The Deficit: It’s the Economy, Stupid!

Government-money 46

America’s approaching debt crisis is the topic de jour, both in the news room and in the living room. We have the fiscal cliff, the battle of the debt ceiling (parts I, II and soon to be III), the sequester, fiscal commissions, etc. We are shown scary charts, and told (truthfully) that the federal government is running another trillion dollar deficit and borrows 46 cents of every $1 it spends.

Federal Deficit

However, what we do not see is a careful examination of what is driving these deficits, and what that means for our future and our policy choices. In this, my first series of post, I will drive to do just that with simple charts from freely available data sources.

There are three things that go into the debt to GDP ratio. First, there is the GDP. A fall in GDP will drive up the ratio even if debt does not change. Second, there are the two parts to the debt: revenues, and expenditures. While the economy goes through booms and bust, over the long haul GDP tends to grow at a pretty steady rate. Economist and statistician have a handy, standardized way of removing cyclical components from GDP. It is called potential GDP. A simple view of it is just to say it is what would GDP be if everyone was employed. As you can see below, it correlates pretty closely with the inverse of the unemployment rate:

Unemp and GDP Gap

For reference, here is the long term view of GDP gap, which is just 1 – Potential GDP / GDP:
GDP Gap
It is clear that something happened in the fall 2007. Something very bad! We will return to that. Here is another view that again, shows that something bad happened to GDP in 2007, and we have not recovered:
Nominal GDP
It is only with the background of what was happening in the economy that we can start to look at the deficit. Here are two simple charts of federal government expenditures and revenue:
Federal Government Expenditures

Federal Government Revenue
We see a small spike in expenditures during the recession, but they then go flat. The revenue side is more dynamic. Federal government revenues drop precipitously (17.4% from peak to trough). In fact, in purely nominal terms (not adjusting for inflation or population) they did not pass the pre-recession peak set in Q2 2005 until Q1 2012 – nearly 5 years!

From 1992-2007 government revenues grow about 1.38% per quarter and expenditures grew at 1.18%. If numbers held over the six quarters of the recession we would expect expenditures to grow by 7.3% and revenue to grow by 8.5%. Instead revenue fell by 16.4% (25% below the pre-recession trend!), and expenditures grew by 18.9% (11.6% off of trend).

The point of these charts and data points is to demonstrate that the budget deficit is mainly driven by the very severe recession, from which we still have not fully recovered. But one final chart to drive home this point. Revenues actually vary pretty consistently with drops in unemployment, and along with that potential GDP. When controlling for the GDP gap, the deficit we are facing is not an outlier . What is abnormal is the size, and duration of this drop in employment and GDP. This is what we should be discussing! (And, in future post, hopefully I will).
GDP Gap and Gov Revenue

APPENDIX: Data Sources

All the data was obtained using Federal Reserve Bank of St. Louis’s excellent excel plug-in: http://research.stlouisfed.org/fred-addin/install_windows.html. Here are the exact series and calculations for each chart. In parentheses are the FRED series IDs. Corrections and concerns appreciated!
1: Federal Deficit. This is simply [Federal government total expenditures] (W019RCQ027SBEA) – [Federal Government Current Receipts] (FGRECPT). Both come from the U.S. Department of Commerce: Bureau of Economic Analysis
2a: Unemployment. [Civilian Unemployment Rate] (unrate) From the U.S. Department of Labor: Bureau of Labor Statistics
2b: GDP Gap. 1 – ( [Nominal Gross Domestic Product] (GDP) ) / ( [Nominal Potential Gross Domestic Product] (NGDPPOT) ). Both from the U.S. Department of Commerce: Bureau of Economic Analysis.
3: GDP Gap. 1 – ( [Nominal Gross Domestic Product] (GDP) ) / ( [Nominal Potential Gross Domestic Product] (NGDPPOT) ). Both from the U.S. Department of Commerce: Bureau of Economic Analysis.
4: Nominal GDP. [Nominal Gross Domestic Product] (GDP). From the U.S. Department of Commerce: Bureau of Economic Analysis.
5: Federal Government Expenditures.[Federal government total expenditures] (W019RCQ027SBEA) From the U.S. Department of Commerce: Bureau of Economic Analysis
6: Federal Government Revenues. [Federal Government Current Receipts] (FGRECPT). From the U.S. Department of Commerce: Bureau of Economic Analysis
7a: Government Revenues / Potential GDP. ( [Federal Government Current Receipts] (FGRECPT) ) / ( [Nominal Potential Gross Domestic Product] (NGDPPOT) ). Both from the U.S. Department of Commerce: Bureau of Economic Analysis
7b: GDP Gap. 1 – ( [Nominal Gross Domestic Product] (GDP) ) / ( [Nominal Potential Gross Domestic Product] (NGDPPOT) ). Both from the U.S. Department of Commerce: Bureau of Economic Analysis.

