Hatzius: The Deficit Will Decline Substantially in the Coming Years

Jan Hatzius of Goldman Sachs had some interesting commentary on the deficit the other day.  You’ll recognize the sectoral balances chart in his work as he’s one of the few analysts on Wall Street who seems to really appreciate the importance of Wynne Godley’s work.

Here, he describes the 3 reasons why the deficit is about to slide in the coming years:

“There are three main reasons for the sharp reduction in the deficit:

1. Lower spending. On a 12-month average basis, federal outlays have fallen by a total of 4% in the past two years, the first decline in nominal dollar terms over a comparable period since the demobilization from the Korean War in the mid-1950s.

2. Higher tax rates. The increase in payroll tax rates in January 2013 has boosted federal receipts by around $120 billion (annualized), or about 0.8% of GDP.

3. Economic improvement. Although real GDP has only grown at a sluggish 2%-2.5% pace since the end of the 2007-2009 recession, this has been enough to generate a sizable improvement in tax receipts, over and above the more recent impact of higher tax rates. Even prior to the tax hike that took effect in early 2013, total federal receipts had grown by 7% (annualized) from the 2009 bottom, nearly twice the growth rate of nominal GDP.

We expect the deficit to continue to decline and are forecasting a deficit of 3% of GDP or less in fiscal 2015. Some of this is policy-related. Sequestration has barely started to show up in the outlay data, and the expiration of the Bush tax cuts for high income earners in 2013 is likely to reduce tax refunds and boost final settlements in early 2014. In addition, the two parties are calling for further spending cuts and/or tax increases (although it is unclear whether these will be enacted).

But the more important reason, in our view, is that there is still a great deal of room for the economic recovery to reduce the deficit for cyclical reasons. The key to this forecast is our expectation that the private sector financial surplus–the difference between the total income and total spending of all households and businesses–will decline substantially further from the 5.5% of GDP reading of the fourth quarter of 2012 toward the historical average of 2% of GDP.

As a matter of accounting, this reduction must be mirrored in a drop in the federal deficit, a drop in the state and local deficit, an increase in the current account deficit, or a combination of all three. In practice, however, we expect it to translate primarily into a decline in the federal deficit, as tax receipts rise and outlays decline (e.g. via reductions in the unemployment rolls.) This expectation is consistent with the historical record. As shown in Exhibit 2, there has been a close inverse relationship between the private sector balance and the federal government balance in recent decades, with a correlation in annual data of -0.72.

gs1

And the conclusion from Hatzius:

“In our view, the most important implication from the reduction in the budget deficit for the near-term economic outlook is reduced pressure for further fiscal retrenchment. Partly for this reason, we expect the drag from fiscal policy on real GDP growth to decline sharply from around 2% of GDP in 2013 to around 0.5% in coming years. This is a key reason for our expectation that real GDP growth will accelerate from around 2% (annualized) in Q2/Q3 2013 to 3%-3.5% in 2014-2016.”

I’d only add that it’s important that the private sector’s de-leveraging is slowing and even turning into a re-leveraging to some degree.  This means the private sector is healthier than most presume and that the government deficit isn’t needed to power private growth as much as it has been in the last few years.  This passing of the baton is important in understanding the future trajectory of the economy.  The decline in the deficit is as much as a result of mild government austerity as it is a sign of increased private sector health.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. So the sky isn’t falling after all, makes me glad I went all in on equities when the S&P was at 1130.

    I am in my 20s though, so diversification be damned.

    It makes me laugh how gloom and doom people can get when it’s so easy to realize that millions of people who want to create and earn are still there working to achieve goals and dreams. Faith in the output of the USA as you describe it.

  2. It’s funny to think that Hatzius is the top guy at one of the top Wall Street firms and I think Cullen has a better grasp on most of this stuff than he does. Here’s to hoping Cullen doesn’t sell out Pragcap at some point. Thanks for all you do.

