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Friday, February 15, 2013

Keep the Sequester Totals But Add Flexibility Within

Scare stories about the automatic reduction in federal spending to start on March 1—commonly called the sequester—fall mainly into two categories. First are the concerns that reducing every discretionary budget account by the same percentage—the “meat-axe” approach—would not allow government agencies to prioritize.  Hence the scare stories of having to furlough key emergency personnel. But this complaint is easily resolved if President Obama agrees to give agencies, including defense agencies, the flexibility to adjust their budgets within the overall sequester totals. Most Republicans in Congress would agree to this.

Second, the size of the total spending reduction for FY2013 is said to be too big and will slow down the economy. But if you put the reduction into perspective, as in the following chart, you can see that this claim is greatly exaggerated and likely to be false.
The chart shows federal outlays as a share of GDP as reported by the Congressional Budget Office in their latest budget outlook report. The past history and CBO baseline shows spending rising from 18.2% of GDP in 2000 and remaining relatively high at 22.8% of GDP in 2023 the last year of the CBO outlook. That baseline includes the sequester totals, so if Washington caves and reduces the size of the spending reductions, spending will be higher as shown in the graph.  

Note that the reduction for 2013—the year currently under discussion—is very small relative to all the other changes in the budget during the quarter century period shown in the graph. It amounts to only 0.26% of GDP or $42 billion according to CBO.  This is less than half the frequently mentioned $85 billion in Budget Authority because it takes time to bring about the outlay reductions. The reduction is also quite gradual, much more gradual than the sudden rise in spending in the past few years, and, with flexibility granted to government agencies, does not have to be draconian.  The Administration and Congress agreed to roughly this amount of budget deficit reduction way back in 2011.

Note also that the reduction for this year should be viewed as a modest installment on an overall long-term strategy to bring the federal spending share down to levels consistent with balancing the budget.  We do not yet know what that strategy will be because the Administration has not submitted a budget and thus the Congress has not submitted budget resolutions. We do know that for that strategy to increase rather than decrease economic growth it is important that it be gradual and credible as illustrated by the “pro-growth” proposal which I sketched into the diagram above.  This pro-growth path brings spending to where it was in 2007 as a share of GDP and would also bring the federal budget roughly into balance—and thus get the debt to GDP ratio on a needed downward path—without any more tax increases.  CBO now projects revenue to be just over 19% in 2023 with the recent tax increases. 

Research discussed here shows that such a path would increase economic growth even with the reduced spending share in 2013.  Indeed, as shown in the next graph total federal spending continues to grow according to the CBO GDP forecast. 
 Whether we get a strategy similar to what I propose here or something else, the diagram shows that postponing or skipping the relatively small installment for 2013 would sap much of the credibility out of any budget consolidation strategy.  From a macroeconomic perspective, providing the agencies with flexibility but sticking with the overall totals agreed to would be best for economic growth. 

Monday, February 4, 2013

Investment-Unemployment Link Still On Track

When the recovery was getting started I pointed out the remarkably strong inverse relationship between fixed investment as a share of GDP and the unemployment rate, and argued that a policy that focused on getting businesses to invest more would help get the unemployment rate down.

The additional data from the past several years gives us a chance to check whether that relationship has held up. As shown in the following two charts, it has held up quite well.  The first time series chart shows that as investment has turned up as a share of GDP, the unemployment rate has fallen.  The increase in fixed investment thus far has been largely in the form of business fixed investment, though residential started to pick up last year.  
The second chart is a scatter plot with unemployment on the vertical axis and the investment ratio (in percent) on the horizontal axis. The lines connecting each quarterly observation represent the path from one quarter to the next. The chart illustrates the close correlation between the two variables. It also shows that the movement of unemployment and the investment ratio during the recovery (the recent dates are marked) has roughly paralleled the path in the recession, but in the reverse direction.  The problem, of course, is that the reverse path is way too short.  Investment has increased very slowly and has a long way to go before it gets back to levels that correspond to the 5 percent range for unemployment that we would like to see.  So the message in the charts is much the same as several years ago: economic policies that focus on more private investment are likely to also reduce unemployment.  

These diagrams would look very much the same if the denominator in the investment ratio was potential GDP rather than actual GDP. Of course, things other than investment can affect unemployment, and the correlation does not prove causation. As I pointed out here in a reply to comments on my original post, the correlation between investment and unemployment was also strong in the 1970s, through the scatter of points would be higher in the diagram then because demographic factors raised the average rate of unemployment.  

Sunday, February 3, 2013

Same Old Slow Recovery

The data released last week generated a lot of news stories, first bad ones about the GDP numbers and then good ones about the employment numbers. When you put the numbers in perspective, however, the economic story is little changed from what we have been experiencing for several years now: a continued weak economic recovery.

If you average out the -.1% and 3.1% growth in the third and fourth quarters, you get 1.5% growth for the second half of 2012 which is the about the same for the year as a whole, and down from 2% in 2011 and from 2.4% in 2010.  Here is an update of two charts I have used in past posts to show the weak growth compared to the early 1980s recovery and compared to the economy’s potential.  Growth is still much less than the 1980s recovery, and the gap between actual and potential GDP is not narrowing.

The jobs report shows that employment growth is still barely keeping up with the growth of the population, and not nearly enough to bring labor markets to pre-recession levels. The percentage of the working age population with a job has yet to take off.  Here is an update of a chart I have used in earlier posts to illustrate this. It is the same worrisome story.