Viewpoints

When it comes to the high and rapidly rising Federal debt, which is now $36 trillion, a lot of attention is paid to the increasing debt service costs, how they are impinging on spending programs, and potential implications for interest rates. Foreign holdings of US treasuries, which amounts to $7.5 trillion, or 31% of total publicly-held government debt, receive a lot of attention. And there’s a large amount of research on the Fed, which through its massive asset purchases, is the largest holder of U.S. treasuries, with $4.4 trillion. This note does not address any of those issues. Rather it addresses the dramatic rise in US treasuries owned by U.S. state and local governments.

The U.S. Treasury estimates that state and local government holdings of treasury securities have soared from roughly $750 billion prior to the Covid pandemic to a whopping $1.7 trillion in 2024Q3. That means state and local governments rank as the second largest holder of US treasuries behind the Fed, well ahead of foreign holders Japan, China and OPEC nations. This observation reflects the evolution of the U.S.’s structure of fiscal federalism and has far-reaching implications for the different fiscal roles played by the different layers of government. It also a central issue in the current initiatives that aim to streamline the government and reduce deficits.

Some of the biggest components of Federal government spending is distributed directly to individuals: Social Security and other income support programs, medical care providers for Medicare and Medicaid, U.S. treasury creditors for debt services costs, and defense contractors. A big chunk of Federal spending that has been authorized by Congress is disbursed to state and local governments for a wide range of activities—education, transportation and infrastructure, commerce and judiciary, etc. State and local governments hold these disbursements along with other savings that result from a surplus of receipts over spending in US treasury securities. All states maintain “rainy day” funds and use them for a variety of purposes.

Prior to the pandemic, as shown in Chart 1, state and local government holdings of US treasuries hovered around $720 billion. Their dramatic rise during 2020-2021 reflected primarily the surge in Covid-related Federal government fiscal transfers to state and local governments that culminated with the $350 billion disbursement as part of President Biden’s $1.9 trillion American Rescue Plan of March 2021. According to the official U.S. Treasury Fact Sheet, “The Rescue Plan will provide needed relief to state, local, and Tribal governments to enable them to continue to support the public health response and lay the foundation for a strong and equitable economic recovery.” (March 18, 2021).

By then, the economic recovery had strengthened significantly and was generating rapid growth and recovery in state and local tax receipts. At the same time, the Federal government was distributing additional Covid-related health care subsidies to state and local governments. State and local government finances quickly repaired, as tax receipts accelerated and health-related spending demands subsided. Unlike Federal taxes, most state governments do not index their individual and corporate income taxes to inflation, so their elasticities of tax receipts with respect to state income is far higher than for the Federal government’s tax receipt elasticities. Thus, increases in real personal incomes and soaring inflation boosted nominal incomes and tax receipts. The quick rebounds in retail sales as the economy reopened generated a big boost to state sales taxes. The soaring home prices generated an acceleration in local government property tax receipts in some states like California, this occurred with a short lag; in other states it unfolded with a longer lag.

Can it be that every geographic region of the World, save for South/Central America practices unfair trade with the US? Since 1976, the only geographic region of the World that the US has come close to running a trade surplus in goods is South/Central America. Are the other regions of the World practicing unfair trade practices with the US or might there be another reason why the US consistently runs goods trade deficits with them?

Of course, if I did not think there is another reason, I would not have posed the question. Consider the following identity:

Gross Domestic Production = Gross Domestic Purchases + (Exports – Imports)

Rearranging some terms, we get:

Gross Domestic Production – Gross Domestic Purchases = (Exports – Imports)

If Gross Domestic Purchases exceeds Gross Domestic Production, then imports must exceed exports. In simpler terms, if the households, businesses and government entities of a country, collectively, spend more than they produce, they must run a trade deficit. Collectively, the rest of the World is “lending” the trade-deficit country goods and services.