  3. What are the implications for margins in the private sector or is this expected to come at the expense of individual savings rates?

  4. That assumes net investment declines substantially. I think it’s more likely that private investment is offsetting (perhaps more than) the decline in the deficit. In sum, I think that like means stagnant or downside risk to margins.

  5. I don’t believe his opinions for one second. In EVERY economic downturn budget deficits go “through the roof” and that’s why I don’t buy into this, for one minute.

  6. Now I’m confused, not for the first time.

    I thought a slowing down of government spending and more government taxation will drain the private sector’s ability to save and invest.

    According to Bart’s post above and the links to the “Deleveraging, by the Z1 numbers” charts, Private, Financial & Mortgage debt are falling relative to total GDP (Government debt is rising)…so does that mean that either the private sector is paying down their debt really fast (I find that hard to believe) or that the GDP is rising really quickly? (I find that also hard to believe)

    AND the second chart (percentage change in growth of debt) shows that private sector debt as a percentage of GDP is GROWING while government debt is shrinking.

    According to the latest National Federation of Independent Businesses(NFIB), they show 0% of their members planning to hire: http://www.chpc.biz/2/post/2013/04/labour-revulsion-update.html

    The same thing is happening here in Canada: http://www.chpc.biz/2/post/2013/04/credit-revulsionupdate.html

    What appears to be growing is not the ability of the private (household) sector to pay down debt but a REVULSION of labour (and credit).

  7. I think this was one of the keys to understanding the MR equation S=I+(S-I). The private sector can save without government spending. But it requires an increase in investment.

  8. Thanks for the note LVG.

    Based on the growth in private sector debt relative to GDP and to the plunging demand in labour … how is that a formula for the private sector to increase its savings and its ability to then make investments in the economy that would drive GDP up?

  9. Private sector deleveraging is a result of foreclosures and weakness in the housing market (fewer people taking on mortgages.)
    As someone else noted in here, while forechosure is usually a positive result for the consumer, the reasons he had to foreclose are still in place. He is not going to go out and start levering up again.

  10. Household debt has definitely stabilized and started improving at a year over year rate. The de-leveraging is basically done at the household level.

  11. If businesses begin to do more investment, would this increase or decrease corporate profits generally, all else equal? This seems like a stupid question cause my gut tells me more investment means more spending and higher profits. If the margins we see today though have been from cost cutting and productivity increases, while PP&E reaches the end of its useful lives, reinvestment will eventually have to occur. When it does, this higher PP&E value will increase depreciation expense, so unless the investment can immediately turnaround revenues greater than depreciation, profit margins will decline. Ultimately, this investment will shrink businesses surplus, but also shrink household and government deficits at the same time. Overall good for economy, but not great for margins. What am I missing?

  12. ‘1. Lower spending. On a 12-month average basis, federal outlays have fallen by a total of 4% in the past two years,”

    I suspect the use of a standard calendar year would show a entirely different picture…

  13. I must be having a dyslexic phase. I cannot grok this.

    Cullen you say:

    “(1) Household debt has definitely stabilized and started improving at a year over year rate. (2) The de-leveraging is basically done at the household level.”

    (1) Bart’s link to Annual growth rates of debt clearly shows all private sector debt is increasing: http://www.nowandfutures.com/images/deleveraging_facts_roc(fed).png

    What does “Household debt has definitely stabilized and started improving” mean? That household debt is increasing and thus stimulating the aggregate demand?

    (2) “de-leveraging is basically done at the household level” “done” meaning ‘finished’? or meaning ‘occurs at’?

    Regardless of the meaning of “done”, Bart’s chart shows private sector debt is rising relative to GDP.

    Are you saying that the rising level of private sector debt at this time is a positive for the economy because it reflects more private sector investment and that will (should) lead to more aggregate demand?

    If yes… then how does this square with chronic wage destruction?

