US Budget Deficit to Grow Much Worse

Original Link: http://www.financialsense.com/fsu/editorials/merk/2008/0801.html

by Joseph Brusuelas, Chief Economist/VP Global strategy, Merk Investments

The mid-session review of the federal budget released during the past week saw the White House revise its outlook for the deficit towards nominal highs. The administration is forecasting that the deficit will come in at $389 billion in 2008 and the 2009 deficit should arrive at $482 billion.

The provisional estimate is a snapshot of current spending plans that does not take into account the emerging economic reality. This year seven banks have failed, which may be a grim preview of the forthcoming problems among regional and second-tier banks. The economic slowdown has generated tax receipts through the first nine months of fiscal 2008 equal to 17.9% of GDP, which is less than the 40-year average. The second half of 2008 is shaping up to be especially painful for the economy and equally deleterious for the federal budget. This time frame, which will bridge the final quarter of fiscal 2008 and first quarter of fiscal 2009, implies that the current assumptions underlying the administrations estimates are more than just a bit rosy.

A hard-nosed, cold-eyed look at the emerging economic and political reality at this time suggests a policy alignment inside Washington that will shape the budget in a very different manner. During fiscal 2009 we anticipate expenditures on the part of the Federal government to expand in the areas of health care, infrastructure, education with little but lip service given to the looming tragedy in the Social Security, Medicare and Medicaid programs. Any claim made that tax increases on the wealthy or the on-renewal of the Bush tax cuts will cover the coming increase in expenditures should be taken with more than a grain of salt.

The $482 billion dollar estimate for fiscal 2009 does not reflect what we expect to be the defining features of the Federal Budget throughout the remainder of the year and well into the new administration. First, pressure for a second stimulus has begun to build as the county moves closer to the election. We expect that when the Congress convenes in the fall that the political calculus in Washington will overtake budgetary sanity and that the House and Senate will pass with veto proof majorities a second fiscal stimulus package. We will take the current conventional wisdom on the Capitol Hill as true and attach an additional $60 billion dollar price tag to 2009 budget.

Second, the FDIC has accepted into receivership 7 banks so far this year after only taking over three in 2007. At the end of Q3'07 the FDIC had $53 billion on account to respond to a crisis among member banks. The seizure of Indy Mac, with $32 billion in assets will put a major dent in that rainy day fund at the FDIC. Based on our very conservative estimate the FDIC may require up to additional $10 billion in funding which will add to the deficit in 2009. The failure of another major bank or a wave of bank failures on a regional basis will require a special supplemental to be passed, to inject funds to cover insured deposits by the FDIC.

Third, one major domestic auto producer has done a very good job at telegraphing to the market that it will come under severe financial pressure through the middle of the next fiscal year. Perhaps, the new President will choose to take a Thatcher-like hard line on rescuing a very important player in the manufacturing economy in the electoral rich upper Midwest, but we doubt it. The exact number and manner in which a potential rescue of one of the three remaining auto producers would be accomplished is unknowable at this time. It is safe to say that should the federal government contemplate the bailout of a major industrial player it will require a quite a bit more than the $1.5 billion dollars in loan guarantees that the Carter Administration and the Congress provided Chrysler in 1979. While admittedly a “wildcard” when it comes to forecasting expenditures on the part of Washington, this possible development should not be discounted. Should one or more of the major auto producers reach a crisis point, it would be quite interesting to see if a newly inaugurated President who in all probability may owe his electoral majority to the states of Michigan and Ohio would adopt a lassie-faire approach to the problem.

Finally, each of the presidential candidates has fiscal and taxation priorities that will add to the already expanding deficit. According to the Wall Street Journal the Obama administration would add $800 billion over the ensuing decade to the budget and a McCain Presidency would add up to $600 billion. So, to avoid unnecessary partisanship we will split the difference and assume that a newly minted American President will add $70 billion to the deficit in the first year after taking office.

Thus, once one starts to make a provisional estimate of what the true deficit may look like in 2009, in all probability it will arrive in the mid $550 billion range with a possible upside to $630 billion depending on how the financial crisis on Wall Street plays out and just how far it spills over to Main Street. Just to be complete, our forecast does not consider off balance sheet activities, ongoing foreign operations that remain off the official books any prospective response to the problems in Social Security that could get under way as early as 2012.

The trend in Federal expenditures under current assumptions, much less the contingencies that we have outlined within the context of continued stress in financial markets will constrain the ability of private economic actors to borrow. For years, economists have warned about the problem of unsustainable deficits to mostly deaf ears. Under conditions of a functioning global market for capital, the US could get away with its profligate ways. But, with money tight on a domestic basis and global creditors increasingly concerned about the financial health of Washington, the conditions are ripe for a fiscal crisis. Should this occur US consumers would observe a sharp rise in the cost of borrowing a concomitant fall in the value of the greenback and a genuine political breakdown. One hopes that this is discussed in more than a tangential manner during the upcoming election.