William P Rehmann : Northwestern Mutual - Economic Commentary - February 2010 : Article: Economic Commentary

Economic Commentary - February 2010

Christopher Bremer

Senior Investment Consultant

Of Moral and Material Importance – The Federal Budget

Can you guess the year and the president for the following reference?

The President has revised the budget outlook to point to an estimated net deficit for the fiscal year. This is more than the President estimated to Congress last year. Expenditures for the current year were the highest in peacetime in any year in American history. The deficit also is the highest in peacetime. This will be the ninth consecutive deficit, bringing the national debt to another all time peak.

The president referenced above is Franklin D. Roosevelt and the year is 1938. An astute federal budget observer may have realized that the most recent budget deficit recorded for 2009 in fact only represents the ‘eighth’ consecutive deficit.

Indeed, also reading Franklin D. Roosevelt’s quote in the next paragraph from The Saturday Evening Post of August 1938 may illustrate the gap between how budget deficits were perceived historically versus today.

“At the very top of the credit structure of the country, surpassing all other groups in moral and material importance, stand the obligations of the Federal Government… Happily, these obligations are secure. They suffer only to the extent that Government is permitted to be extravagant, wasteful or ill-managed. They suffer if the Federal budget is not balanced, and particularly where the deficit on one year is not cleared up in the succeeding year.”

In this month’s commentary we examine the federal deficit from three angles; the current state of the federal budget, future implications of sustained deficits, and ways to reduce the deficit.

Today’s Budget Deficit

A budget deficit results when the federal government spends more money than it takes in. The budget deficit in fiscal year 2009 (ending October) reached a record $1.417 trillion, a level equal to 9.9% of Gross Domestic Product (GDP). (Fig. 1.) The budget for the first three months of the current fiscal year is +16.8% higher than the same period last year. Government revenues for the first three months of the year declined 10.9% from same period as last year. Government outlays for the first three months of fiscal year 2010 declined by 0.4%, reflecting smaller outlays for last year’s $700 billion bailout package.

Just like the 1938 newspaper clip, as a percentage of GDP, last year’s deficit represented the largest peacetime deficit in the history of the U.S. While much of the deficit results from the fiscal stimulus package and the Troubled Asset Relief Program (TARP), many budget projections still anticipate ongoing deficits around 5% of GDP. Higher revenues and a moderation in the rate of growth of government expenditures, due primarily to the near completion of the stimulus package spending, may lead to improvements in the federal budget deficit levels.

There are many causes underlying the massive current budget deficits, including unrestrained government spending, reckless private sector expansion, and public and private debt accumulation, to a large degree, encouraged by the federal government. An emphasis on home ownership in conjunction with a sustained low interest rate policy, particularly after the Internet and Technology bubble collapse in 2000, certainly contributed to excess risk taking in the housing and commercial real estate markets.

After taking on huge liabilities that outgrew the potential to grow, governments have assumed the debt of much of the private sector. The fiscal and monetary stimulus measures were easy to enact when the world seemed to descend into depression. But in the longer term, how will governments pay the money back?

While it is easy to blame politicians for large annual deficits, at one level, deficits may represent the dichotomy of American government; a high demand for government services with a simultaneous low tolerance for taxes.

What is the difference between government deficits and debt?

Deficits are generated when the government’s total expenditures exceed the revenue that comes into the Treasury. Debt is an accumulation of annual deficits and must be paid in interest to holders of U.S. debt obligations. In order to finance the budget deficits, the federal government borrows primarily by issuing debt obligations (U.S. Treasury Bills, Notes and Bonds). The Treasury Department schedules auctions to fund the operations of the federal government and to refinance maturing securities.

Escalating budget deficits are causing a sharp spike in national government debts globally, and the U.S. is no exception. (Fig. 2.) According to the International Monetary Fund (IMF), the ratio of government debt to GDP may rise in developed countries from 78% of GDP in 2007 to 114% in 2014. Further deterioration in government revenues would likely result in an even higher spike in the debt to GDP ratio. Typically, high debt to GDP levels can be associated with slower GDP growth. The Administration’s Office of Management and Budget (OMB) recently projected the national debt to surpass 75% of GDP over the next 10 years, which would represent the highest level since the Second World War.