  14. But do you really expect it can get back even close to level it was before? First off, most people have seen their incomes drop or fear they will in the future, so this means the ceiling for debt accumulation is lower. Secondly many of those people are like me I suspect. Ive paid down debt and have no intention of levering back up.

    I know you dont think that our debt levels (private that is) were sustainable pre 2008, your position on that has been clear, but Im asking if you really think we should expect much if any more leverage from the average household. It would have to improve a lot year over year in order to restore demand to where it was pre crisis.

    My point is someone is still going to have to step in to make up for the lost demand from household borrowing

  15. Dismal and all:
    Kalecki equations explain it all:

    Investment (I) (net of depreciation) increases profits because the buyer of the inventory, equipment, building, etc. incurs no income statement hit. It is funded out of borrowings or cash. However, the seller of the inventory, etc. gets the revenue with no increase in costs, hence a profit occurs at the macro level.

    A net export (NE) also increases business revenue with no increase in their net costs. However, the US is a net importer so that is a drag on profits.
    When consumers (C) spend more than their wages, that boosts profits and conversely. Their income to spend includes dividends – which are substantial.
    When governments run a deficit (D), then business gets revenues with
    no increase in costs – hence a profit.
    Consequently After-tax profits = I + NE + C + D – as defined.

    So the decline in the deficit will be reducing profits. However,
    net investment appears to be on the upswing, providing an offset.
    Also profits per share grow faster than profits (about 2% more)
    because of buybacks.
    If the consumer spends a bit more relative to wages than they have been, the overall bottom line may be a modest increase in profits.

    Despite widespread belief, “cost cutting” has nothing to do with
    profits. One business’s lower costs are another business’s lower revenues. The same is true for productivity. While productivity is the key to our standard of living, changes in productivity have no impact on profits – this can be shown with simple math which I won’t do here. Since they have no impact, “cost cutting” and productivity are not part of the “profit equation”

    Hope that is helpful to those new to the subject.

  16. Valuation Consultant: “It makes me laugh how gloom and doom people can get when it’s so easy to realize that millions of people who want to create and earn and blah blah blah”

    LOL. A few years ago in 2001 (when you were all pimply and in junior high), a lot of naive people said the same thing about the NASDAQ, which promptly crashed from 5,000 to 1,000. Then, in 2006, when you were finger-banging high school cheerleaders in your dad’s Oldsmobile, a lot of people said the same about the housing market and promptly got slaughtered. Point being: You are a young twit and know nothing. Your best role on these boards is to read, and not post. Come back in ten years when your life experiences allow you to have something useful to say. Now run along, sonny, and I’ll buy you a balloon and lollipop.

  17. “. Higher tax rates. The increase in payroll tax rates in January 2013 has boosted federal receipts by around $120 billion (annualized), or about 0.8% of GDP.”

    Does anyone agree with this statement?

  18. One of the key issues I think many ignore in these debt to GDP ratio arguments is that for private entities the appropriate figure is debt cost to income ratio or something similar, NOT debt level to income. While a bank does look at debt level to income, the primary calculation is the debt payment to income ratio. This is equally true for business, which calculates the cost of debt vs the expected income from whatever additional activity is supported by the debt. This is essentially also true for the government.

    Interest rates, at least across all secured debt, have decreased substantially over the past 35+ years. It seems possible that the primary reason for this is the increase in income and wealth disparity across the globe driving up relative demand for low risk financial assets.

    What is odd, is that many on the right, want lower (or zero) government debt levels relative to GDP and at the same time argue that the Fed is punishing savers with QE. Lower government debt reduces the supply of zero-risk (zero without the Tea Party wackos who seem willing to default on it) financial assets which will drive down the interest rates even further.

  19. Mr Daschbach, I am a Tea Party wacko, but do not believe debts are an asset like so many of you folks(JMKs)…

    “Lower government debt reduces the supply of zero-risk (zero without the Tea Party wackos who seem willing to default on it) financial assets which will drive down the interest rates even further.”

