At the risk of standing on a soapbox, Congress never explains the budget process. This can be self-serving and misleading for most Americans. Every year Congress establishes a baseline spending level for each of the next seven years. Each year’s spending level becomes the baseline. All future changes in spending are referenced to the baseline. For instance, if spending on defense and Medicare is budgeted to increase by 3% in the next two years, any additional spending above the baseline’s 3% growth rate is deemed an increase in spending. Any reduction below the baseline’s 3% growth rate is called a cut in spending. So, if the growth rate of next year’s spending on defense and Medicare were lowered from 3 to 2.9%, members of Congress would say they cut spending, even though spending is going to increase 2.9%.
In order to lower government spending from 24.8% of GDP to 19.4% over the next six years, Congress could consider only spending 99% of next year’s baseline for every item in the budget. One advantage to this approach is there would be nothing to debate since every program is cut and every program is impacted to the same degree. If this process was continued for the next six years, the increase in government spending against the baseline would gradually slow.
As we have often discussed in the past, economic growth is likely to be restrained, while the imbalances from the credit bubble are worked through. Extensive research on growth rates after a credit bubble suggests that GDP is likely to grow 1 to 1.5% less in the 10 years following a credit bubble reversal. This suggests that GDP is unlikely to grow above 2.0% on a sustained basis in coming years.
The plan should incorporate this expectation for slower growth, so surprises are more likely to be positive. It will also reinforce why gradually slowing government spending growth is prudent. If government spending grew less than 2% annually, at some point in the next three to six years the private economy would begin to grow faster than 2%, which accomplishes two things. Government spending as a percent of GDP will shrink, and tax receipts will increase from organic economic growth.
However, in the short run, tax increases need to be considered. If we are to come together as a nation, it must be clear that everyone is on board. According to the nonpartisan Tax Policy Center, 46.4% of workers pay no federal income taxes, but that is because their income is so low. According to IRS data, the top 10% of wage earners pay more than 70% of total personal income taxes, so the tax code is already fairly progressive.
However, these figures mask the income inequality that has developed, especially over the last 15 years. At the end of 2010, 19.8% of total pretax income went to the top 1% of wage earners. Since this figure includes capital gains from the stock market, their share of total income is likely even higher now.
After peaking at 23.9% in 1928, the percent of pretax income going to the top 1% of wage earners fell to under 15% in 1942, and stayed under 15% until 1995. The most recent peak occurred in 2007, when the top 1% received 23.5% of total pretax income. These figures are based on IRS data as analyzed by Emmanuel Saez, an economics professor at the University of California, and Thomas Piketty, an economics professor at the Paris School of Economics, and were provided to us by Philippa Dunne from the Liscio Report.
The average CEO of an S&P 500 company is making 780 times the median income of the average worker’s $50,054 income, or about $3.9 million. We’re no fan of higher taxes, but the imbalance in income distribution is a problem that can only be addressed in the short run with higher taxes, since company boards are unlikely to change compensation packages.
If Congress chose to increase taxes on the top 10% of wage earners so an additional $125 billion in tax receipts were generated, those funds could reverse the $95 billion in higher taxes workers will pay in 2013 when the 2% reduction in social security taxes is reversed. For the average worker that will amount to about $20 a week. Median household income has declined in each of the last four years, and is now down to 1995 levels, which coincidently is when income going to the top 1% exceeded 15% for the first time since 1942.
Corporate balance sheets have never been stronger, with most companies holding a significant level of cash. We have millions of unemployed who just want a job and millions more wanting to work full time instead of part time. The only thing we have to fear is uncertainty. A plan that incorporates common sense goals and the path to reach them would eliminate much of the uncertainty that keeps business owners from moving forward. Our country is facing a crisis that calls for leadership, and someone who can communicate the scope of our crisis with a sense of urgency, as well as convince the American people it is time for collective sacrifice. It wouldn’t hurt if both parties made John F. Kennedy’s mantra their own: “Ask not what your country can do for you – ask what you can do for your country.”
But enough of the soapbox.
The primary benefit of the Fed’s decision to launch QE3 now is the certainty provided by targeting improvement in the labor market, and continuing until job growth improves. With so much uncertainty surrounding fiscal policy, developments in Europe, and growth in China, there can be no doubt about the direction of monetary policy in the U.S. The Fed’s decision to not have an ending date or a ceiling on its purchases is brilliant. For the foreseeable future, there will be no countdown to the end of QE3, no possibility for conjecture about a QE4, and mercifully no debate about whether they will or won’t or should do QE4. The Federal Reserve is simply all in.
GDP growth in the second quarter was 1.7%, and as the Fed noted in its Federal Open Market Committee press release,
“Economic activity has continued to expand at a moderate pace in recent months. Growth in employment has been slow, and the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment appears to have slowed.”
Effectively the economy is growing at stall speed, which means it is vulnerable to significant downside risks posed by strains in global financial markets. What the press release tactfully did not mention are the significant risks from fiscal policy that Congress must address very soon. In 2013, fiscal policy will be a drag on economic growth. The only unknown is how much of a drag.
By announcing QE3 now, the economy may get a bit of a lift before the drag from fiscal policy begins to bite in the first half of 2013. According to the laws of physics, it takes less energy to lift an object that is in a state of stasis, than one which is falling, since energy is expended arresting the decline. We thought the Federal Reserve would wait to see how Congress dealt with the fiscal cliff, and keep QE3 as their “ace in the hole.” The Fed chose to get out ahead of the curve and not wait to act until slowing materialized. One of the mistakes the Fed made in 2008 was being behind the curve. We think the Federal Reserve made the right choice.
The Federal Reserve has expanded its balance sheet from $900 billion in April 2008 to $2.8 trillion. A year from now it will top $3.5 trillion, if the Fed is still in QE3 mode. But most of the expansion in the Fed’s balance sheet has not made it into the economy. Banks have parked $1.6 trillion in excess reserves with the Fed, and that money is going nowhere fast. The formal definition of GDP is: GDP = money supply (M2) multiplied by velocity (turnover rate). If money supply increases, and the velocity of money remains the same, GDP growth will pick up. If an increase in confidence causes velocity to quicken, and money supply rises, GDP growth will surge. Conversely, if money supply grows by 5%, but velocity slows by 5%, GDP will remain stagnant.
It is noteworthy that after all of the Fed’s efforts and extraordinary monetary accommodation, the velocity of money has fallen to its lowest turnover rate in 50 years. A recent report from the Federal Deposit Insurance Corporation showed that at the end of the second quarter insured deposits reached a new record of $10.3 trillion, despite negligible yields. The weakness in monetary velocity and record deposits, underscores the degree of uncertainty felt by most consumers and business executives. They hear about the looming fiscal cliff, remember how well Congress handled the debt ceiling issue last August, and feel the best course of action is to do nothing.
All of this reinforces our conviction that dealing with the fiscal grand canyon and lowering fiscal uncertainty for 2013 and beyond would be very helpful in getting money moving again.