Festivus Stocking Health

Belated Lumps of Coal for Those with Stockings Still Hanging

by Paul Kasriel, The Econtrarian, former Chief Economist, The Northern Trust Company

2012 Festivus Stocking Stuffers

Since I retired at the end of April, I have been having a lot of problems with you people. So, as Festivus is nearly upon us, it is time for the airing of grievances. Here are few of mine.

Fiscal and Mayan Armageddon

As this is being written, both economists and other quacks are predicting the end of the world as we know it. The economist quacks are forecasting that another recession will occur in the U.S. in 2013 if the scheduled return to the Clinton-era federal personal income-tax levels and if the scheduled sequestration of federal government expenditures occur on January 1. Some other quacks were predicting the end of times December 21 (or was it the 22nd?) as the Mayan calendar runs out of dates. Ten days later, it is not looking too good for the Mayan calendar quacks. And my bet is that if we ever get to test the fiscal quacks’ hypothesis, we’ll shuffle them off with the Mayan quacksters.

What is the logic for fiscal Armageddon? Let’s talk about tax increase first. I keep hearing that if tax rates and revenues rise, there will be a huge amount of spending power sucked out of the economy. Really? You mean that the Treasury is going to collect all of these taxes and just let its cash balance rise by this amount? I don’t think so. I think the Treasury is going to collect higher taxes from me and either transfer them to you or buy something from you. In other words, an increase in tax revenues is not going to “suck” spending power out of the economy, but rather redistribute that spending power. Now, you may not like the outcome of this redistribution, but don’t confuse a redistribution of a given amount of spending in the economy with a net decline in spending.

What about the cut in federal spending due to the sequestration that Congress voted for? Surely, that will reduce total spending in the economy, right? Probably wrong. If the government spends less, all else the same, it will need to borrow less. If it borrows less, those folks – households, financial institutions, feriners – who were planning to lend to the government will now find themselves with excess funds. What are they going to do with these funds? There are three things they can do with these excess funds and two of them will result in offsetting the government’s decline in spending.

One thing they can do with their excess funds is lend them to some other entity – a household, a business or municipal government. These recipients of funds will then spend them, offsetting the decline in federal government spending.

Another thing these otherwise lenders to the federal government can do with their excess funds is spend the funds themselves. If interest rates are too low and/or the credit risk of other borrowers is too high, they won’t lend; they will spend. This increased spending by the otherwise lenders will offset the decreased spending of the federal government.

A third thing these otherwise lenders can do is simply hold more cash than they had previously planned to do. For the nonbank public, this means an increased demand for bank deposits and currency, also known as a decline in the velocity of money. For banks, an increased demand for cash means an increased demand for excess reserves. If the decrease in federal government borrowing results in a decrease in velocity / an increase in banks’ demand for excess reserves, then, and only then, will there be no offsetting increased spending to match the decline in government spending.

So, logically, there is not much of a case to expect an increase in taxes and/or a decrease in government spending to have a significant impact on aggregate spending in the economy. But according to the fiscal quacksters, a reduction in the budget deficit brought on by a “tightening” in fiscal policy should be associated with slower nominal GDP growth. Conversely, an increase in the budget deficit resulting from a decrease in taxes and/or an increase in government spending should be associated with faster nominal GDP growth. Thus, the fiscal quacksters would expect there to be a negative correlation between changes in the budget deficit and growth in nominal GDP.