    Can you give any examples, please..

  20. Brian, the rate-of-change chart shows does not show private debt rising as a % of GDP. The latest data point is about -1%. It’s not shrinking as fast as before, but as of the last report it was still shrinking.

  21. Hans the “debt” is an asset. Assume you held all of the $16T in debt.
    These are your savings, an asset for you. If the government wanted to retire the debt they could do so. It would be an “asset swap” where you receive the cash and lose the bonds. You are no wealthier. The composition of your savings has changed but not the amount. (you would move the money to CDs, corporate bonds, stocks, whatever). And the debt is gone – witn no taxpayers or grandchildren in sight!

    This action is not recommended, of course. The Treasury bond market serves several useful purposes. It is used as one instrument to implement monetary policy. There are many constituencies who wish to own Treasury bonds. And it provides a useful benchmark for other fixed income securities. The only point is that the debt could be eliminated in this manner – demonstrating that it is a private sector
    asset not a potential private sector liability. Most of the world has it upside down.

    Hope this was helpful.

  22. CharlesD,

    A few points I think need clarifying in your 2nd paragraph:

    “If the government wanted to retire the debt they could do so.”

    1. You write “government” above, by which you are including the Fed I presume? Specifically you meant that the Fed buys the Treasury bonds from the public in these “asset swaps,” correct?

    2. Also, don’t forget that the Fed needs people who are willing to sell their Treasuries. I’m sure you already know that, but your paragraph reads a little like the private bond holders don’t have a say in the matter.

    3. Also, the Treasury still needs to pay the Fed the principal on the bonds that the Fed buys. The Fed remits the interest payments back to Treasury, but the principal amount of each bond must still be paid.

    In order to raise that principal amount, the Treasury may have to auction more bonds. Now if the Fed were allowed to purchase bonds directly from Treasury and their policy were to always outbid anyone else, then this is one method for Treasury/Fed “team” to fund Treasury w/o “going into debt.” That wouldn’t technically be true because the Treasury would still owe the Fed the principal amount, but it would essentially allow interest free unlimited deficit spending. However, the Fed is not just a desk in the Treasury, and they can’t necessary be seen as one “team.” There is a degree of independence there, and they keep separate balance sheets for a reason.

  23. I should have written “Also, the Treasury still needs to pay the Fed the principal on the bonds that the Fed buys and holds to maturity.”

  24. Very well said, Charles. However, I’m not sure that Tbonds are a useful benchmark for other fixed income securities anymore. Tbonds aren’t really a “market” anymore given that they are effectively controlled by the Fed. I think the rest of the fixed income market should decouple from Treasuries and find their own level based on supply and demand. In fact, this process may have already begun in the corporate bond market, for example, where spreads vs Treasuries have become a little sticky on the downside. Spreads are nowhere near their all-time tights, which seems odd at first blush. There appears to be a certain level of absolute yields below which corporate bond investors are unwilling to go.

  25. Hans, CharlesD does a good job describing public debts below, however, in general, I’ll point out that your debt is a liability to you, but somebody else’s debt may well be your asset! You may see that asset as your “money” but it came from somebody’s debt!

  26. It’s certainly helpful to me. If someone were to come up to me and give me $1 million in Treasury Bonds, I’d be thrilled ! I wouldn’t think, “Oh Shit…this is debt…how do I know this is any good..”? But, given that the US is a sovereign currency issuer, the US can always make good on any of its obligations. The thing is, the Tea Party does buy this…they’re still stuck in the currency user/gold standard paradigm….and to make their point, many of them want to FORCE the US to renage on its debts…just to prove it could happen ! ….which seems pretty reckless and silly to me.

  27. Tom, I don’t speak for Charles but the Treasury could just issue currency and buy the bonds directly (after Congress repealed the Federal Reserve Act). Voila, no more debt.

