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An Extraodinary Thing

An extraordinary thing has happened. The United States budget deficit improved dramatically in FY2013; and it did so without hurling the US economy into a severe recession. Taxes went up and government spending went down. As a result, for the fiscal year ending 30 September 2013, the government's budget deficit fell by 38%, or by $409 billion, to $680 billion from $1,089 billion in FY2012 (and from a peak of $1,413 billion in 2009). This was the first year since 2008 that the budget deficit was less than $1 trillion.

As a percentage of GDP, the budget deficit declined by 2.7 percentage points from 6.8% of GDP in FY2012 to 4.1% of GDP in FY2013. It peaked at 9.8% of GDP in FY2009.

Under normal circumstances such a sharp reduction in the budget deficit would have caused the GDP to be at least 2.7 percentage points lower (and probably closer to 4.0 percentage points lower, taking into consideration the multiplier effect) than it otherwise would have been. The increase in taxes would have reduced personal consumption, while the reduction in government spending would have directly reduced the size of the economy. This would almost certainly have thrown the economy into recession.

The fact that the US economy still managed to grow by an average of 1.6% during the last four quarters can only be explained by one thing: Quantitative Easing. During FY2013, the Fed created nearly $1 trillion of fiat money, an amount roughly equivalent to 6% of GDP. It injected that money into the economy by buying government bonds and mortgage backed securities. In this way, QE pushed up asset prices, most notably the price of stocks and property; and rising asset prices created a wealth effect that fuelled consumption and economic growth - despite the severe government austerity.

Before discussing the budget in greater detail, I would like to point out here that it is very important for investors to monitor the size of the US budget deficit relative to the size of QE. The government's budget deficit sucks liquidity out of the economy. QE pumps it in. When QE is larger than the budget deficit - as it is now - there is a great deal of excess liquidity that tends to push asset prices higher.

I have developed a "Liquidity Gauge" to measure the extent to which liquidity is excessive or inadequate. For a full explanation of the Liquidity Gauge and how it can be used as a tool to anticipate the direction of asset prices, please see Macro Watch, Fourth Quarter 2013:

http://www.richdad.com/Resources/Rich-Dad-Financial-Education-Blog/November-2013/announcing-macro-watch-richard-duncans-video-news.aspx

Now, back to the budget. Here are some of the budget details that I believe are important and interesting.

• Government spending declined for the second year in a row in FY2013. This was the first time that government spending has fallen two years straight since 1955.

• Total government spending fell by 2.4%, or $84 billion, to $3,454 billion. That amount was equivalent to 20.8% of GDP. That was lower than the 22.0% of GDP recorded in FY2012, but still above the 40-year average of 20.4%.

• Defense spending fell by 7.2%, or $47 billion, to $608 billion. This was the second year of decline, after growing at an annual rate of 6.2% over the previous five years.

• Spending on unemployment benefits declined by 25%, or $24 billion, to $80 billion.

• Spending on Homeland Security increased by 21%, or $10 billion, to $57 billion.

• Interest expense on the government's debt increased by 16%, or $56 billion, to $416 billion.

• Spending related to Veterans Affairs increased by 12%, or $14 billion, to $138 billion.

• Outlays for Medicare rose by $11 billion or by 2%. This was a slower rate of increase than the 5% average over the previous five years.

• Fannie Mae, which had returned to profitability, repaid $50 billion to the government.

• Government revenues increased by 13%, or $325 billion, to $2,774 billion, a new all time high.

• As a percentage of GDP, government revenues rose from 15.2% in FY2012 to 16.7% of GDP in FY2013. However, they remained below the average over the past 40 years of 17.4%.

• Individual income taxes increased by 16%, or by $184 billion, to $1,316 billion.

• Payroll taxes rose by 12%, or $103 billion, to $948 billion due to the expiry of the temporary 2-percentage point reduction put into place during the crisis.

• Corporate taxes increased by 12.9%, or $31 billion, to $274 billion.

• The Fed handed over $76 billion of its profits to the Treasury Department. This was less than the $82 billion it gave the government in FY2012. This drop came as a surprise to me since the Fed should have earned more, given the much larger size of its balance sheet in FY2013.

Looking ahead, the Congressional Budget Office has forecast that the government's budget deficit will fall further in FY2014 to $560 billion or 3.4% of GDP. The decline in the budget deficit since FY2012 represents a very significant improvement in the United States finances over a very short period of time. The economy has weathered this fiscal austerity much better than could have been expected. Its next challenge will be to weather the end of the Fed's monetary largess. Things could soon get rough. QE tapering is fast approaching.