Let’s go to the tape, i.e., Chart 1. As everyone, except those with a political bias, knows, the federal budget deficit can change because of the pace of economic activity. For example, when the economy crashes into the deepest recession in the post-WWII era, federal government expenditures increase because of income maintenance programs for the unemployed – e.g., unemployment insurance benefits, food stamps, etc. Also when the economy crashes, tax revenues fall. So, when the economy crashes, the federal budget deficit tends to widen because of these automatic stabilizers. Symmetrically, when the economy booms, all else the same, the budget deficit shrinks or, once in a Mayan calendar, maybe even moves into a surplus. If we are going to test for the effect on GDP of changes in the budget unrelated to these automatic stabilizers, we need to cyclically-adjust the budget deficit. The experts on the budget, the Congressional Budget Office (CBO) staff, are kind enough to do this for us. The red bars in Chart 1 are the fiscal year-to-fiscal year percentage point changes in the cyclically-adjusted budget deficits/surpluses as a percent of CBO-estimated potential nominal GDP. Whew! The blue line in Chart 1 is the fiscal year-to-fiscal year percent change in nominal GDP. According to the fiscal quacksters, as the cyclically-adjusted budget deficit gets smaller, i.e., the red bar moves higher toward the zero line or even higher above it, nominal GDP growth should weaken, i.e., the blue line should move down. In other words, there should be a negative relationship or correlation between these two series. But alas, we find another beautiful theory of the economic quacksters spoiled by some ugly facts. The contemporaneous correlation between changes in the cyclically-adjusted budget deficit/surplus and nominal GDP growth is not negative from 1973 through 2011, but positive at a value of 0.3 out of a possible 1.0. The ugly facts, then, suggest that increases in taxes and/or decreases in government spending are associated with faster nominal GDP growth, not the slower growth predicted by the fiscal quacksters.

Now, you might argue that it is not fair to expect a change in fiscal policy this year to have a large impact on GDP growth in the same year. Policy changes might have their maximum effect in later years. This, of course is not what the fiscal quacksters are arguing now. They are predicting a recession in 2013 if the scheduled tax increases and spending cuts commence and persist in 2013. But I did test for lags in the effect of fiscal policy changes. I found that the first negative correlation between changes in fiscal policy and nominal GDP growth occurs after three years and even then the absolute value of the correlation coefficient is small at 0.1. In sum, the historical data simply do not support the view that going over and staying over the fiscal cliff will have a material effect on the pace of economic activity.

Is Federal Government Spending Out of Control?

That’s what I keep hearing. Does anyone ever look at the data? As shown in Chart 2, growth in federal government spending flared up in the second half of 2008 through early 2010. Why? Does anyone remember the $700 billion authorization for TARP spending back in October 2008? And then there were those automatic stabilizers I talked about earlier. And yes, there was about $500 billion of extra stimulus spending. But since early 2010, growth in total federal government spending – entitlements, defense, interest, waste & fraud – has been quite tame, especially when measured against the median annualized growth in total federal spending of 5.1%. Remember that $1 trillion reduction in spending over a 10-year period authorized by Congress back in 2011? Well, the data suggest that this spending reduction is biting.

Are Banks Going to Suffer a Deposit Outflow on January 1?

That’s the talk around the wood stove at the general store up here in the Wisconsin tundra. Yes, that special FDIC insurance on non-interest-bearing bank deposits is due to expire in 2013. Without this insurance, pension funds and large corporations are expected to pull their funds out of banks and put them in some other federally-insured instrument, such as a Treasury bill. (Where will the funds go if Congress does not increase the debt limit?). But if this happens, will the banking system actually lose deposits? Not unless the pension funds et.al. decide to hold actual folding money. Suppose that a pension fund decides to buy a new T-bill from the Treasury, paying for it by drawing down an account at its bank. The pension fund’s bank does see its deposits fall, all else the same. But what does the Treasury do with its new funds? It spends them. So, the deposits come back into the banking system. There may be real things to worry about with regard to our financial system, but this isn’t one of them.

Discouraged Dropouts Are Largely Responsible for the Declining Unemployment Rate?

Again, doesn’t anyone look at the relevant data? The BLS has a measure of the unemployment rate that adds back in so-called discouraged workers. It is called the U-5 measure. The first measure of the unemployment rate to hit CNBC’s crawl is the U-3 rate that the talking heads then disparage because of a declining labor force – “thought” to be declining because of discouraged workers. I put thought in quotes because the talking heads never look at U-5, which includes the discouraged to see how it changed. But if they did look at Chart 3, they would see that both the “headline” unemployment rate, U-3, and the more inclusive unemployment rate,

U-5, both have fallen by one whole percentage point in the 12 months ended November 12. What the talking heads fail to take into consideration is that more and more of us baby boomers are voluntarily dropping out of the labor force. It is called retirement. And so long as Congress doesn’t means test our Social Security and Medicare A benefits, more and more of the luckiest generation will continue to voluntarily drop out of the labor force.

Alright, now it’s time for the feats of strength. You can pin Paul (Ron, that is), Bernanke!

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