    As you note, most Treasury bonds are non-callable, but with the inflation such a move would likely create willing sellers should be easy to find :)

  28. “after Congress repealed the Federal Reserve Act”… ah, that’s the key, isn’t it? Not the system we have… thus one of the main differences between MR and eM eM Tee. But yes, I agree if the Fed were made into a desk at Treasury, what you say is correct. It’s even correct if the $1T coin idea is actually used some day.

  29. Tom thanks for your comments. I was purposely vague about whether the
    Fed or the Treasury would buy the bonds because I am no expert on the
    subject and you probably know more than I do. I was just trying to address the “big picture” – which I think I understand but I’m still
    learning also. So I will assume you are right and it would be the Fed
    buying the bonds.
    You are right, I think, that the Fed would need people willing to sell. So perhaps I could turn the example around and point out that you could “cash in” all of your Treasuries – with the same result – only the private sector (you) were the initiator, not the Fed.

    Regarding the Fed “needing” the Treasury to ultimately pay the principal amount on the bonds, this would certainly be the convention.
    However, the Fed could, in principle, “forgive” the principal and take
    a huge writedown on its capital (equity) account). While this sounds
    bad, it would just be accounting (changing a number in a spreadsheet) – demonstrating in a different way that the debt could be made to disappear with no real world impact.

    Somewhat separately, I was thinking that people are worried about the Treasuries the Fed holds as an asset. At the same time, many of the same people are worried about the “National Debt”, which the Treasury
    has as a liability. Unless I’m missing something (which I could be) it would seem to me that on a consolidated “Ggvernment” basis (Fed
    plus Treasury), the portion of the “debt” which the Fed holds is effectively gone. The Treasury pays the Fed interest and the Fed ships the interest back to the Treasury, demonstrating the neutrality of the overall Government. So putting the two “worries” together results in “no worries” – perhaps another way of demonstrating that that the “National Debt” is a non-issue. Like I said, I’m still learning and I could be missing something – but this observation seems to demonstrate the silliness of a lot of the “conventional thinking”.

  30. CharlesD, you write: “I’m still learning and I could be missing something.” … I’m in the same boat! I happened to have been down the same path as your original comment, and so I was really just passing on what I’ve learned from Cullen and others after asking questions. In terms of learning more about what is going on, I really think the tool on this website is a great resource:

    http://econviz.org/macroeconomic-balance-sheet-visualizer/

    Down in the lower left corner you can run various operations in the drop down list box. What I was describing as a means of government self financing of deficit spending (Fed buying every T-bond), is represented by the somewhat unfortunately named operation “Government Spends (Without Borrowing).” If you read the “Explanation” at the very bottom (there’s one for each operation) they go through some alternatives to this self financed deficit spending that some em em tee folks have proposed. At least one of these is akin to your idea of the Fed forgiving the principal debt of the Treasury. The 3rd bullet though is key though: “Governments currently do not use this spending approach.”

    The rest of the operations in that pull down list are not hypothetical though. The “Government Spends (Consolidated)” for instance shows what Cullen often describes as “gov deficit spending is when the gov redistributes inside money from Peter to Paul, issuing Paul an NFA in the process.” In other words, thats the real world of deficit spending as it exists now… from Treas bond auction to every $ of proceeds being spent back into the private economy.

    Along those same lines, I ran though a very very simplified thought experiment regarding what would happen if the Fed really were to buy every Treasury and hold it until maturity, and then the Treasury had to pay the principal back, issuing more bonds to do so (rather than taxing), etc. Here’s what I came up with:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-6-cb-holds-gov-debt-to.html

    The result being that it’s as if Treasury just issued T-bonds to the public for free (you can skip to the last set of balance sheets to see this). This led me to the conclusion that if all of our dollars are based on debt, then the amount in the private economy that could be said to have originated from government debt is the same as the principal amount, in dollars, of T-bonds held by the Fed. It is NOT the total amount of T-bonds in existence (although those T-bonds do have a level of moneyness somewhat below bank deposits). I discuss this in the 3rd to last paragraph of the post here:

    http://brown-blog-5.blogspot.com/2013/03/list-of-ways-reserves-leave-banking.html

