The Biggest Bomb in Bush's Budget


By Christopher Farrell It seems that no one outside the Bush Administration has anything good to say about the federal budget -- with good reason. The government's finances are a fiasco of mammoth proportions. Thanks to fiscal profligacy, more and more voices are heard arguing that America is rushing headlong into severe economic decline. In a National Interest article late last year, Niall Ferguson, history professor at New York University, and Laurence J. Kotlikoff, professor of economics at Boston University, drew ominous parallels between fiscal overstretch in imperial Bourbon France and contemporary America.

"In the same way, the decline and fall of America's undeclared empire will be due not to terrorists at our gates nor to the rogue regimes that sponsor them, but to a fiscal crisis of the welfare state," they wrote.

Let's review the numbers. The deficit will approach a record $500 billion in fiscal 2004, up from $375 billion last year. That gargantuan sum is also too low. The Administration's proposed budget doesn't include the costs for ongoing military operations in Iraq and Afghanistan (see BW Online, 9/10/03, "The Neatest Thing about That $87 Billion"). And the White House has overestimated revenues and underestimated the deficit in each of its previous budget proposals.

DIRE PREDICTIONS. At the least, the projected deficit over the next decade would run about $2.4 trillion. But if President Bush wins his campaign to turn temporary tax cuts into permanent ones, including the elimination of the estate tax, the red ink would exceed $5.2 trillion.

A report by fiscal hawks at the Concord Coalition offers a scathing review of President Bush's 2005 budget proposal: "Experience tells us that without a conscious change in attitude toward fiscal policy -- and actions on the part of lawmakers -- the budget outlook will be decidedly worse."

No kidding. A closer look at the fiscal situation easily leads to dire predictions. The first wave of the massive baby-boom generation -- the roughly 76 million Americans born from 1946 to 1964 -- is nearing retirement. Taking into account the funds that need to be spent on this demographic time bomb lifts the long-term fiscal gap to $44 trillion. That's the "optimistic" calculation made by sober economists and green-eyeshade budget experts drawn from the U.S. Treasury, the Federal Reserve, the Office of Management & Budget, and the Congressional Budget Office during the tenure of former Treasury Secretary Paul O'Neill. (Is it any wonder he was ousted?)

"MENU OF PAIN." The leaders of the study, Jagadeesh Gokhale and Kent Smetters, estimate that restoring fiscal sanity requires either hiking federal income tax collections by 69% or raising payroll taxes by 95%. Don't want to raise taxes? Well, Social Security and Medicare benefits could be slashed by 56%. Another alternative is to cut federal discretionary spending by more than 100% (although that's impossible). By the way, their "menu of pain" starts today and not a Presidential election cycle or two from now. Ouch.

It's taxpayers who need to be concerned. On the one hand, long-term prospects for economic growth and healthy tax revenues look good. Productivity has been growing at an average annual rate of 3% from 1995 to 2003, double the rate achieved from 1973 to 1995. Productivity is the economic measure that matters, capturing the wealth of nations, the competitiveness of companies, and overall living standards.

Strong productivity growth will make it easier to fund the Social Security and health-care bills that threaten to squeeze America's wallet. What's more, aging workers today can be productive far longer in an information and services economy than one dominated by factories and heavy industry. Healthier lifestyles and medical advances (though they're often very expensive) should also postpone disability among the elderly. So, the widespread fear of an economy weighed down by an aging population may be greatly exaggerated.

PIDDLING SUMS. The concern should be where tax revenues are going. The risk is that Americans are living off the seed corn sown from human-capital investments and research and development efforts of the past. To fund its tax cuts, the Bush Administration isn't putting enough money into education or basic research. The same goes for strapped state and local governments. The amount federal, state, and local governments are spending on worker retraining is a piddling sum, after adjusting for inflation.

Speaking of inflation, where's the fear and loathing one might expect from bond investors at the prospect of sky-high deficits? The current Administration's fiscal irresponsibility is well known. Uncle Sam's long-term obligations are hardly news. The history of governments everywhere when faced with too big an IOU is to run the printing presses. They almost invariably try to inflate their way out of trouble.

Bond investors know that spiraling inflation is anathema since the loans they're holding would be paid back with devalued currency. For instance, a saver with $10,000 in 1965 would have had an account worth $18,000 in 1980. Problem is, after adjusting for rising inflation with the consumer price index peaking at more than 14% in 1980, the true value of that $18,000 savings account was only $8,000. Memories are short in the market, but not that short. So, why haven't long-term bond yields, currently around 4.1%, soared into the stratosphere?

A RATIONAL BET? One theory is that bond investors are simply in denial. Investors aren't always right. Markets are prone to periodic bursts of investor enthusiasm followed by a bust -- what Princeton University finance economist Burton Malkiel calls "occasional trips to the looney bin." Still, it's hard to believe that hardnosed money managers from around the world are suffering from a self-induced mass myopia concerning a well-publicized fiscal imbalance.

Instead of denial, perhaps bond investors are making a rational bet that sustained inflation isn't in the cards now or even a decade from now. That doesn't mean there won't be inflation scares in 2004, 2005, and other years. It means printing extra money is no longer an option in the global economy, at least for a major industrial nation like America. The global capital markets abhor inflation, and professionals overseeing vast sums for insurance companies, mutual funds, pension plans, hedge funds, and other pools of money exert enormous pressure on central banks to stick with price stability.

The growing global competition for jobs, markets, and profits also lends a deflationary cast to the price outlook. The competition will become fiercer. Economists at Goldman Sachs estimate that within 40 years the emerging economies of Brazil, Russia, India, and China (BRICs) will overtake the G-6 (the U.S., Japan, Britain, Germany, France, and Italy). The BRICs' total gross domestic product now amount to less than 15% of what the G-6 produces. And long-term forecasts are notoriously suspect.

COMPROMISE NEEDED. Still, the odds seem to favor these nations joining the ranks of major industrial nations. Look at what's already happening in some sectors of their economies. Intel's (INTC) Andy Grove has said he expects India's software industry to surpass America's in the number of software and tech-service jobs, possibly by as soon as 2010. Auto makers believe China will soon overtake Japan in the car industry. This is not an inflationary environment. Investors don't need to flee bonds, as long as they believe inflation will remain tame.

Of course, this isn't meant to be an encouraging brief for budget deficits. In a wealthy country like the U.S., bringing the budget back into balance shouldn't be all that difficult, assuming Democrats and Republicans are willing to sit down together and hash out a compromise. Managing the people's money well has major benefits. It's just that the concern shouldn't be the deficit per se but that not enough tax dollars are going to nurture the infrastructure that allows an innovation-driven economy to thrive. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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