The federal budget deficit numbers released by the Treasury Department on October 15 were not exactly a surprise. Economists and analysts such as the Congressional Budget Office and the Committee for a Responsible Federal Budget have predicted for months that the 2018 fiscal year deficit would widen, potentially sharply, as a result of the Tax Cuts and Jobs Act (TCJA) of 2017. If anything, most of the predictions from earlier this year overestimated 2018 tax revenues, despite the fact that economic growth actually exceeded many of the forecasts on which these estimates were based.
The big surprise is the extraordinary lack of concern outside the economics community in the 17% increase in the federal deficit, to an attention-deserving $779 billion. The outrage of 2009, when the economic stimulus provided by a dramatic increase in deficit spending may have been the only thing preventing a much deeper and more prolonged recession, seems to have been replaced by a complacency that is equally inappropriate for the times.
It is not at all uncommon to find an almost moralistic view of federal budget deficits and national debt. In that expression, the frowned-upon idea of “living beyond one’s means” becomes an argument for balanced budget legislation. However, the federal government lives in perpetuity (fortunately or unfortunately) and has considerable taxing authority, making the direct analogy to individual financial behavior incorrect. Furthermore, arguing that federal spending should always be determined by income (tax revenues) ignores the very real value of fiscal policy as a partner to monetary policy in times of economic crisis. Pairing expansionary fiscal policy (deficit spending) with expansionary monetary policy (growth in money supply and low interest rates) can prevent either policy lever from moving to extreme actions that are difficult to unwind. The same is true when neutral or contractionary economic policy is warranted.
And therein should be the unease over the 2018 deficit — a deficit projected to increase towards $1 trillion by 2020. Monetary policy has moved to a neutral stance, with Federal Reserve Chairman Powell stating recently that the economic stimulus from low interest rates is no longer warranted by an economy growing in excess of 3% and an unemployment rate below 4%. Given trends in product prices, tightness in labor markets and the capacity constraints typical of these later stages of the economic cycle, it is not difficult to envision a move to mildly contractionary monetary policy sometime in 2019. Concurrent with these present and anticipated changes in monetary policy, fiscal policy is roaring ahead in expansionary mode – a scenario somewhat akin to driving down the freeway at 90 mph with one’s other foot on the brake. The short-term effect is the ridicule of other drivers on the road; the longer term effect is that the brakes burn out, either setting the car on fire or leading to a crash. Or both.
As the current US economic expansion moves closer and closer to becoming the longest on record, questions abound as to what will bring the growth to a halt. Federal Reserve “mistakes” are frequently cited, with little attention to the developments that may have forced the Federal Reserve into raising interests too high, too fast. One of the challenges of fiscal policy is that whereas the Federal Reserve can relatively quickly make alterations in its economic stance, spending and tax policy is not easily or readily changed if it is discovered that the policy was designed for an economic environment of the past, not the present. The size of the current budget deficit is an additional concern because of the implication that increasing federal spending to mitigate the economic impact of a “Fed Mistake”, stock market crash, trade war, etc. may simply not be possible.
The situation is largely self-inflicted. Not quite half of the deficit is attributable to recent legislation. In theory, this means the situation could be readily reversed. The devil, however, is in the details, practical and political. Notable in the 2018 fiscal year budget numbers is the more than 30% decline in corporate tax revenues. Forecasters and analysts have long recognized the skill evidenced by corporate tax strategists in reducing the impact on company revenues from changes in tax legislation aimed at increasing the flow of dollars to the federal government. Government revenue actually received from increased corporate tax rates never seems to meet expectations. Coupled with a lack of political appetite for altering such recently enacted legislation, it is small wonder that any contemplated action on the deficit appears to be focused on reducing spending. Yet, the political will for spending cuts is not very high either, especially if it means touching sacrosanct Social Security and Medicare programs. The rising cost of servicing the rising debt, as interest rates increase, adds another rock to this hard place of trying to reduce the deficit through spending cuts alone.
After so many years of focus on “below average” economic growth, weak labor markets and low interest rates, it is understandable to wish to enjoy the lovely view outside the window. But it becomes more dangerous to take one’s eyes off the road ahead the faster the economy hurtles forward. The deficit demands attention from more than just the Federal Reserve. Whether that happens in 2019 will be an important determinant of the next few years of economic and financial market prospects.
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