In our previous piece we discussed how monetary policy largely works through housing. Residential investment is most impacted by monetary policy, and is a leading indicator for the economy. This is in contrast to private credit growth and nonresidential spending, which rise during tightening episodes. We explored the issue in the context of Federal Reserve driven yield curve flattening (as short-term rates climb faster than long-term rates), and potential inversion – the last nine recessions have all been foreshadowed by yield curve inversions.
At the same time, housing is a much smaller part of the economy now than in the past and so the effectiveness of monetary policy (to constrict the economy) comes into question. Ergo, the power of the yield curve to predict the next recession.
However, in addition to consumer spending and residential/nonresidential investments, government spending/investment also plays a large role in the economy. The role of the latter, in prior expansions and in the current one, is our focus here.
How fiscal policy worked in the past
Instead of looking at the federal government’s overall fiscal position, we looked at its primary surplus or deficit, i.e. the fiscal position excluding interest payments on debt. The idea behind the primary surplus/deficit is probably best illustrated using a household.
Consider a family whose expenses exceed the income they are bringing in. In order to meet the excess expenses, they start to charge more on their credit card. As they sink deeper into debt, they realize that something has to change. So they work hard to get their finances in order and reach a point where their household expenses are slightly below their income. At this point, their finances are in ‘primary surplus’ – so they do not need to borrow any more money. Nevertheless, they are still in an overall financial deficit because of all the interest payments they owe on their previous credit card purchases. In order to get rid of the overall deficit, they would have to raise their primary surplus by cutting even more expenses, i.e. more austerity. Or they could declare bankruptcy and walk away from their creditors, making it harder to get a loan in the future.
The Obama administration made this exact argument in 2011 to pursue austerity. They argued that while the Federal budget is enormously more complex, it works similar to a household described above. The goal was to get federal spending into a primary balance by the middle of the decade, putting the nation on a path to fiscal sustainability.
However, the analogy fails when you consider the fact that a country that issues its own currency does not have to declare bankruptcy, i.e. default. It can always print more money to pay off its creditors, an option that is not available to households and businesses.
In any case, if the government is collecting more in taxes than it spends on various programs, excluding interest payments on its existing debt stock, that is essentially a pullback in investment/spending by an entity that typically accounts for close to 20 percent of the US economy.
The exhibit below shows the primary surplus/deficit for the US federal government as a percent of potential GDP over five and half decades (1954 – 2009), and across nine recessions (shaded gray). We use potential GDP to detrend and eliminate variations that arise when using actual GDP – for example, actual GDP falls sharply during recessions and makes fiscal balance/GDP larger. The red lines in the chart indicate when the yield curve first inverted, as measured by the difference between yields on the ten-year and one-year US Treasury bonds. As the chart illustrates, the yield curve inverted prior to each of the last nine recessions. There was only one false positive, in the mid-1960s, which was followed by an economic slowdown.
Source: Primary fiscal balance calculated using federal government receipts, expenditures, interest payments (seasonally adjusted quarterly data) and nominal potential GDP: BEA and FRED. Ten-year and one-year US Treasury yields: FRED.
In general, we see that the primary fiscal balance moves into surplus as the economic expansion continues, and hits a peak before the next recession starts – coinciding with, or following, yield curve inversion. The primary balance then declines into the beginning of the recession, and drops precipitously into deficit territory as the recession deepens.
Even the brief expansion between the 1980 and 1981 – 82 recessions saw a rising primary surplus. The yield curve inverted in September 1980, ten months prior to the recession that began in July 1981, while the federal government’s primary surplus crested at 1.65% of GDP in the first quarter of 1981.
One would naturally expect the primary balance to move from surplus to deficit during recessions, as tax receipts drop due to lower incomes and more individuals become eligible for government programs like unemployment insurance and food stamps. What is interesting is that the primary surplus starts to shrink prior to the recession.
A couple of exceptions are the 1973-75 and 1990-91 recessions, which saw the primary surplus rising even after the recession began – though in the former case it fell sharply after Q4 1974 as economic conditions worsened.