Let’s go to a chart. Plotted in the chart below are the annual trade deficits in goods the US runs (blue bars) along with the difference between annual US Gross Domestic Production and Gross Domestic Purchases (the red line).

The Chinese corporate profit cycle is worsening, which together with risk aversion in the household sector, signal the economy is yet to bottom.

Manufacturing is struggling

In business cycle analysis framework the profit cycle is the single most important business cycle indicator. Profits are the core driver of economic activity. It underpins investment decisions, drives innovation and the fluctuations in economic activity. The profit cycle is the leading indicator of the business cycle and marks the tipping points. Moreover in a downturn the stabilisation of the profit cycle precedes the bottoming of the economy. The Chinese corporate profit cycle downswing deepened through the first three quarters of 2024 (Figure 1).

Sort of like the chicken or the egg conundrum, a perennial question is whether the U.S. federal government has a spending problem, a revenue problem or both. In this commentary, I will compare the U.S. federal budget data with those of the euro zone. On this comparative basis, I would say that that the US has a revenue problem. Then I will examine the CBO’s latest baseline forecast of federal outlays and revenues to try to determine where our fiscal “problem” lies. I will conclude that we have both a spending and revenue problem.

Chart 1 suggests that the federal government has a fiscal “problem” inasmuch as federal outlays have, with a few exceptions, been higher than federal revenues in the fiscal years starting in 1966 through 2024. The exceptions were in fiscal years 1998 through 2001. According to the Congressional Budget Office’s (CBO) January 17, 2025 baseline (current law) forecast, total federal outlays as a percent of total federal revenues will remain above 100% through fiscal year 2029 and will remain above the 1966-2024 median of 117.05% through fiscal year 2029. This does not tell us whether forecast federal deficits are due to a spending problem or a revenue problem. Rather it just establishes that federal budget deficits relative to their median value will persist through fiscal year 2029.

The Federal Reserve Bank of Philadelphia’s state coincident indexes were mixed to soft in December. In the one-month changes, Delaware led with a .72 percent gain, and Minnesota, Montana, and Washington had increases above .5 percent. 15 states registered declines, with Alabama down more than .4 percent. Over the 3 months ending in December, 11 states were down, with Michigan off by .7 percent and Maine dropping .71 percent. Delaware, though, was up more than 1.8 percent, with Washington, Missouri, Utah and Montana also showing increases above 1 percent. Over the last 12 months, 6 states were down, and 10 others saw increases of less than 1 percent. South Carolina’s index dropped 1.52 percent. Connecticut was up 4.72 percent and Arizona rose 4.28 percent.

The independently estimated national estimates of growth over the last 3 months and 12 months were, respectively, .61 and 2.65 percent. These both appear to be roughly in line with the state numbers.

State labor markets in December remained in similar patterns to recent months. The vast majority of states reported statistically insignificant increases in payrolls from November; Missouri and Texas were the only ones showing significant gains. A few states reported insignificant drops.

Eight states had statistically significant changes in their unemployment rates—two down and six up. None of these changes were larger than .2 percentage point. The highest unemployment rates were in Nevada (5.7%), DC (5.5%), California (5.5%), Illinois (5.2%), and Kentucky (5.2%) The number of state with unemployment rates under 3.0% declined, with Nebraska, New Hampshire, North Dakota, South Dakota, and Vermont remaining in that category. South Dakota’s 1.9% was the lowest in the nation.

Puerto Rico’s unemployment rate was unchanged at 5.4%, while the island’s job count was essentially stable (the point estimate fell by 100).

With price stability as a key mandate, the Federal Reserve bears a significant responsibility to guarantee that the targeted price statistics accurately reflect people's experiences and are not influenced by political or statistical manipulation. However, the Fed's price targeting regime has become misleading and unbalanced since the price measure it targets has become less relevant to "actual" inflation. The Fed nowadays lacks a "Greenspan," or an individual who is both an expert in economic statistics and methodology and possesses the political power and influence to challenge the accuracy of published statistics or request their review. The matter of accurate price measurement is not just academic; it has real economic and financial effects.

