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Eye on the Market | April 9, 2012
J.P.Morgan

Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain

So, how tight is US fiscal policy supposed to get next year?
Very, if you look at what is supposed to happen according to current law. In the chart, we show the annual change in the budget deficit over the last 25 years. The impact of all provisions scheduled to expire and kick in during 2013 would be very large. But if Congress and the President elect to extend current tax rates, retain lower payroll tax rates and extended jobless benefits, etc, the adjustment would not be as big, and only reflect expiration of Recovery Act provisions, the recently passed Budget Control Act, and some other smaller provisions. There are of course plenty of permutations in between.

[Chart Left]
Wide range of outcomes for 2013 austerity
Change in cyclically-adjusted federal deficit, % of potential GDP
Fiscal stimulus
Fiscal drag
1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013
2013 scenario estimates
Congress punts
Current law
Source: CBO, IMF, Goldman Sachs, J.P. Morgan Private Bank.

[Table Right]
Policies set to expire or take effect under current law | Fiscal Drag (% of 2013 PGDP)
Sequester Automatic Cuts (Discretionary Spending) | -0.4%
Sequester Automatic Cuts (Mandatory Spending) | -0.1%
Bush Tax Cuts ($250k+ Incomes, Estate Tax) | -0.3%
Bush Tax Cuts (Middle Income) | -0.9%
Alternative Minimum Tax | -0.8%
Payroll Tax Cut | -0.6%
Emergency Unemployment Compensation | -0.2%
Affordable Care Act | -0.2%
Source: CBO, Goldman Sachs.

What direction is the Congress heading, and what did Larry Summers and Brad DeLong have to say about this recently?
Political outcomes this fall will affect what Congress does, but I get the sense that they will punt fiscal adjustments into the future if they can, and impose austerity of no more than 1% of GDP in 2013. If so, Congress can point to a March 2012 paper by Summers and DeLong as justification. The bottom line from the paper: don't tighten fiscal policy when interest rates are near zero. The authors assert that (a) additional government spending can ease the long-term budget constraint in conditions similar to today's, and (b) tightening policy now would risk permanent loss of human capital, lower labor productivity growth and lower trend growth. They have held these views for a while; the paper appears designed to convince others.

Advocates for more fiscal and monetary stimulus often point to the charts below. Rising Federal debt has not resulted in higher interest rates, so why not keep borrowing more? As for the Fed, balance sheet expansion prevented deflation and hasn't resulted in an inflationary surge (core inflation measured over 3 months just came in below 2%), so why not keep doing it? Aren't these charts amazing?

[Chart Left]
Rising Federal debt? No problem for Treasury markets
Percent of GDP | Yield, percent, 90 day moving average
Debt to GDP
10-year Treasury yield
Sep-04 Feb-06 Jun-07 Nov-08 Mar-10 Aug-11 Dec-12
Source: CBO, Bloomberg. Assumes CBO Alternative Case for estimates.

[Chart Right]
Rising Fed balance sheet? No problem for inflation
Percent of GDP | Percent change, YoY
Balance sheet
Core CPI
2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Federal Reserve Board, Bureau of Labor Statistics.

They are amazing, but no one knows how long they can be sustained. Even Summers and DeLong concede that "even if it is granted that the stimulus can be both timely and temporary, the question of how large it can be while preserving these attributes remains for future research". If one of these trends could not be sustained, my guess is that it would be fiscal constraints rather than monetary ones. While it's great to see rising Federal debt not adversely affecting Treasury markets, the chart on the left reminds me of The Day of the Triffids.

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