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More guns, less butter, improbable deficit reduction target

Author: Roger M. Kubarych
February 10, 2005
Council on Foreign Relations

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Europeans would like many things from the Second Bush Administration: more respect, less sarcasm, more patience to negotiate thorny problems, fewer threats – and a cut in the Federal Government’s budget deficit. They are getting the initial installment on the first four through Secretary of State Rice’s successful European trip. They are hoping the ambitious budget message that President Bush sent to Congress this week will turn out to be a major turning point in what up to now has been a complacent, sometimes even dismissive, attitude toward fiscal discipline. They should not lose hope, but Congressional resistance is likely to lead to some disappointments.

Near-term pessimism, long-term optimism against a backdrop of conservative Republican priorities: that is a quick summary of the fiscal year [fy] 2006 budget.

THE 2006 BUDGET

Fiscal Years, as % of GDP or $ billion

graph

Source: White House, OMB

The budget proposal clearly shows the priorities of the Bush administration and of the right-wing of the Republican Party that dominates policy-making these days: low taxes, high military spending, untouched entitlement programs (pending elaboration of a proposal for sweeping reform of Social Security), and sharp cuts in domestic discretionary spending. This is the platform on which President Bush ran for re-election and it is how he wants to govern. The program is advertised to cut the budget in half through fy 2009 -- that is, over Bush’s second term. Actually, it is only cut in half against a deficit projection for fy 2004 that was highly exaggerated. But as a ratio to GDP, the projected deficit would fall by even more than half: from 3.6% of GDP in fy 2004 to 1.5% in fy 2009. None of the improvement comes from revenue raising measures, because none is proposed. Taxes go up only in line with growth in the economy.

But according to the White House,

  • Overall discretionary spending is set to rise by just 2.1% a year, lower than the rate of expected inflation.
  • Non-security discretionary spending is set to fall by nearly 1% a year, the tightest such restraint proposed since the Reagan Administration.

Over 150 programs are targeted for cuts. Among others, these include popular subsidies for farmers, the nationalized Amtrak rail system, and beach restoration. Veterans programs are slated to rise, but less than inflation. Even conservative Republicans will find much of that unacceptable. The budget also calls for reductions in various education, environmental, and housing programs. Many of these requests have been made in prior budgets of the Bush administration but were overturned by Congress.

The other important consideration is the budgetary cost of a flock of new initiatives that the Bush administration is proposing. In the area of domestic discretionary spending, the White House Budget Overview lists 28 such programs, with a cumulative price tag of over $100 billion through fy 2010. If these are legislated, the likelihood that the budget deficit can be brought down to 1.5% by fy 2009 becomes even more remote.

Moreover, the budget as submitted does not contain complete estimates for military costs of continuing operations in Iraq and Afghanistan in fy 2006 and beyond. It does not incorporate transition costs of any Social Security reform effort. And it side-steps the thorny issue of revision of the Alternative Minimum Tax or AMT. That is the parallel income tax system which was originally imposed on wealthy individuals to make sure they paid some taxes but which now applies to millions of upper middle class professionals, especially in states with high state and local tax burdens. Political pressures are building to restore the system to its original purpose, but the lost revenues would be several hundred billion dollars over the next several years.

Therefore, given the omissions and the large areas of controversy, the White House budget numbers have to be viewed only as a starting point for several months of possibly fractious negotiations with powerful Congressional leaders. The President will not get all that he is asking for. But he has taken the first step and is clearly committed to substantial budget reduction. Wish him luck.

What about the Democrats? They will play little or no role. Procedural rules adopted years ago protect the budget process from filibusters. Thus, it only takes a simple majority in each house of Congress to pass a budget resolution. So the key compromises are those between conservative and moderate Republicans. The power of the President is therefore less obvious than it may appear on the surface – and certainly far less than European heads of government are accustomed to. Indeed, the budget submission proposes a number of reforms of the budget process, including imposing caps on discretionary spending and giving the President what are called “line-item veto” powers, something that both Democrat and Republican presidents have long sought but which Congress has never approved. President Bush is unlikely to have much better luck this year, either.

Economic Assumptions

It has become standard practice for the Office of Management and Budget [OMB] to prepare the budget based on economic assumptions that do not stray too far from the consensus forecasts of private-sector economists. These are shown in the table below.

MAIN ECONOMIC ASSUMPTIONS

Calendar Years

graph

Sources: OMB

The projection of a small rise in the budget deficit in the present fiscal year and only modest change in fy 2006, when omitted Iraq-Afghanistan expenses are incorporated, signifies a small positive fiscal policy thrust to the domestic economy. Economic growth will be hardly different from what would otherwise be forecast based on likely Federal Reserve monetary policy tightening. That means a relatively high level of business investment, moderate consumption growth, and a rising current-account deficit, but at a decelerating pace as the effects of prior depreciation of the dollar gradually work their way through the economy.

Fiscal thrust does not turn negative until fy 2007 and only in fy 2008-2009 is there a strong contractionary element put in place. That would tend to reduce domestic demand as disposable incomes grow more slowly and as the multiplier effects of reduced government spending take effect. Growth in both consumption and capital expenditures would tend to taper off, curbing import expansion and setting the stage for a likely decline in the magnitude of the current-account deficit. By fy 2009, the current-account deficit as a ratio to GDP would probably settle back to where it is now or even slightly below.

