- The federal deficit used to expand as the whole of the US economy was getting worse and shrink as the economy grew stronger, but that’s no longer the case.
- Despite the relatively strong economy, the federal deficit is growing and that appears to be in response to the weakening manufacturing sector.
- The focus on manufacturing seems to be driven by the outsized political influence of the industry, causing politicians to focus on boosting the sector.
- George Pearkes is the global macro strategist for Bespoke Investment Group.
- Visit Business Insider’s homepage for more stories.
The recent surge in federal budget deficits has caused a lot of hand-wringing among federal debt worriers but little action among lawmakers. The sudden jump in deficits despite a relatively strong US economy appears to represent a serious political economy shift.
Instead of increasing fiscal stimulus as a response to a broad slowdown in the US economy, the deficit increase appears to be targeting recent softness in the manufacturing sector. Policymakers, possibly due to the outsized political influence of the sector, have gone from ignoring pain in manufacturing to over-compensating for it.
The deficit used to mirror the strength of the economy as a whole
From the late 1960s through the early 2010s, it was pretty easy to predict where the federal budget deficit would be based on the performance of the broad economy.
During periods of economic strength, stronger tax receipts meant smaller deficits, while policy responses such as stimulus programs kicked in during weaker periods and raised federal spending as tax collections fell.
A broad economic variable like the unemployment rate for Americans in their prime working years was a clear explanation of how big the deficit would run relative to the economy. The chart below is clear: this was a very stable relationship.
George Pearkes
Put another way, the deficit was primarily responsive to the strength of the whole economy, not just one sector.
More recently, things look very different, in part because the macroeconomic drivers of lawmakers’ incentives have shifted.
But now the growing deficit seems tied to weak manufacturing
The mechanics of higher deficits in recent years are broadly familiar and uncontroversial.
The first jump came from weaker corporate tax revenues in 2015 and 2016 thanks to a strengthening US dollar and lower oil prices. This was followed by the Tax Cuts and Jobs Act — the Republican-supported corporate income and personal tax cut that reduced federal revenues relative to previous projections.
Looking at the struggles of the industrial sector, there are ways to argue that the recent fiscal stimulus through deficit expansion makes sense.
For one thing, factory output plunged as global growth, a sagging energy industry, and a strong US dollar weighed on the sector during the mid-2010s. And output has since slowed again amid a fresh slowdown in global demand.
As a result, Federal Reserve estimates of the spare capacity in aggregate across utilities, manufacturing, and mining (including oil extraction) are much weaker today than they were during other economic expansions. This measure tries to capture what percentage of existing production capacity is being used. For example, a factory that adds a night shift is operating at a higher capacity utilization than it was previously.
George Pearkes
The deficit is still wider than industrial capacity utilization would predict, but on first glance deficits around 5% of GDP would be plausible based on what we know about the manufacturing sector alone.
It’s important to remember that manufacturing accounts for just 8.5% of total employment (a record low) versus about one-third of the workforce in the 1950s. Notably, manufacturing has gone from adding about one-quarter of output in the 1950s to 11% today, a less dramatic decline that has been helped by higher productivity.
So the question becomes, why did lawmakers suddenly start focusing on the manufacturing sector over the overall economy?
The politics of manufacturing are driving the deficit
What looks to be happening is a shift in political economy.
During the late 1990s and early 2000s, the industrial sector was badly hurt by a range of factors: economic cycles, competition from foreign imports, and higher productivity squeezing less efficient producers. But other sectors were able to step up and cover the lost of employment; output losses were more modest than employment losses thanks to higher productivity overall.
If the industrial sector had been the only sector of the economy, then it would have made sense to run substantial deficits over the 1996-2002 period reduce slack, but instead federal surpluses roared to over 4% of GDP during the heart of that period.
Now, it appears policymakers are more sensitive to the concerns of the industrial sector. This could be because of the outsized importance of historically manufacturing-centric states like Pennsylvania, Michigan, and Wisconsin. In 2016, just 110,000 votes spread across those states secured President Donald Trump’s Electoral College victory. Given those states’ political importance and industrial make up, it’s not a surprise to see more focus on manufacturing’s concerns.
Additionally, close association between the Republican party and the mining sector (especially oil, gas, and coal) are another reason to explain why a GOP-controlled Congress (for 2016-2018) and White House might be willing to run bigger deficits than might be indicated by other economic variables.
Is the deficit shift a problem?
The shifting politics of the deficit leads to another question: should we be worried about side-effects on the broader economic backdrop? The simple answer is no.
Both neoclassical and to a lesser degree Keynesian branches of economic theory would argue that running large deficits during periods of economic expansion have negative side-effects. Inflation as too much deficit-fueled demand chases fixed productive capacity is one example. Another would be mis-allocation of resources, with too much government investment in politically popular projects crowding out more efficient private sector investment.
But so far we haven’t seen those negative effects. The Fed has cut rates three times this year in part over concerns that inflation is too low. Meanwhile, combined public and private spending net of depreciation as a percentage of GDP, a solid proxy for total investment, is running well below previous decades. There just isn’t enough investment going on for much of it to be allocated inefficiently.
George Pearkes
You don’t need to reinvent the wheel to explain why inflation has been so low over the past decade. A radical slowdown in the growth of total-economy debt has meant that even with relatively quickly rising government debt, inflation pressures have been muted.
In fact, CUNY economist JW. Mason argued in a recent presentation that if anything, the deficit is still too low to get US economic growth back to its pre-financial crisis strength, and that side effects of running large deficits are minimal.
While the household, financial, and state/local government sectors have continuously paid down debt for the past decade, federal debt growth has served to pick up the slack and prevent broader whole-economy deleveraging.
That growth has had limited negative side-effects so far, thanks in large part to the muted debt growth elsewhere. Given the apparent renewed focus on the political economy of deficits’ benefits, it’s worth asking why those benefits aren’t getting more attention instead of efforts to wipe them out with deficit “pay-fors.”
George Pearkes is the global macro strategist for Bespoke Investment Group. He covers markets and economies around the world and across assets, relying on economic data and models, policy analysis, and behavioral factors to guide asset allocation, idea generation, and analytical background for individual investors and large institutions.
