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Eye on the Market | april 9, 2012 J.P Morgan Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain So, how tight is US fiscal policy supposed to get next year? Very, if you look at what is supposed to happen according to current law. In the chart, we show the annual change in the budget deficit over the last 25 years. The impact of all provisions scheduled to expire and kick in during 2013 would be very large. But if Congress and the President elect to extend current tax rates, retain lower payroll tax rates and extended jobless benefits, etc, the adjustment would not be as big, and only reflect expiration of Recovery Act provisions, the recently passed Budget Control Act, and some other smaller provisions. There are of course plenty of permutations in between. Wide range of outcomes for 2013 austerity Policies set to expire or take | Fiscal Drag (% Change in cyclically-adjusted federal deficit, % of potential GDP effect under current law of 2013 PGDP) 570. : Sequester Automatic Cuts 6 A Fiscalstimulus (Discretionary Spending) 0.4% 3 | 2013 See na Cuts 0.1% 2 Seehario (Mandatory Spending) 1 estimates Bush Tax Cuts ($250k+ -0.3% 0 Incomes, Estate Tax) -1 Congress Bush Tax Cuts (Middle Income) -0.9% 2 punts Alternative Minimum Tax -0.8% 3 Payroll Tax Cut -0.6% Fiscaldrag Current Emergency Unemployment -4 law CG ti -0.2% 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 SUIPe ie atlen Source: CBO, IMF, Goldman Sachs, J.P. Morgan Private Bank. Affordable Care Act 0.2% Source: CBO, Goldman Sachs. What direction is the Congress heading, and what did Larry Summers and Brad DeLong have to say about this recently? Political outcomes this fall will affect what Congress does, but I get the sense that they will punt fiscal adjustments into the future if they can, and impose austerity of no more than 1% of GDP in 2013. Ifso, Congress can point to a March 2012 paper by Summers and DeLong as justification. The bottom line from the paper: don’t tighten fiscal policy when interest rates are near zero. The authors assert that (a) additional government spending can ease the long-term budget constraint in conditions similar to today’s, and (b) tightening policy now would risk permanent loss of human capital, lower labor productivity growth and lower trend growth. They have held these views for a while; the paper appears designed to convince others. Advocates for more fiscal and monetary stimulus often point to the charts below. Rising Federal debt has not resulted in higher interest rates, so why not keep borrowing more? As for the Fed, balance sheet expansion prevented deflation and hasn’t resulted in an inflationary surge (core inflation measured over 3 months just came in below 2%), so why not keep doing it? Aren’t these charts amazing? Rising Federal debt? No problem for Treasury markets Rising Fed balance sheet? No problem for inflation Percentof GDP Yield, percent, 90 day moving average -Percentof GDP Percentchange, YoY 80% 20% 4.0% i 48% 18% 3.5% 70% 65% 43% 16% 3.0% 60% 10-year | 3.8% 14% ea 9 Treasury yield 55% 50% ==> 3.3% 12% 20% fos Debtto GDP 28% 10% 7 newt 1.5% 35%, —_— 23% 8% alance shee 1.0% 30% 1.8% 6% 0.5% Sep-04 Feb-06 Jun-07 Nov-08 Mar-10 Aug-11 Dec-12 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: CBO, Bloomberg. Assumes CBO Alternative Case for estimates. Source: Federal Reserve Board ,Bureau of Labor Statistics . They are amazing, but no one knows how long they can be sustained. Even Summers and DeLong concede that “even if it is granted that the stimulus can be both timely and temporary, the question of how large it can be while preserving these attributes remains for future research”. If one of these trends could not be sustained, my guess is that it would be fiscal constraints rather than monetary ones. While it’s great to see rising Federal debt not adversely affecting Treasury markets, the chart on the left reminds me of The Day of the Triffids. 2 HOUSE_OVERSIGHT_025243