Implications for the bond market

According to the budget document, new public issuance of US Treasuries will cumulate to $2 trillion over the fy 2005-fy 2010 period. The total debt held by the public will go up almost 45% from $4.3 trillion today and will rise to 39.1% of GDP from 37.2% of GDP at present.

The actual totals are almost certain to be higher. That is because not all the proposed budget cuts will be implemented and because of the costs that will arise from passage of some of the Bush administration’s own spending initiatives. For example, an independent government accounting watchdog has revised up sharply the medium-term costs of the President’s recent prescription drug program. That alone could add as much as $20 billion a year to future deficits, according to private budget experts.

Moreover, only a small fraction of military outlays for Iraq-Afghanistan are formally budgeted. (As Defense Secretary Rumsfeld told journalists, the real meat will be in the “supplementals” – that is, supplemental budget requests, which are the main mechanism for Congress to appropriate funds for those actions.) So the budget deficit as a proportion of US GDP is unlikely to dip much below 2.5% through fy 2010 and may average between 2.75% and 3.0% for the next three or four years. That would add another $500 billion or somewhat more to cumulative net borrowing from the public through the end of this decade.

In short, bond markets will get little respite from sizable new issuance, although as in the past a considerable portion of gross Federal debt will go into the Social Security Trust Fund and other governmental investment vehicles.

DEBT HELD BY THE PUBLIC

Fiscal Years, $ billion

graph

Source: OMB, US Treasury

What’s even more bizarre is that, taken at face value, the budget assumptions cry out to potential investors, whether domestic or foreign: Don’t buy our bonds! That is because the White House economists are assuming substantial increases in the yield on 10-year US Treasuries.

White House Interest Rate Projections

Calendar year averages

graph

Source: OMB

So investors buying bonds today at the relatively low yield of 4.03% would face a considerable mark-to-market loss over the next two to three years that would not be fully offset by the coupon on the bonds. Their total rate of return would be negative, and they would be better off waiting it out in cash instruments until yields stabilized in fy 2008.

However, notwithstanding this implicit warning, the initial market response to the budget was broadly favorable. The budget as a political document positioned President Bush as a born-again fiscal disciplinarian. That is something that he was not during his first term in office, when domestic discretionary spending went up at nearly double-digit rates in some years. Indeed, he failed to veto a single bill during those four years. Shifting from a highly stimulative fiscal policy to a more restrictive policy is ordinarily associated with lower real yields on government bonds, all other things equal. Bond investors may also hold the view that greater fiscal discipline would enable the Fed to maintain greater monetary accommodation than would otherwise be possible, allowing the entire yield curve to remain positively sloped.

What about the corporate bond market? Tighter fiscal policy tends to increase the personal savings rate and thus is not favorable to corporate profit margins. Companies with weaker financial positions would tend to do relatively worse under this regime than firms with strong balance sheets, high cash flow, and solid credit ratings. Thus, the credit quality yield curve would tend to steepen if the Bush budget was fully implemented. Indeed, even if it was only partially implemented, which is most likely, investors are likely to be more discriminating among the different corporate credits. Naturally, spreads on junk bonds would widen most from present depressed levels, but all but the highest rated credits would be adversely affected.

Impact on the dollar

The impact on the dollar of the Bush budget is not easy to discern. Many investors take for granted that a lower budget deficit will almost automatically translate into a lower current-account deficit and a lower current-account deficit will strengthen the dollar. Something like this is usually true for developing countries, but it has not been consistently the case for industrial countries, especially the US and Japan.

For example, the US achieved large budget surpluses in the late 1990s, yet the current account deficit rose throughout. The dollar strengthened despite the rising current-account deficit, however, as a huge surge of foreign direct investment into the US elevated the demand for dollars. Conversely, Japan experienced enormous budget deficits during most of the past dozen years, while maintaining a substantial current-account surplus throughout that period. The yen went through periods of significant strength and steep declines almost without regard to either the budget deficits or the current-account surplus.

FOREIGN HOLDINGS OF FEDERAL DEBT

Selected Fiscal Years

graph

Source: OMB, US Treasury

This said, a move to greater fiscal discipline is bound to enhance the respect of foreign investors for the policy acumen of the Bush administration and that should pay off in a greater willingness among private foreign investors to accumulate dollar assets. Those bond acquisitions will replace foreign official purchases as the main source of finance for both the budget and the current-account deficits.

But to the extent that Congress waters down the Bush proposals, the subsequent financial market reaction is bound to be one of disappointment and frustration with the messy US political system. It is a system in which the Executive Branch of government apparently has relatively little control over what the Legislative Branch decides to spend.

President Bush’s budget Director, former Goldman Sachs executive Josh Bolten, sought to allay these fears by insisting that unlike so many others, this budget would not be DOA (dead on arrival). After all, a newly re-elected President Bush comes into the budget negotiations with considerable political clout.

But members of Congress already have their eyes on the next election in 2006, and they will not be eager to embrace unpopular cuts in their favorite government programs, regardless of the risk of disapproval in the financial markets.

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