Years ago, the Price Statistic Review Committee (PSRC), a group of academics, economists and statisticians, stated that, “If a satisfactory rent index for units comparable to those that are owner-occupied can be developed" then the committee recommends that BLS to use this approach for house prices and related expenses.

The General Accounting Office (GAO), which released a comprehensive report on how housing costs are measured in inflation metrics, made a similar suggestion. The GAO stated, "Most owner-occupied housing units differ significantly from many rental units. To apply rental equivalence in the CPI, a sufficient number of rental units must be identified that are comparable to owner-occupied units in terms of size, location, and quality, allowing the BLS to create a sample that accurately reflects owner-occupied houses."

In 1983, based on recommendations from the PSRC, GAO and others, the Bureau of Labor Statistics introduced the owners' rental equivalence method to estimate housing costs of owner-occupied homes. This estimation procedure continued until 1998, when the BLS announced that it had to discontinue the owner-sample due to an insufficient sample of owner-housing units. Moving forward, they decided to link the rent estimates for owners' rent to the other rent series. Neither the PSRC nor the GAO provided any comments.

The owners-occupied rent series constitutes roughly fifteen percent of the Fed's preferred price target, the personal consumption expenditure deflator (PCE). Combined with the thirty percent of the PCE that individuals do not buy, nearly half of the PCE deflator reflects an inflation rate derived from administered and non-market prices or imputations. How can this be regarded as a reliable or accurate measure of actual inflation people experience?

Price data should represent "actual" inflation, not a statistical distortion. Considering its essential role in shaping both monetary and fiscal policy, it is crucial for the price data to be accurate, relevant, and objective. The general public benefits from "actual" sustainable low inflation. But who gains when inflation might be understated, or its cyclical fluctuations are dampened or eliminated due to a new statistical method?

Over the past sixteen years, from 1998 to 2024, the average S&P 500 P/E ratio was 26.7. In contrast, during the preceding fifteen years, from 1983 to 1998, it averaged 15. Is this just a coincidence, or could the alteration in inflation estimation for housing costs, combined with the Fed's emphasis on an inflation measure representing only half of the actual inflation rate experienced by people, partly explain this shift? This misleading measure of inflation and policy approach has led to maintaining official rates lower than they might have been otherwise, which benefit finance, especially equity investments.

According to history, "Washington" is unlikely to change it frameworks (price and policy) unless another crisis occurs. The financial press could increase public awareness of this issue, but it has not done so yet. As long as the existing price and policy frameworks remain in place, finance benefits while "Joe Six Pack" loses ground to "actual" inflation.

The persistently stronger growth of the U.S. economy relative to most other advanced nations has been the driving factor that has resulted in a stronger stock market with higher valuations, higher interest rates and a strong US dollar. A handful of charts highlight the sizable differences in economic and financial market performance across nations. Nothing is permanent, and things—particularly shifts in economic policies--can initiate sizable changes in trends. As we assess shifts in economic policies and central bank monetary policies, it’s important to keep in mind the economic fundamentals that drive financial markets.

Real growth comparisons. Chart 1 shows the cumulative percent change in real GDP since 2000 in the U.S., UK, Europe and Japan. In general, the faster growth in the U.S. reflects a combination of healthier gains in labor force and productivity. Real GDP growth in the UK matched the U.S.’s pace from 2000-2008, while Europe nearly kept pace, benefiting from the boom in global trade fueled by the China super-cycle. While the decade following the Great Financial Crisis was lackluster in the U.S., it was markedly slower elsewhere, particularly in Europe, which was hampered with ongoing financial crises during 2010-2014.

Chart 2 shows the same data but indexes real GDP to 2019Q4, which highlights the U.S.’s continued healthy growth following the pandemic-related contraction in the first half of 2020, while growth in Japan, the UK and Europe has been particularly weak. The persistent outperformance of the U.S. economy is sizable.