Federal Budget update

For the 12 months ending March 2009, the federal government's deficit was $1.096 trillion dollars. The age of trillion-dollar deficits has finally arrived.

As the top two charts show, the main reason for the ballooning deficit is spending. A good deal of the extra spending in the past six months has been due to things like TARP and Treasury purchases of assets (e.g., $119 billion of Freddie and Fannie debt in the past three months)—which are arguably one-time, emergency measures, and they aren't really spending so much as they are investments, because Treasury is likely to earn interest on this money unless the economy completely collapses. But the thing that will give us trillion-dollar deficits in the future is the huge planned increase in plain-vanilla government spending thanks to a) the recently-passed stimulus bill and b) Obama's ambitious spending plans.

The Obama administration is making some huge assumptions when it projects that spending will slow down sharply in years to come and revenues will pick up dramatically (third chart). But it's not hard to imagine that a lot of the "temporary" spending programs that will kick in over the next year or so will end up becoming permanent, and then continue growing—that's one unwritten rule of federal budgets. If Washington lacks spending discipline in the future, then spending could remain "stuck" in the range of 26-28% of GDP. Meanwhile, if higher tax rates and higher tax burdens end up slowing the economy's recovery and sapping its future strength, then tax revenues might well fail to exceed 19% of GDP. Thus we have a plausible scenario in which the deficit ranges from 7-9% of GDP for many years to come. The current 12-month deficit of $1.1 trillion is equal to 7.8% of GDP—and there you have the makings of deficits which could be $1.5 trillion per year five years from now.

In any event, we are now in uncharted (post-war) territory. A trillion-dollar deficit is not difficult to fund in today's climate, because the one asset the world is desperate to own is U.S. government debt. Treasury could probably sell significantly more than $1 trillion of debt this year without causing more than a modest ripple in interest rates. Moreover, Japan has run deficits of more than 10% of GDP for years without the sky falling. For now, the worst thing about all this is that the prospect of a significant and lasting increase in the deficit weighs heavily on the economy, because it means that at some point in the future, tax burdens will have to rise. If you know taxes will increase in the future, you reduce the expected after-tax return on capital today, and that means a lower price for our existing capital stock. That is basic financial math, and it goes a long way to explaining why, even after a 26% gain in the S&P 500 index in the past month, equities remain historically undervalued by just about any measure.

There are other potentially worse problems that loom, the principal one being that the Federal Reserve is now buying Treasury debt and other debt in quantity. Past deficits have never been a source of inflation, mainly because they were funded by the sale of debt, rather than by printing money. That no longer holds, unfortunately. The WSJ has put together a great chart which tracks the growth of the Fed's balance sheet.

I'm reminded of the four years I spent in Argentina, when inflation averaged over 7% per month. After returning to the states I spent a good deal of time in my first job studying the Argentine economy, and it was then that I saw how and why they had so much inflation. Since the Argentine government couldn't convince anyone to buy its debt, almost all of the deficit was financed by running the printing presses 24/7. I remember figuring out an equation which translated a given deficit into a future inflation rate, and my boss (John Rutledge) and I went to talk to the government in the mid-1980s to warn them that hyperinflation was on the way (and we were right).

I'm not saying that hyperinflation is in our future, because it is still possible for the Fed to withdraw all the money it is pumping into the economy in a timely fashion. For now the economy seems desperate for more money and more Treasury bonds, but that can and most likely will change once the economy shifts into recovery mode. It is then that the risk of rising inflation could become the dominant feature on the economic horizon. It seems to me that the balance of risks favors scenarios in which the Fed withdraws the money in an untimely fashion, thus fueling higher-than-expected inflation in the years to come.