The Truth About QE, The Deficit, And GDP Growth

by: Skeptical Investor

In the financial press and elsewhere, the Federal Reserve is overwhelmingly credited with having kept the recent economy from falling back into recession through its use of a series of quantitative easing (QE) programs. But the transmission mechanism between QE and economic improvement is acknowledged at the same time to be at best indirect, and is frequently explained in terms of a wealth effect. In this view, the Fed's purchase of bonds (Treasuries and mortgage-backed securities) reduces the corresponding interest rates, which eventually raises other asset values (e.g., stocks and real estate), and the new wealth generated stimulates private sector spending, which increases GDP. There is perhaps some truth to this, but it is somewhat uncomfortable to suppose that we are relying on the creation of sequential asset bubbles for the solution to our economic troubles.

Unfortunately, a more accurate explanation of the primary source of our modest economic improvement since the "great recession" may lead to even greater discomfort, and this may explain why one seldom hears it discussed. The high federal deficit maintained in recent years is typically viewed as an inconvenient problem to be addressed sometime in the future once the economy improves, but better left alone for the present. But in actual fact, it is precisely this high deficit that deserves the credit for the economic recovery that has been achieved. To see this, it is important to understand the relationship between deficit spending and GDP. This is thankfully not very difficult. One common method of calculating GDP, known as the expenditure method, can be simply expressed as the following sum: GDP = Private consumption + Gross investment + Government spending + (Exports − Imports). The last term is included to represent net domestic production that is consumed outside the country. While GDP can be calculated in other ways, these ideally should yield the same result.

The most important aspect of GDP to recognize for the present discussion is that the definition is indifferent to where the funds for these expenditures come from, and in particular whether they come from income or from an increase in indebtedness. So for example, when the government indulges in deficit spending, or when private sector spending is financed by incurred debt, the resulting expenditure raises GDP directly, with no penalty for the increase in the corresponding debt. Higher GDP results if the government uses the borrowed money to consume end products and services directly (as where an aircraft carrier is purchased) or if the funds are used for transfer payments that are not themselves included in GDP (as in the case of unemployment benefits or social security outlays), where these transfer payments are ultimately used to purchase products or services that are included in GDP.

There are of course numerous complexities involved in the precise evaluation of the terms in the GDP definition. But one can still estimate the impact of deficit spending on GDP behavior during the last few years since the great recession. This is done here using data provided by the Bureau of Economic Analysis (BEA) within the U.S. Department of Commerce . Figure 1 shows the variation of "nominal" U.S. GDP (i.e., unadjusted for inflation) during the period from 2005 through the end of 2012. Also shown is the federal deficit incurred during the same period. Finally, by subtracting the federal deficit (which is also unadjusted for inflation) from the GDP, we produce a quantity that is referred to here as the "nominal deficit-adjusted GDP". This is viewed as representing the nominal GDP that would have been obtained if the U.S. had, during these subject years, avoided the deficit by balancing the federal budget. Of course, this simple view ignores the many secondary effects that the resulting lack of stimulus would have produced, so the results can probably be seen as quite optimistic.

Figure 1. Comparison of nominal U.S. GDP with a "deficit-adjusted" nominal GDP obtained by subtracting the annual deficit.

However, if we take the results at their face value, it might appear that even without the deficit "stimulus", the economy would have reasonably recovered by now, although it would have taken much longer to do so. But this appearance is misleading, since the GDP values in Figure 1 do not take inflation into account. A more realistic assessment of the effects of federal deficit spending is shown in Figure 2. Here, again taking data directly from the BEA, the variation of the "real" (i.e., inflation-adjusted) GDP over the same time period is shown. Specifically, the values plotted represent the GDP in "chained 2005 dollars", obtained by applying the appropriate "GDP deflator" to the values in Figure 1. A "real deficit-adjusted GDP" is also defined and shown in Figure 2 for comparison by applying the same inflation adjustment to the deficit-adjusted GDP values shown in Figure 1.

Figure 2. Comparison of real U.S. GDP (in chained 2005 dollars) with a real "deficit-adjusted" GDP obtained with the same GDP deflator.

The conclusions seen here are more sobering. As a result of deficit spending, the economy, as represented by the real GDP level, is not seen to have recovered to its previous peak level (the 2007 value) until some time during 2011. Without this deficit spending, the real GDP loss would have been strikingly deeper (11.6% rather than 3.4%), and we would still be waiting for a recovery to the previous peak. As admitted above, this simplified analysis ignores certain factors that can amplify or suppress the short- and long-term impact of various fiscal changes on GDP. The values of such factors are in any case controversial, particularly when the relative merits of deficit reduction through spending reductions or tax increases are the subject at hand. But it seems clear that deficit spending, and not QE, has been the important source of our economic recovery since the great recession. It is also obvious why few politicians are interested in serious reduction of budget deficits any time soon, certainly while they expect to continue in office. Something would seem to be amiss in the economy if the fact of running an excessive fiscal deficit can be viewed as a good thing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.