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.