from Follow the Money

When will the bond market wake up

January 25, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Budget, Debt, and Deficits

I know, I know, Morgan Stanley’s investors have spoken, and there is no bond market bubble.

But the federal government certainly is swimming in a sea of red ink.

I hope we have asked the Bank of Japan, the People’s Bank of China, the Central Bank of China (Taiwan), the Bank of Korea, the Reserve Bank of India, the Bank of Russia, the Monetary Authority of Singapore, the Monetary Authority of Hong Kong, the Bank of Mexico and many others to up the limit on our credit card. Alas, our bankers may not be thrilled to be asked to keep on financing us: the US government only pays 4.2% (less for short-term money), a far cry from what American banks charge to Americans wanting to borrow just a bit more on their credit cards.

A while back there was lots of talk about how FY 05 budget deficit would be smaller than the FY 04 budget deficit. I certainly remember this piece by David Greenlaw of Morgan Stanley. Well, the administration now estimates the deficit at $427 billion, including the their latest war supplemental. Last I checked, that is more than the $412 billion FY 2004 deficit. A strong economy and a rising deficit -- that is what happens when you try to fight the Global War on Terror on the cheap. Why should anyone take the Bush Administration’s talk of controlling the deficit seriously until they start delivering?

Some think the Administration is back to playing expectation games, and that they have swung from underestimating the FY 05 deficit to overestimated it.

The White House deficit estimate is too high, said Drew Matus, senior economist at Lehman Brothers Inc. in New York. ``Given spending initiatives, anything above the CBO estimate of $400 billion including Iraq is too high,’’ Matus said. It is ``better to be too high and announce a positive surprise than too low and adjust higher,’’ Matus said in an e- mail.

Maybe -- the CBO estimated the FY 05 deficit at $370 billion, and they officially estimate than continuing "war spending" at the FY 04 pace would only add another $30 billion to their overall estimate, bringing the deficit up to $400 billion. I think that works out to spending about $60 billion for the year, or around $5 billion a month, on Iraq and Afghanistan. I suspect that is a bit too low; we probably will need to spend more in Iraq this year than last year. The insurgency is not getting weaker. $370 billion + $80 billion, or $450 billion, may be too high: it implies FY 05 spending $105 billion in Iraq and Afghanistan, or about $9 billion a month. We will see -- $420-430 billion actually seems like a reasonable estimate to me.

And remember, this deficit comes at a time when the interest rate the US government is paying on its debt (thanks in part to a bit of strategic maturity shortening) is unusually low.

The CBO’s official long-term forecast is not really even worth discussing: the CBO, by law, had to assume all the tax cuts expire at the end of 2010, and that discretionary spending falls in 2006 and 2007 because the end of war-related supplementals lead to sharp falls in defense spending. More realistic forecasts, including the informal forecast delivered by the CBO’s director in his briefing today, imply deficits of $350 billion or more from now on. Here is one way of thinking about the likely future course of the deficit. Revenues are likely to stay at roughly 17% of GDP if the tax cuts are made permanent (the CBO estimates revenues of 16.8% of GDP this year). Mandatory spending is likely to stay at around 10.8% of GDP for a few years (before really increasing after 2010). Discretionary spending -- including defense spending -- will probably stay in the 8.0% of GDP range, barring a big fall off in defense expenditures (CBO forecasts 7.6% of GDP, but the supplemental will increase that to between 7.8%-8.3% -- depending on whether it is a net +30 or a net +80). That allows for some rise in defense/ homeland security spending to be offset by some cuts in non-defense spending. Our interest bill is likely to rise by 0.4-0.5% over the next few years, to 1.9% of GDP (it could well rise much more -- the CBO’s forecast for interest expenses assume that falling deficits stabilize the US "publicly held" debt to GDP ratio at 38%; if higher deficits than the CBO forecasts push the debt to GDP ratio rises to say 42%, the interest bill would go up to 2.1% of GDP). Those assumptions push spending up to over 20.7% of GDP, barring any offsetting changes -- and generate estimated deficits in the 3.5-4.0% of GDP range. 3.5% of estimated GDP is $526 billion, about two times the Administration’s ridiculously convoluted FY 2009 deficit target.

One last note: Social Security is running a major surplus, keeping the deficit a lot smaller than it otherwise would be. I am all in favor of proposals to end the practice of netting out social security’s surplus from the consolidated budget, to present a better picture of the government’s true finances. That picture is not pretty: think deficits of $600 billion, or 4.9% of GDP, in 2005, rather than $430 billion, 3.5% of GDP. Try doing the present value of 5% of GDP "on budget" deficits forever ... I guarantee you it is a lot more than the $10 trillion present value hole in Social Security. The cash flow deficits creating that present value hole don’t start til 2042, or 2052, and even then they are much smaller, as a share of GDP, than the United States’ current structural fiscal deficit.

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Budget, Debt, and Deficits

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