Markets & Finance

The Deficit May Be Back on a Leash


By Ryan Brecht The red ink from the U.S. Treasury has turned into a torrent, with the annual budget deficit deepening in July to a record $324 billion. The growing shortfall further highlights the deterioration in the government's finances this year. Not surprisingly, the expanding deficit for fiscal 2003, which ends September 30, has generated a considerable amount of handwringing among Democrats and Republicans alike.

Their concerns are certainly not out of place, given that the U.S. government's books were in surplus only two years ago. The speed with which the Bush Administration and Congress have plunged into deficit spending again is worrisome. But let's take a step back: when the deficit is put in the context of previous periods of rising government debt, the impending shortfall doesn't appear to be as alarming.

TRENDING DOWN. With only two months left in this fiscal year, the deficit will likely swell to more than $400 billion. There's no mystery to why: government outlays have surged on the back of waging a war and an occupation in Iraq and homeland security spending, as well as the usual counter-cyclical spending that accompanies a slowdown in economic growth.

On the other side of the ledger -- receipts -- a slowing economy took a toll early this year. While a subsequent pickup in the economy has bolstered money inflows, the implementation of President Bush's tax-cut package means further erosion in government revenue.

Here's the more encouraging news, however: It looks as if the Office on Management and Budget (OMB) overshot the mark in forecasting a $455 billion deficit for the full fiscal year. It would be quite a stretch for the deficit to swell another $130 billion in the final two months of bookkeeping. Even in the worst deficit years of the 1980s and 1990s, the total deficit for the last two months totaled less than $60 billion.

DOCILE DEFICIT? It will likely turn out that the Congressional Budget Office's (CBO) cautious forecast of a $400 billion deficit will be closer to the real number. Given increasing signs that growth in the gross domestic product should exceed 4% in the second half of 2003, before posting further solid gains in 2004, we at MMS International now expect a $425 billion deficit for fiscal 2003.

Moreover, the prospects for an even larger deficit during 2004 are looking increasingly remote, notwithstanding the OMB forecast that the shortfall will balloon to $475 billion. We have left our forecast of a $400 billion deficit in place for 2004, but the risk is clearly skewed toward an even smaller amount of red ink, given the upside prospects for the economy.

Even though the deficit should fall short of the worst-case scenario, a final number in excess of $400 billion is likely to generate a controversy. That's especially true given that election-year politics will be heating up in October. The $425 billion shortfall we expect would dwarf the previous record $290 billion deficit seen in 1992.

BONDS AND RATES. A little perspective is in order, however. The deficit accounted for 4.7% of GDP in 1992, which exceeds the 4.0% ratio for fiscal 2004 implied by our forecasts. Even the OMB's projection of a larger deficit boosts the ratio by only 0.2%, to 4.2% of GDP.

As a percentage of GDP, this deficit should be well short of the record 5.7% in 1983. And looking ahead, a stronger economy, along with a reduced deficit, should sharply reduce the deficit's share of future GDP. A deficit in line with our forecast in 2004 would pull the ratio to 3.5% of anticipated GDP. Even the OMB's increasingly unrealistic deficit estimate for 2004, when compared to our growth estimate, translates to 4.2% of GDP.

The upshot for the markets: Given the elevated deficit fears just a few months ago, a fiscal 2003 figure that fell short of the OMB's worst-case scenario would likely be viewed favorably by Treasury market players. Moreover, since an even larger deficit next year is looking increasingly unlikely, the budget figures may help support bond prices -- and keep a lid on interest rates -- through 2004. Brecht is a senior economist for MMS International


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