. This was entirely predictable and was one reason why I, amongst many, never worried about the budget or the level of debt. Government spending is designed to rise when there is a crisis and fall when that crisis goes away. So the surge we saw in 2009 and 2010 was not the beginning of some nefarious socialist take over – as was represented in right wing media – but was a sensible response to a crisis. It happens every time. It ebbs every time. That this last surge was so large is simply a reflection of the size of the crisis, not of some shift in philosophy.

So what do we take away from all this?

The economy is not as weak as the headline numbers suggest. It wasn’t as strong as those headlines suggested in the third quarter either. The truth sits in the middle as usual. We seem to be growing at a rate hovering between 1.5% and 2.0%, which is what I have been saying is what to expect for the best part of two years now. Absent any attempts in Washington to kick us into a higher gear I can see no cause for predicting faster growth. All the risks remain on the downside. Especially if the Republicans get their way and cut government spending this year. Such a cut in spending could send us into recession, increase unemployment, and set us back a couple of years.

Which is why spending cuts are such a bad idea.

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