The Budget Stupid
Many of you are various states of disbelief or anger about the state of the union [as opposed to The State of the Union speech which was also a source of angst!]. So I thought I should give a few comments about where we actually are, as compared to where Bush says we are. So here goes:
We are not heading into 2006 with a “full head of steam”. Sorry George that’s not correct. The economy has been growing for a few years now so we have a good idea of what it looks like. It is underperforming when compared with past growth periods in the following categories: growth in GDP, personal consumption, private domestic investment, net worth, income from wages or salaries, and employment. Only corporate profits have been above average. While the pace of job creation has picked up somewhat in recent months is is abysmal by post-World War II standards. This is not a very good scorecard for the administration. Only if you derive your income from capital can this economy be described as ‘good’. Everyone else is getting progressively more and more squeezed, and the pooorest are getting left behind completely.
This dismal performance has come at great cost: the collapse of the Fedral Budget. The tax cuts clearly did nothing to stimulate growth, but they surely punched a hole right through government revenues. As a result we now have a growing deficit that looms as a major imbalance and potential trouble spot for the future. Let’s be clear: the tax cuts did not create sufficient growth to offset themselves. That they did is the tired old supply side argument that Bush and his minions roll out to defend them. A look at the budget is all that’s needed to refute that claim: Federal revenues have been hammered and in 2004 were lower as a share of GDP [at 17.5%] than at any time since 1959. That they recovered in 2005 is not a surprise either: there were a number of one time revenue sources, mainly in corporate taxes, that produced what Bush refers to as the “revenue recovery”. They are not repeatable. So the projection of a rising trajectory from a low in 2004, through an increase in 2005 toward more revenue growth beyond 2006 cannot be made. Besides which Greg Mankiw, until recently Bush’s economic advisor, has said: that there is “no credible evidence that tax revenues … rise in the face of lower taxes”.
Why is the deficit a problem? Because to the extent that the government borrows to pay its bills it “crowds out” other borrowers who might have otherwise been able to borrow and put the money to better use [they cannot get the funds because the U.S. Treasury has better credit rating and therefore gets first crack at the money markets]. A second problem is that the continuing run up in debt exposes the U.S to an interest rate risk. Right now the payment of interest on debt is a moderate, but growing, part of the Federal Budget. As debt payments continue to grow they will begin to take money from other programs that the government might like to spend on. This conflict will accelerate if interest rates rise: rates have been very low for the duration of the entire Bush regime and so have not yet become an issue. If investors begin to feel that the deficit is permanent or out of control they might start to look elsewhere for investment opportunities hence causing U.S. rates to rise. This is because the U.S. will have to pay higher rates to keep them investing here as opposed to elsehwere and to compensate for the riskier state of the U.S Treasury. We should not forget that not all the debt is bought by foreign investors: a large majority of the total is owned by American investors, so if rates rise the values of their existing portfolios will drop and may damage other parts of the economy as a result.
Finally I want to point out that the Federal Deficit is bulging not because domestic spending is out of control, but because, as I just said, revenues collapsed. In any case, the real run up in spending has been on security: either in the miltary or homeland security budgets. When expressed in raw dollars the increase in spending since 2001 has been 18% for domestic programs and 58% for security. But when these figures are adjusted for inflation and population growth, as they should be for accurate analysis, we find that domestic programs had zero growth while security rose 34%. In other words, for all the panic about run away entitlement programs they have not contributed to the budget problem at all: we have a security spending problem, not an entitlementy spending problem. Now I admit that entitlements are poised to take off and need careful debate about their budget impact, but right now they are not the issue that Republican lawmakers are trying to make them into.
So as we head deeper into 2006 here is the overview: Consumer spending, because wage and salary growth has been poor, has been supported by debt — consumers have borrowed to buy things. This borrowing has been contingent on low interest rates and booming house prices, two things that are already going away. So consumption may well weaken. If it does, the weakness we saw in the fourth quarter of 2005 will continue into 2006. Energy prices are likely to stay higher than the last few years and will therefore be a drag on spending. Corporate profits and investment will start to fade as they always do in the latter parts of a business cycle. The trade deficit will be trimmed by slackening demand, but not by increasing domestic production. This all makes the Federal Deficit more important: if it stays higher it stimulates the economy, but if it shrinks it acts as a drag. And this is the conundrum Bush has created: by slashing revenues in a series of inefficient tax cuts he gave up the chance to stimulate the economy in 2006 or 2007 just when he might want to. In other words he sacrificed his flexibility in the future for what has turned out to be a very poor return over the past three years. He added rather than reduced risk in the economy.
The odds are that there is enough strength to stave off a recession, but I doubt that the year will be strong. And the risks are increasing, not decreasing.