    “phil” and I get into a long thread underneath about a difference of philosophy that mostly boils down to him seeing the Fed and Treasury as a consolidated whole that really ought to be regarded as having a single balance sheet (I think, similar to what you’re getting at) and me arguing that there’s a good reason to consider them to be separate entities with separate balance sheets. I’m 99% certain that phil is the same guy that gets involved in long arguments with Cullen here on pragcap, and I’m pretty sure he’s an em em tee-er. Anyway, I’m pointing it out because I’m inclined to defend the MR view over the em em tee view, but have never directly been involved in one of those arguments until now (I usually avoid them here on pragcap). Anyway, I think I actually learned a bit more about how the two views relate to each other because of phil.

  31. Tom Thanks! Will take me a while to absorb but extremely helpful in thinking through these issues. As you point out, it is the real world of the consequences of deficit spending which is where it all begins
    That is, the only reason we can discuss all sorts of ways that the
    “debt” can be erased with “ex-nihilo” money is that the Treasuries were created “ex-nihilo” as a consequence of deficit spending in the first place. So, for example, replacing the “ex-nihilo” bonds which the private sector owns with “ex-nihilo” cash doesn’t change anything because the bonds were already created earlier as a result of deficit spending. The deficit spending is where the “money” or “near-money” came from. At least that’s my take at this point. Thanks.

  32. This is pure fantasy. There has NEVER been a case where a nation has organically grown out of such leverage without some major pain.

    Cullen, I cannot believe you really share that view?

    For one thing, the real government leverage is much bigger than just the federal and state debt. You have to account for the impossible levels of future entitlements, which can only be reduced by a very painful reduction in benefits to retirees.

    Since when Goldman Sachs is such a reliable source of macro analysis?

  33. I’ll add one more consideration.

    Private sector health? I think that is way too optimistic, albeit it is the conventional view.

    The private sector has been releveraging because it is taking advantage of cheap money to do things like bribe investors with large dividends, cover their pension underfunding and such.

    You need to look far deeper under the hood before declaring the return to the good times …

  34. If you’re JUST talking about government debt, then how about 1945 – 1975. In 1945 the US had an enormous debt to GDP ratio (bigger than now), plus two more wars (12 more years total), a public highway system, a cold war, a space race and moon landings, a new medicare/medicaid system and a great society to pay for in its future, yet we did all that while simultaneously paying off the debt in 10 years and sustaining 30 years of solid economic growth. Granted private debt levels were very small in 1945… different than today!

  35. Do you think that (being on the gold standard) had something to do with it? I’m guessing it was more a matter of private debt levels being in better shape, although I’m thinking debt/GDP whereas I know Cullen favors a different measure (debt to income)… and I don’t know what that measure was in 1945. Plus in 1945 didn’t the US have MOST of the gold in the world? I don’t know if that’s true or even if that should somehow make a difference… but it was perhaps an unusual circumstance.

  36. Do you think that (being on the gold standard) had something to do with it? I’m guessing it was more a matter of private debt levels being in better shape, although I’m thinking debt/GDP whereas I know Cullen favors a different measure (debt to income)… and I don’t know what that measure was in 1945. Plus in 1945 didn’t the US have MOST of the gold in the world? I don’t know if that’s true or even if that should somehow make a difference… but it was perhaps an unusual circumstance.

  37. Naaa not really. WW2 broke the world into pieces.
    The US was the only place to make stuff and we did.
    We provided the world with lots of stuff and reaped the benefit.

  38. @VC

    When you believe in things that you don’t understand, then you suffer

    (Stevie Wonder, H/T J Hussman)