Election campaigns always involve sweeping under the rug a lot of long term questions, particularly economic questions. The election is now over, the rug looks pretty lumpy, and the day of reckoning has arrived, when problems that cannot be left for another four years must be addressed.
Some problems, happily for the George W. