Do Larger Federal Budget Deficits Stimulate Spending? Depends on Where the Funding Comes From
John Mauldin
In the true spirit of stepping outside the box, today’s OTB is a counterintuitive argument against the concept that fiscal deficits and/or infrastructure spending constitute effective economic stimulus. It comes from Paul Kasriel, who was one of my favorite reads when he was at Northern Trust, and I am glad he continues to write in “retirement.” He always has a way of looking at things from different angles than everybody else does.
Paul is a self-confessed reformed Keynesian. He likens his own longtime tendency to revert to Keynesian macro analysis to the damnable difficulty of fixing a faulty golf grip: “If you start out playing golf with an incorrect grip, you will have a tendency to revert to it on the golf course even after hours of practicing at the driving range with a correct grip.” But as he struggled with his unfortunate tendency over the years, Paul was forever reminded of a question a fellow student asked him when Paul delivered his very first homily on the wonders of Keynesianism to an undergraduate political science class: “Where does the government get the funds to pay for the increased spending or tax cuts?”
As Paul himself notes, the post-election US stock market rally has been due in part to the expectation that the Trump administration will enact stimulative fiscal policies, which in turn will jumpstart growth. Paul begs to differ. He tells us that after some years out in the real world, he realized that tracing through where government gets the funds to finance tax cuts and increased spending is the most important issue in assessing the potential effects of stimulative fiscal policy. And, to cut to the chase, his conclusion was and remains that “Tax-rate cuts and increased government spending do not have a significant positive cyclical effect on economic growth and employment unless the government receives the funding for such out of “thin air.”
“Thin air.” You know, that stuff they bottle at the Federal Reserve, slap a fancy label on, and sell by the boatload. Or that emerges – POOF! – from banks as they create credit.
Paul engages us in a thought experiment to make his case, and I think I’ll just step aside and let him lead the thinking. He got me thinking, that’s for sure.
I click on Bloomberg (the website, not the terminal, which I don’t have) and see a sea of green. As I write, the stock market is once again at new highs. OPEC announces that it will somehow or other figure out how to cut the production of their oil, which will raise the price, which will immediately mean that more wells are drilled all over the world, especially in the US, and so production will rise sooner rather than later back to the level where it is now – and, globally, we are already outproducing demand. Interest rates are rising and bonds are falling off. I keep hearing talk about inflation coming back. The euro is close to a seasonal low and the yen is (finally) once again rising. The pound is down some 40% from its peak. US GDP was revised up to over 3% last quarter, making for growth of roughly 2% year-over-year. Gold is down over 10% from its peak just prior to the election.
The Fed’s Beige Book just came out, and it was generally positive .
The Fed’s Beige Book just came out, and it was generally positive .
This just isn’t making for a gloom and doom mindset, but gloom and doom is pretty much what you hear if you pay attention to the mainstream media.
Evidently, US markets are not as concerned about the political scene as the news media are. Or maybe they have different priorities.
Evidently, US markets are not as concerned about the political scene as the news media are. Or maybe they have different priorities.
Sidebar: I wonder how many individuals and businesses are going to try to rearrange their end-of-year income and push as much as they can into 2017 to take advantage of what everyone believes will be lower tax rates. It is going to be interesting to see what corporate earnings look like for the fourth quarter versus the first quarter. And especially what pro forma income looks like compared to tax form income. Let the games begin.
You have a great week. I’m already working on this weekend’s letter, as I want to write about Italy and I really want to get it to you before the actual election there on Sunday. So until this weekend,
Your the more things change analyst,
John Mauldin, Editor
Outside the Box
Do Larger Federal Budget Deficits Stimulate Spending? Depends on Where the Funding Comes From
By Paul Kasriel
The U.S. equity markets have rallied in the wake
of Donald Trump’s presidential election victory. Various explanations have been
given for the stock market rally.
President-elect Trump’s pledge to scale back
business regulations are favorable for various industries, especially financial
services and pharmaceuticals. Likewise, President-elect Trump’s vow to increase
military spending is an undeniable plus for defense contractors. But another
explanation given for the post-election stock market rally is that U.S.
economic growth will be stimulated by the almost certain business and personal
tax-rate cuts that will occur in the next year, along with the somewhat less
certain increase in infrastructure spending. It is this conventional –wisdom
notion that tax-rate cuts and/or increased federal government spending
stimulate domestic spending on goods and services that I want to discuss in
this commentary.
Although I have been a recovering Keynesian for
decades, I got hooked on the Keynesian proposition that tax-rate cuts and
increased government spending could stimulate domestic spending after having
taken my first macroeconomics course way back in 19 and 65. I was so
intoxicated with Keynesianism that I made a presentation about it in a
political science class. I dazzled my classmates with explanations of the
marginal propensity to consume and Keynesian multipliers.
My conclusion was
that economies need not endure recessions if only policymakers would pursue
Keynesian prescriptions with regard to tax rates and government spending.
Reading the body language of my classmates, I believed that I had just enlisted
a new cadre of Keynesians. That is, until one older student sitting in the back
of the class raised his hand and asked the simple question:
Where does the government get the funds to
pay for the increased spending or tax cuts? I had to call on al
l of my obfuscational talents to keep my classmates and me in the Keynesian camp.
When I graduated from college with a degree in
economics, I still was a Keynesian, perhaps a bit more sophisticated one, but
not much. At graduate school, I became less enchanted with Keynesianism. But
Keynesianism is similar to an incorrect golf grip. If you start out playing
golf with an incorrect grip, you will have a tendency to revert to it on the
golf course even after hours of practicing at the driving range with a correct
grip. Bad habits die hard. So, even though I had drifted away from
Keynesianism, it was easy and “comfortable” to slip back into a Keynesian
framework when performing macroeconomic analysis. Yet, I continued to be
haunted by that question my fellow student asked me: Where does the government get the funds to
pay for the increased spending or tax cuts?
I guess I am a slow learner, but after a number of
years in the “real world”, away from the pressure of academic group-think, I
realized that tracing through the implications of where the government gets the funds to finance
tax-rate cuts and increased spending is the most important issue in assessing
the stimulative effect of changes in fiscal policy. And my conclusion is that
tax-rate cuts and increased government spending do not have a significant positive cyclical effect on economic
growth and employment unless the
government receives the funding for such out of “thin air”.
Let’s engage in some thought experiments,
beginning with a net increase in federal government spending, say on
infrastructure projects. Let’s assume that these projects are funded by an
increase in government bonds purchased by households.
Let’s further assume that
the households increase their saving
in order to purchase these new government bonds. When households
save more, they cut back on their current
spending on goods and services, transferring
this spending power to another entity, in this case the federal
government. So, the federal government increases its spending on
infrastructure, resulting in increased hiring, equipment purchases and profits
in the infrastructure sector of the economy. But with households cutting back
on their current spending on goods and services, that is, increasing their
saving, spending and hiring in the non-infrastructure sectors of the economy
decline. There is no net increase
i n spending on domestically-produced goods and services in the
economy as a result of the bond-financed increase in infrastructure spending.
Rather, there is only a redistribution
in total spending toward
the infrastructure sector and away
from other sectors.
What if a pension fund purchases the new bonds
issued to finance the increase in government infrastructure spending? Where
does the pension fund get the money to purchase the new bonds? One way might be
from increased pension contributions. But an increase in pension contributions
implies an increase in saving by
the pension beneficiary. The pension fund is just an intermediary between the
borrower, the government, and the ultimate saver, households or businesses
saving for the benefit of households. Again, there is no net increase in spending on
domestically-produced goods and services in the economy.
What if households or pension funds sell other
assets to nonbank entities to fund their purchases of new government bonds?
Ultimately, some nonbank entity needs to increase its saving to purchase the
assets sold by households and pension funds.
Again, there is no net increase in spending on
domestically- produced goods and services in the economy.
What if foreign entities purchase the new
government bonds? Where do these foreign entities get the U.S. dollars to pay
for the new U.S. government bonds? By running a larger trade surplus with the
U.S. That is, foreign entities export more to the U.S. and/or import less from
the U.S., thereby acquiring more U.S. dollars with which to purchase the new
U.S. government bonds. Hiring and profits increase in the U.S. infrastructure
sector, decrease in the U.S. export or import-competing sectors.
Now, let’s assume that the new government bonds
issued to fund new government infrastructure spending are purchased by the
depository institution system (commercial banks, S&Ls and credit unions)
and the Federal Reserve. In this case, the funds to purchase the new government
bonds are created, figuratively, out of “thin air”. This implies that no other
entity need cut back on its current spending on goods and services while the
government increases it spending in the infrastructure sector. All else the
same, if an increase in
government infrastructure spending is funded by a net increase in thin-air
credit, then there will be a net increase in spending on domestically-produced
goods and services and a net increase in domestic employment. We
cannot conclude that
an increase in government infrastructure spending funded from sources other than thin-air credit will
unambiguously result in a net increase in spending on domestically-produced
goods and services and a net increase in employment.
President-elect Trump’s economic advisers have
suggested that an increase in infrastructure spending could be funded largely
by private entities through some kind of public-private plan. This still would
not result in net increase in U.S. spending on domestically-produced goods and
services and net increase in employment unless
there were a net increase in thin-air credit. The private entities
providing the bulk of financing of the increased infrastructure spending would
have to get the funds either from some entities increasing their saving, that
is, by cutting back on their current spending, or by selling other existing
assets from their portfolios. As explained above, under these circumstances, there
would be no net increase in spending on domestically-produced goods and
services.
Now, it is conceivable that an increase in
infrastructure spending, while not resulting in an immediate net increase in spending on
domestically-produced goods and services, could result in the economy’s future potential rate of growth
in the production of goods and services. To the degree that increased
infrastructure increases the productivity of labor, for example, speeds up the
delivery of goods and services, then that increase in infrastructure spending
could allow for faster growth in the future
production of goods and services.
Another key element in President-elect Trump’s
proposed policies to raise U.S GDP growth is to cut tax rates on households and
businesses. To the degree that tax-rate cuts result in a redistribution of a
given amount of spending away from pure consumption to the accumulation of
physical capital (machinery, et.
al.), human capital (education) or an increased supply of labor,
tax-rate cuts might result in an increase in the future potential rate of growth in GDP, but not the immediate rate of
growth unless the
tax-rate cuts are financed by a
net increase in thin-air credit.
At least starting with the federal personal income
tax-rate cut of 1964, all personal income tax-rate cuts have been followed with
cumulative net widenings in the federal budget deficits. So, for the sake of
argument, let’s assume that the likely forthcoming personal and business
tax-rate cuts result in a wider federal budget deficit. Suppose that households
in the aggregate use their extra after-tax income to purchase the new bonds the
federal government sells to finance the larger budget deficits resulting from the
tax-rate cuts. The upshot is that there is no net increase in spending on
domestically-produced goods and services nor is there any net increase in
employment emanating from the tax-rate cuts.
My conclusion from the thought experiments
discussed above is that increases in federal government spending and/or cuts in
tax rates have no meaningful positive cyclical
effect on GDP growth unless
the resulting wider budget deficits are financed by a net increase
in thin-air credit, that is a net increase in the sum of credit created by the
depository institution system and credit created by the Fed.
Let’s look at some actual data relating changes in
the federal deficit/surplus to growth in nominal GDP. I have calculated the
annual calendar- year federal
deficits/surpluses, and then calculated these deficits/surpluses as a percent
of annual average nominal GDP. The red bars in Chart 1 are the year-to- year
percentage-point changes in the annual budget deficits/surpluses as a percent
of annual-average nominal GDP. The blue line in Chart 1 is the year-to-year
percent change in average annual nominal GDP. According to mainstream Keynesian
theory, a widening in the budget deficit relative to GDP is a “stimulative”
fiscal policy and should be associated with faster nominal GDP growth. A
widening in the budget deficit relative to GDP would be represented by the red
bars in Chart 1 decreasing in magnitude, that is, becoming less positive or
more negative in value. According to mainstream Keynesian theory, this should
be associated with faster n ominal GDP growth, that is, with the blue line in
Chart 1 moving up. Thus, according to mainstream Keynesian theory, there should
be a negative correlation
between changes in the relative budget deficit/surplus and growth in nominal GDP.
The annual data points in Chart 1 start in 1982 and conclude in 2007. This time
span includes the Reagan administration’s “stimulative” fiscal policies of
tax-rate cuts and faster-growth federal spending, the George H. W. Bush and
Clinton administrations’ “restrictive” fiscal policies of tax-rate increases
and slower-growth federal spending and the George H. Bush administration’s
“stimulative” fiscal policies of tax-rate cuts and faster- growth federal
spending.
In the top left-hand corner of Chart 1 is a little
box with “r=0.36” within it. This is the correlation coefficient between
changes in fiscal policy and growth in nominal GDP. If the two series are
perfectly correlated, the absolute
value of the correlation coefficient, “r”, would be equal to 1.00.
Both series would move in perfect tandem. As mentioned above, according to
mainstream Keynesian theory, there should be a negative correlation between changes in fiscal
policy and growth in nominal GDP. That is, as the red bars decrease in
magnitude, the blue line should rise in value. But the sign of the correlation
coefficient in Chart 1 is, in fact, positive,
not negative as
Keynesians hypothesize. Look, for example, at 1984, when nominal GDP growth
(the blue line) spiked up, but fiscal policy got “tighter”, that is the
relative budget deficit in 1984 got smaller compared to 1983. During the
Clinton administration, budget deficits relative to nominal GDP shrank every
calendar year from 1993 through 1997, turning into progressively higher surpluses relative to nominal
GDP starting in calendar year 1998 through 2000. Yet from 1993 through 2000,
year-to-year growth in nominal GDP was relatively steady holding in a range of
4.9% to 6.5%. Turning to the George H. Bush administration years, there was a
sharp “easing” in fiscal policy in calendar year 2002, with little response in
nominal GDP growth. As fiscal policy “tightened” in subsequent years, nominal
GDP growth picked up – exactly opposite from what mainstream Keynesian theory
would predict.
Of course, there are macroeconomic policies that
might be changing and having an effect on the cyclical behavior of the economy
other than fiscal policy. The most important of these other macroeconomic
policies is monetary policy, specifically the behavior of thin-air credit. In
Chart 2, I have added an additional series to those in Chart 1 – the
year-to-year growth in the annual average sum of depository institution credit
and the monetary base (reserves at the Fed plus currency in circulation).
“Kasrielian” theory hypothesizes that there should be a positive correlation between
changes in thin-air credit and changes in nominal GDP. With three variables in
chart, Haver Analytics will not calculate the cross correlations among all the
variables. But E-Views will. And the correlation between annual growth in
thin-air credit and nominal GDP from 1982 through 2007 is a positive 0.53. Not only is this
correlation coefficient 1-1/2 times larger than that between changes in fiscal
policy and nominal GDP growth, more importantly, this correlation has the theoretically correct sign in
front of it. By adding growth in thin-air credit to the chart, we can see that
the strength in nominal GDP growth in President Reagan’s first term was more
likely due to the Fed, knowingly or unknowingly, allowing thin-air credit to
grow rapidly. Similarly, the reason nominal GDP growth recovered from the
George H. W. Bush presidential years and was relatively steady was not because tax rates were
increased in 1993 and federal spending growth slowed, but rather because growth
in thin-air credit recovered in 1994 and held relatively steady through 1999.
In sum, there may be rational reasons why the U.S.
equity markets rallied in the wake of Donald Trump’s presidential election
victory. But an expectation of faster U.S. economic growth due to a more
“stimulative” fiscal policy is not
one of them unless
the larger budget deficits are financed with thin-air credit. Fed
Chairwoman Yellen, whether you know it or not, you are in the driver’s (hot?)
seat.
Paul L. Kasriel - Founder, Econtrarian, LLC
- Senior
Economic and Investment Advisor Legacy Private Trust Co. of Neenah, WI
“For most of human history, it has made good
adaptive sense to be fearful and emphasize the negative; any mistake could be
fatal”, Joost Swarte
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