Future Implications

Concerns over the federal deficit are generally twofold; an immediate concern over the potential for a heightened short-term crisis and a concern over the long run structural component of running sustained budget deficits. A materialization of the first does not necessarily diminish the probability of the second. A materialization of the second increases the probability of the first at some point in the future.

Heightened short-term crisis

The specific concerns over more immediate impacts of outsized budgetary deficits depend on the country in question. For some countries like Greece and Iceland, the sharp spike in government liabilities has raised concerns globally about the ability of governments to make good on their debts. Closer to home, short-term concerns center on the possibility of investors demonstrating a lower appetite for U.S. Treasuries. In this situation, the U.S. Government may be forced into swift and unsound cuts in spending. Interest rates would spike, further choking off economic growth.

With an explosion in Treasury issuance to finance the U.S. budget deficit combined with a weaker dollar, some economists suggest that China, other central banks, and other institutional investors would shun investing in U.S. debt instruments. On the contrary, they have bought more over the past year. According to the U.S. Treasury, foreigners bought almost half of the $1.4 trillion in Treasury securities issued this year compared with slightly less than 30% of the $500 billion during the same time frame in 2008. China increased its purchase of Treasuries by 10% this year. With almost $800 billion in Treasuries, China is still the dominant foreign borrower. China has become accustomed to running trade surpluses and its holdings of Treasuries increases as a result. So far, there is no indication that foreign investors are dumping Treasuries in a meaningful manner. (Fig. 3.)

Long-term structural crisis

According to the Government Accounting Office (GAO), “escalating levels of debt illustrate that the long-term fiscal outlook remains unsustainable.”¹

Temporary, or cyclical, deficits may support economic activity or boost aggregate demand in the short-term. Structural deficits, however, reflect the long-term impact of the federal budget. Persistent long-term deficits, according to the Congressional Budget Office (CBO), can “erode the growth of future living standards by reducing national saving, which slows the accumulation of wealth, and degrading economic performance.¹

How to Reduce Deficits

Peter Orszag, the White House budget director, has stated his aim to lower the deficit to 3% of GDP within five years. Absent defaulting on debt obligations, there are five primary means of managing budget deficits and reducing debt as a percentage of GDP; faster economic growth, higher taxes, lower spending, inflation and benefiting from unanticipated economic surprises. The first three are policy decisions. The fourth is a Fed priority to keep under control. The last may result from policy decisions or from economic developments outside the control of policymakers. Excluded from this list is a commonly used tool, budgetary and accounting smoke and mirrors.

Faster economic growth

Secretary of Treasury, Timothy Geithner, has stated that this is the first option for tackling the deficit. “Our immediate imperative is to get growth back on track. It requires us to do things that are expensive and in the short term will raise deficits. If we were to not do those things, then future deficits would be higher and growth would be lower.” Higher growth in the aftermath of the recent recession would increase tax revenues from a low base and reduce the need for ongoing stimulus. Congressional ineptitude with regard to curtailing spending would reduce the positive impact of stronger economic growth.

Higher taxes

Raising taxes increased inflows into the federal coffers, but at the expense of growth. Another way of increasing tax receipts is for Congress to do nothing and let tax breaks expire in 2010. Also, policies that

create incentives to hire and promote job growth increase tax receipts. It is unlikely that Congress will want to be seen as raising taxes on the middle class in a difficult economic environment. Some tax breaks for the more wealthy, however, may expire.

Lower spending

Lower spending over time will be a critical factor. In the short-term, however, lower spending and higher taxes could neutralize the first option, faster growth.

Last year, corporate income tax revenues fell by more than 50% and individual income taxes by 20%. With total revenue declining 16% in fiscal year 2009, does Congress have the courage to offset lower revenues? (Fig. 4.)

And furthermore, from where will spending cuts be made? The ratio of discretionary spending to net budget outlays has been in a downward trend for decades. (Fig. 5.) Certainly difficult choices will have to be made here, but the opportunity for impactful spending reductions from the discretionary component of the federal budget continues to diminish. The defense budget, while historically getting a lot of negative press, is probably not big enough to make a material impact on the national debt.

Congressional precedent indicates that making tough spending choices is highly unlikely. If there is a glimmer of hope, it may lie in the recession-related stimulus spending. According to some estimates, nearly 60% of the growth in 2009 federal spending was due to the stimulus programs. Also, net interest on the public debt fell 23% as high demand for U.S. Treasuries during the 2008-2009 market dislocation periods drove down yields.