We refrain from setting an exact level that the primary surplus should hit before the economy starts to contract, especially with such a small sample of historical recessions. Yet, a local peak in the primary surplus may still have value as a coincident indicator, if not a leading recession indicator. Especially when used in conjunction with yield curve inversions, whose lead time over recessions has ranged between 6 and 24 months over the past 60 years. Note that the exact timing of a recession by the National Bureau of Economic Research is declared well after the recession has ended.
Austerity at the wrong time?
What is notable from the previous chart is that the federal government has mostly been in austerity mode across the nine expansions prior to 2009, highlighting the deeply countercyclical nature of government spending in the US. The federal government has been in overall deficit across most of this period only because of interest payments on debt.
In fact, the 1960s and mid-to-late 1990s saw the federal government running significant primary surpluses over a sustained period of time. The late 1990s saw primary surpluses reach as high as 5.3% of GDP. Both these expansions saw high productivity growth and low slack, with economic growth averaging more than 4 percent. So government austerity was not imprudent, since there was significant private demand.
At the same time, it is interesting to consider US fiscal policy in the context of Hyman Minsky’s financial instability hypothesis (which got renewed interest after the 2007-2008 Financial Crisis) – also discussed on a recent Bloomberg Odd Lots podcast by Srinivas Thiruvadanthai, an economist and Director of Research at the Jerome Levy Forecasting Center. Without getting too far into the weeds, the idea is that capitalist economies have a tendency towards instability, especially as expansions lengthen, i.e. stability breeds instability. In that event, government deficits and debt can act as a stabilizing influence.
So our question is whether government policy became too contractionary as the 1960s and 1990s expansions got long in the tooth. This applies to the other seven expansions as well, including in the 2000s prior to the Great Financial Crisis. The primary balance was in surplus for three whole years leading up to Q1 2008, and exceeded 1 percent of GDP between Q3 2006 and Q2 2007 (the recession began in December 2007). During all this time, instability bred amid a rapid growth in private debt, with no countervailing stabilizer.
In other words, does US fiscal policy become too biased toward austerity as an expansion moves along, almost perfectly coinciding with tighter monetary policy. Perhaps tight fiscal policy is a lurking variable (to use a statistical phrase) when using yield curve inversions to forecast recessions.
It is intriguing to think about whether policymakers could use a simple heuristic like yield curve inversion as a signal to pro-actively increase government spending, without waiting for automatic stabilizers (like unemployment insurance) to kick in at the onset of a recession.
Which brings us to the current expansion.
A new fiscal policy experiment
The following chart shows the federal government’s primary balance since the end of the 2007-2009 recession. A familiar story can be seen for most of the current expansion, as the primary balance recovered from deep deficits that came about during the worst recession since the 1930s. However, in contrast to previous expansions, the primary balance never entered a surplus. Though it was not due to a lack of effort. The push toward austerity accelerated in 2011 and 2012, as the Obama administration looked to put the nation on a path of fiscal sustainability. This ultimately resulted in the budget sequestration of 2013, which reduced federal spending at a rate of $85 billion a year between 2013 and 2021.
Where the story changes is after President Trump took office in 2017. The new administration and its Republican allies in Congress pushed through massive fiscal stimulus in late 2017, in the form of tax cuts. On top of this, Congress also removed the budget sequestration caps for 2018 and 2019, providing the economy with even more stimulus.
The net result is that for the first time in recent history, the federal government is pushing its primary deficit even lower this far into an expansion, which is already slated to become the longest expansion on record. Note that the chart shows the primary balance only through Q1 2018 – it is expected to decline even further in Q2 2018.
With the yield curve rapidly flattening, and the Federal Reserve on track to continue its interest rate hikes, an inversion may come about sooner rather than later – beginning the countdown to a recession. Though as we saw above, previous yield curve inversions, and subsequent recessions, have also coincided with government austerity. This is not the case today.
Could this time be different thanks to unorthodox fiscal policy that may have pushed a potential recession even further into the future. While there is much bemoaning of the fact that deficits are rising while the economy is pushing towards a 3 percent rate of expansion, perhaps it is these rising deficits that is pushing economic growth higher.
Of course, tax cuts provide only a one time boost but it will be interesting to see whether the current administration, or the next one, will continue to push pro-cyclical fiscal policy (like student debt forgiveness) – in an attempt to further stabilize the business cycle beyond traditional countercyclical fiscal policy. Which would be a paradigm shift for the US.
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