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n the
late-'90s, the confluence of strong economic growth, decelerating
federal government spending, and substantial increases in tax rates
(revenues) had the unexpected effect of producing enormous budget
surpluses. As unexpected budget surpluses burst on the scene in
the late 1990s, most mainstream economists weren’t sensitive to
the contractionary impact that surpluses can have on the economy.
The reason was simple: none of their economic models ever included
the forecast of a substantial surplus.
As the 1990s
came to an end, virtually all financial-market observers and politicians
rejoiced that budget deficits were gone and that the U.S. had entered
a period of fiscal stability. Politicians on both sides of the aisle
viewed the new world of budget surpluses as an opportunity to save
Social Security, to cut Federal debt, and to lower taxes.
Budget deficits
— or budget surpluses — are neither good nor bad, they
are fiscal policy options that can stabilize or de-stabilize an
economy. The U.S. economy, under Reagan, Bush, and early Clinton,
experienced higher — not lower — rates of economic growth
at a time when budget deficits were at record levels and tax rates
were on the decline. Over the past 20 years — a period of record
budget deficits — the stock market (as measured by the Dow
Jones Industrial Average) increased from 950 to over 11,000, providing
ample evidence that budget deficits are not necessarily bad for
an economy.
On the other
hand, budget surpluses are not necessarily good. As the budget surpluses
began to expand dramatically in late 1999 and into 2000, the stock
market appeared to be reversing the record up-trend of the 1980s
and '90s. One possible reason for the reversal: the growing budget
surplus was sapping the savings of the private sector. Consumers
were able to maintain their spending only through expanding debt
to record levels.
By overtaxing
the private sector, the government reduced savings. Historically,
when the government drives the tax burden higher, recessions are
usually the result (see chart above). The lack of understanding
of the contractionary effect of the budget surplus is evident in
omnipresent commentary about the anticipated stimulative effect
of President Bush’s $40 billion tax cut this year. There is no stimulus
in the tax cut if it only results in the reduction in the size of
the budget surplus. The President’s tax cut only makes the budget
surplus less contractionary.
It’s one thing
to run a budget surplus and remove savings when the economy is booming,
but running a budget surplus and removing savings when the economy
is weakening is a sure formula for economic malaise. President Bush’s
tax cut that takes effect this year should reduce the contractionary
impact of the surplus but it is only a small step in the right direction.
Rates
& Dollars
Market observers are either relying on the Federal Reserve’s lower
interest-rate policy to turn the economy around or President Bush’s
lower tax rates to stimulate consumer spending. However, monetary
policy and low interest rates may not produce the intended result
— a maintainenance of consumer spending. The reason is that
consumer debt is already at record levels relative to income, so
lower rates may not lead to more debt-driven spending. The Japanese
experiment to use lower interest rates to stimulate their economy
has failed. The Japanese have been lowering interest rates for years
— they are now below 1% — and still there is no response
from their economy. To the extent that the U.S. consumer can’t save
and must borrow to pay taxes, there is a risk that he won’t be able
to sustain this economy much longer. The $600-per-couple Bush tax
cut this year may act as a short-term palliative, but is insufficient
to trigger a new expansionary phase.
Then there
is the strong U.S. dollar. With U.S. interest rates falling sharply
and the U.S. economy slowing, it is almost unimaginable that the
greenback could have been hitting record highs. Traditional analysis
can’t explain this strange dichotomy. Yet, the budget surplus gives
us another perspective on why the dollar is strong. As the government
pays off debt and thereby reduces non-government savings, business
and consumers are forced to sell real assets in an attempt to restore
desired nominal savings. There is shrinkage in the amount of available
investment alternatives that are equally as attractive as safe U.S.
government bonds. With a shrinking pool of safe U.S. government
investments, foreigners who want U.S. dollars continue to export
to the U.S. at lower and lower prices to get the needed dollars,
and convert local profits to U.S. dollars as well. (Foreigners are
buying dollars, the equivalent of non-interest bearing U.S. government
securities, because there is a shortage of U.S. government securities.)
In stock-market
parlance, there has been a short squeeze on the dollar. The rapidly
collapsing budget surplus may provide a clue as to why the dollar
has begun to weaken.
Early in 2001,
jubilant fiscal planners forecast budget surpluses continuing at
a $200 billion rate over the next six years. The implications are
an equivalent private-sector deficit. Can the U.S. consumer continue
to have his savings drained at that rate and, at the same time,
continue to borrow to replace the excess taxes that he is paying
in a budget-surplus world? Unlikely. Something will have to give.
Recent indications
are that the budget surplus will shrink as unemployment compensation
increases and tax receipts fall with the slowdown. Recently, Treasury
officials indicated that they were planning to borrow $51 billion
in the quarter ending Sept. 30. In April of this year the forecast
was for a planned reduction in the federal debt of $57 billion.
That $108 billion swing is the largest on record. Recent and surprisingly
large quarterly losses of corporations suggest that dramatically
smaller corporate tax collections will contribute to further shrinkage
in the government surplus.
A major risk
to the economy in light of a shrinking surplus is reactive government
policies that attempt to maintain, if not increase, the budget surplus
through raising taxes — or not cutting them and reducing federal
government spending. According to the Associated Press, Rep. Jim
Nussle, House Budget Committee Chairman, is planning to force automatic
spending cuts if this year’s debt reduction ends up falling below
the $155 billion the budget envisioned.
“The problem
around here is we have spent too much,” Nussle told reporters at
a recent interview. Any steps either to curtail spending or increase
taxes (reduce the tax cut) will accelerate the economic downturn
and virtually guarantee a prolonged recession. As the economy continues
to deteriorate, an easy fiscal policy that restores savings is the
only alternative to reversing a continued downward slide. The sooner
the government realizes that an easy fiscal policy will cure a weak
economy, the less chance there is that the U.S. will have to run
substantial budget deficits.
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