Inflation

Inflation is often cited as a classic way to reduce a country’s debt burden. Rising inflation can be a means of offsetting declining tax revenues. A rise in inflation coupled with a decline in the U.S. dollar would erode the value of U.S. Treasury investors, particularly foreign investors. Warren Buffet has indicated that inflation is the easiest thing to do, and therefore, the likeliest.

There is historical precedent in the U.S. for “inflating” down the national debt burden. Between 1946 and 1955, the debt to GDP ratio was cut almost in half as inflation averaged just over 4% during this span. There is one key difference, however, between this period and the current environment; the average maturity of debt. In 1946 the average maturity was nine years. Of the $6.6 trillion in outstanding U.S. Treasury Bills, Notes and Bonds today, 39% mature within one year and 74% within five years. Should rates rise, the U.S. government will incur significantly greater costs of refinancing the debt. Shorter maturities limit the government’s ability to inflate away high debt levels.

Unanticipated developments

In January 2007, Fed Chairman Ben Bernanke said to the Senate Committee on the Budget, “the deficit in the unified federal budget declined for a second year in fiscal year 2006… Official projections suggest that the unified budget deficit may stabilize or moderate further over the next few years.”

Our intent is not to criticize the Fed Chairman for an assessment made on the best available information at the time. Rather, the point is that, not unlike stock markets that can reverse course and exhibit directional swings of much greater magnitude than market expectations, so can drivers of economic growth and output, including federal receipts, industrial production and consumer demand.

What to Watch For

Employment is critical. Only about 400,000 more Americans were employed in December 2009 than in December 1999, while the population grew by nearly 30 million. While the economy almost certainly expanded during the second half of 2009 (fourth quarter GDP results released after publication), 800,000 additional jobs were lost. Around four in every ten of the unemployed (some six million Americans) have been out of work for 27 weeks or more. The civilian labor force has experienced a drop of 1.5 million (which excludes unemployed workers who have stopped looking for work), an unprecedented decline in the post-war period. Finally, after the 2001 recession, it took four solid years for employment to regain its peak.

Against this challenging backdrop, we monitor weekly initial and continuing jobless claims. (Fig. 6.) A continuous descent back toward historical average levels must also be accompanied by job creation.

Where Are We Headed?

We have in previous commentaries encouraged readers to favor monitoring directional trends over absolute readings of economic data. Absolute readings are subject to volatility, seasonality, and most importantly, misinterpretation. With regard to the federal budget, this is a difficult approach to champion. There is little to no room for subjectivity. Deficits must be financed, interest debt outstanding paid and capital eventually returned to investors.

State and local governments are running massive deficits and the vast majority are constitutionally required to balance budgets. State governments are currently making drastic cuts on services and are increasing taxes.

Indeed, it may take years before the job market bounces back. With less borrowing power, consumers will curb spending. Businesses will remain cautious about ramping up. And once the stimulus is spent, there could be another contraction. In some cases, further job loss might lead to more stimulus.

While the outlook seems bleak, in general, we have a strong bias against “it’s different this time” arguments. In fact, debates over the consequences of budget deficits are nothing new. While the considerations over the budget deficit are not different, the magnitude today is certainly bigger. Therein may lie the positive; this time the levels of the deficit and projected debt are so severe that the opportunity for resolve may be greater than during historical episodes of deficit accumulation.

In fact, a sense of urgency has recently resurfaced within both the Administration and Congress. The White House has indicated that President Barack Obama’s second year on the job will be focused on employment and the economy.

Congress must pass a bill raising the debt ceiling by mid-February. As this commentary goes to press, the Senate is considering an amendment to debt-limit legislation to establish an “empowered” commission on deficit reduction. The amendment is not expected to pass, but given recent sweeping shifts in the health care debate (Massachusetts’ special Senate election), the federal budget deficit is certain to move up the chain of priorities. Heading into the mid-term elections, both parties are likely to champion their support for deficit reduction.

There is still a large degree of economic separation from pre-recession levels, most acutely with regard to unemployment. Just as the economic foundation underlying the easy credit era was simply unsustainable over the long-term, so will be the current and projected levels of the budget deficit and national debt. A return toward “moral and material importance” from the U.S. government on budgetary issues would be a welcome development and instill confidence in global financial markets. Much work remains to be done.