When you have a job and are earning some income, typically you look to save. In other words, spend less than you earn, and tuck away or invest the difference.
If you lose your job, you lose your pay cheque. Being unemployed means drawing down on those savings. You run your own budget deficit, if you will… spending more than you earn.
Get another job, and hopefully you start running a budget surplus again.
Economies and governments operate in much the same way. When the economy is doing well, unemployment typically trends down, wages increase along with spending, investment and (hopefully) tax receipts for the government.
This is a time that the government can run a budget surplus, or at the very least a narrow deficit.
When the economy turns, as it ultimately will because economies grow in cycles, unemployment rises, tax receipts dwindle, and maybe the government is paying out unemployment benefits and hit with other costs as it tries to inject some spending (or fiscal stimulus) to try and soften the cyclical blow.
As a result, historically we see a very clear correlation between a government’s budget deficit and its unemployment rate. As unemployment rises, so too does the deficit and vice versa.
Take a look at the chart below tracking these metrics in the U.S. for the last 40 years. The correlation is visible. As the Global Financial Crisis (GFC) tore through the U.S. economy in 2008 and 2009, unemployment and the federal budget deficit skyrocketed in lockstep.
Both recovered in the five years from 2009 to 2014 as the economy slowly healed… but look what’s happened since… and, more importantly, where the U.S. economy is headed.
A yawning gap…
The Committee for a Responsible Federal Budget, a fiscal watchdog group, is forecasting that in 2019 the budget deficit could rise to US$1.12 trillion.
That’s around 5.5 percent of current GDP, an extraordinarily large deficit for a growing economy with near record unemployment, in peacetime no less (Note: previous divergences between the deficit and unemployment occurred during the Korean and Vietnam Wars respectively).
This is terrible fiscal policy. You don’t have to be a genius to figure out that ratcheting up the deficit so late in an economic recovery cycle is a bad idea. It’s simple – at some stage the cycle will turn.
Just take a look at the past 40 years of unemployment history above! It’s cyclical. This kind of policy is like ramping up your spending when you know the factory you work at is going to be closed down in the next two years.
And credit is the key word here. How does the U.S. finance this gaping deficit spending? It borrows money in the bond markets. And these are the same bond markets that are being whacked by a Federal Reserve that is increasing interest rates and hence increasing the cost of borrowing for the U.S. government (as 10-year yields are now nearly 3 percent, double the rate in mid-2016).
So, we’ve got a government that’s spending more, saving less, borrowing more and looking at rising borrowing costs – that means more of the budget spent just to service all that extra debt.
And it doesn’t set things up well for the next part of the economic cycle, the inevitable downturn. The reason deficit spending and unemployment are so tightly linked is that increased deficit spending is how you cushion a correcting economy. In the same way you spend down your savings in the leaner times. But as it stands, that cushion is being taken away.
The debt cushion is also a lot less comfortable now. When Reagan cut taxes back in ’81, gross government debt was around 30 percent of GDP. Today it’s over 105 percent… and climbing.
Heads in the sand
Most economists and market analysts are forecasting a very rosy 2018 for the U.S. – and why not? Unemployment continues to fall, the S&P500 has rebounded up 6.5 percent from its lows earlier this month. Tax cuts and overseas cash repatriations give people reason to cheer. Wages are finally starting to rise, with a 2.9 percent year-on-year increase in January, the best pace since mid-2009. And unemployment remains at its lowest point since 2000.
So why is the U.S. digging itself a fiscal hole?
