Wednesday, October 31, 2012

The Debt of Unemployment

In the United States
Calls for fiscal policy change have arisen in the US - for both spending cuts and tax increases.  A so called fiscal cliff will be enacted at the beginning of 2013 whereby some spending is reduced and some tax revenue increased.  The recent recession has created a large budget deficit, bringing gross federal debt to $16 trillion with a net federal debt of $11 trillion (non-intragovernmental).
Quarterly yearly change in US federal debt held by the public (blue) and the monthly unemployment rate (red).
During recessions, when GDP growth decreases and unemployment increases, tax revenue decreases and unemployment insurance increase (as well as other welfare spending).  The combination of declining revenue and rising spending on such a short time scale can only be funded by issuing debt to the public (investors, foreign governments, etc).

Annual federal budget surplus or deficit (blue) and the monthly unemployment rate (red).

Since the early-1970s, the US has run some very large non-wartime budget deficits.  The budget surpluses of the late-1990s almost seem like a fluke - perhaps the culmination of a secular bull market in stocks from 1982 to 2000.  Since the end of the secular bull market, we have now gone into a secular bear market.  In the late-1990s,  an unprecedented increase in housing market prices began; the housing bubble deflated in the mid-2000s, and the government has been running a large deficit since.

Various orders of economic cycles at work. Unemployment data at FRED goes back to 1948; the unemployment rate in 1934 was about 22%.
The situation in Spain, where a real estate bubble has formed a very large economic imbalance, is experiencing a similar yet harsher situation compared to the US.  Spain and other fiscally troubled countries have been told they must cut spending from their budgets.  The austerity measures have thus far lead toward sky-rocketing unemployment while the European Debt Racket seeks to impose its will.  Spain is stuck in a Catch-22 in which its fiscal policy becomes a type of end-all-be-all solution while in either case (remaining in the Euro or exiting) real estate must go down, employment must increase and real income must grow.

Spain's neighbors think that by adjusting Spain's budget deficit to 5% of GDP somehow everything will be fine again.
No stranger to high-unemployment, Spain's unemployment rate is now rising above 25%, and welfare is now a major transgenerational benefit.  The unemployed youth, victims of the post real estate bubble, are relying upon family household wealth and family income to support themselves, often in the form of government welfare.  The high unemployment rates Spain felt in the 1990s are now being cast into a greater long-term structural problem - as real estate prices decline so too will household net worth.

The combination of falling real estate prices and high unemployment will have the effect of driving down labor costs in Spain - recently passed by Australia as the 12th largest world economy.  This phenomena is happening in other Euro countries.  For Germany, the looming prospect of slower-than-expected growth in China and contracted purchasing power in their Euro neighbors has already driven down factory production outlook - a likely indicator of increasing unemployment.

Compare and Contrast
Fiscal restraint is needed in Spain but that can only happen when unemployment rates decline.  What needs to unwind in both Spain and the US (and throughout much of the world) is inflation disparity.  As real estate prices rise, people are priced out of the market, and they transfer a greater share of their income to pay rent or mortgage.  In the long-term, only an increase in income or decline in real estate value can resolve such a disparity. 

When inflation lead GDP growth and real estate prices greatly outpace the growth in real income the consumer becomes overleveraged.  In order to pay for the deficit, as a result of this imbalance, the US has run a carry trade amongst interest rates.  To run the carry trade, short-term rates are lowered relative to long-term rates.  Therefore, the short-term debt is rolled over at the expense of passing interest along to the long-term debt (which pays the yield).

The carry trade has been most pronounced since the early-1990s recession.
In Spain, this past summer, interest rates on 2-year and 10-year bonds rose.  How much longer can Spain pass along interest payments while unemployment continues to increase?

The great convergence, at the heart of the matter many countries benefited from the "artificially" low interest rates under the one exchange rate mechanism (essentially a currency peg). Since problems in the economy cannot be corrected with exchange rates they must be corrected with taking on unsustainable debt.  Germany (blue), France (purple), Euro are (orange), Italy (green) and Spain (red).

1 comment:

  1. Some really great graphs here, Luke. And I like the commentaries you put under each graph, too.