The Private Sector

[DRAFT] Carpe Diem posted the following chart, which I’ve seen elsewhere. I find it interesting because of the strong rightward lean of that blog.

So, we can see the Obama administration instituted a massive increase in government spending which is crushing the private sector and holding back growth! Oh wait… that’s not the story at all. To be fair, Mark Perry was not trying to make that point but I do hear it often enough. Many fair, and strong arguments can be made against big government. Many fair, and strong arguments can be made against the Obama administration. The argument that Obama has ballooned the size of government and is killing growth just simply does not hold any water.

Uncertainty vs Uncertainty

[DRAFT] “Uncertainty” plays a major role in the debate about what ails the US economy. Conservative bloggers, columnists and economists tend to emphasize the role of uncertainty and blame the sluggish recovery on government actions which may increase uncertainty. Tax policy and health care reform are the two big ones. I definitely have doubts about some of their specific claims in regards to the degree of uncertainty present in these issues, and the degree to which current policy (and the current administration) is responsible for this uncertainty. But that is not the point of this post. What is missing from the discourse is a clear agreement about what are the important causes and drivers of uncertainty for both businesses and consumers. The idea that uncertainty can have negative economic effects is not a new or controversial idea, even for those on the left. Keynes himself talked about it (uncertainty-and-the-keynesians).

The real disagreement is about the causes and drivers. Investment and spending are driven by expectations of future income, sales for businesses and wages for consumers. I personally feel (without a lot of hard evidence to back this up) that uncertainty about whether you are going to have job 6 months from now is going to hold spending back much more than uncertainty about whether the tax rate on your income will be 22% or 27%. Likewise for businesses, I think uncertainty about the ability to move future products holds back investment and growth a lot more than the possibility of increasing health care costs.

I would really like to see this argued and discussed. Instead I see the left-leaning pundits yelling “DEMAND” while the right-leaning shout “UNCERTAINTY”, without much of an agreement about terms. It’s really both.

Another household-US Gov analogy

What would you do if someone offered you a loan at a negative (real) interest rate for 10 to 20 years? Would you take it? If so, how would you use the money? Hopefully, you’d invest it in something that would give a positive return – maybe buy a house, or some other large capital investment.

For the United States government this scenario is not hypothetical. Real interest rates are, and have been negative. This is not some artifact of high inflation expectations (which would show up in a large spread between real and nominal yields). This is not some monkeying with markets. This represents the fundamental problem that due to the continued slow worldwide  economy there is a scarcity of good investment opportunities – both businesses and at this point countries in Europe (supply) , and a glut of people who are looking to cut back and save more (demand).

Yield Curve

The fundamentals demand that the government undertake long-term investments – build schools, fix bridges, invest in human capital (make money by giving grad students interest-free loans). This makes sense even ignoring the Keynesian argument for stimulus. These things need to be done, and should be done while borrowing costs are so low. But alas, politically we’re not even going to talk about these facts or these options.

Health Care circa 1993

Before Obamacare was coined, and labeled as the source of all evils a very similar proposal was introduced in the Senate. This was a response to Clinton’s health care proposal. It was quite similar to what was passed by Congress in 2010.
In November, 1993, Sen. John Chafee, R-R.I., introduced what was considered to be one of the main Republican health overhaul proposals: “A bill to provide comprehensive reform of the health care system of the United States.
Two thoughts from this:
1. I am amazed how quickly the past is so forgetten. I am not so idealistic that I expect all everyday citizens to be able to make this connection, however, I feel like it is reasonable to expect that our news media would be able to do the background research and I expect that they should be calling out hypocrisy for what it is.
2. Strong partisanship leads to very strong cognitive dissonance. If an idea comes from your party is it right. If that same idea comes from the other guy, it’s the worse thing ever. I wish there was some way to make these proposals partisanly blind. No one would know who wrote them or who supports them until they decide them on their merits.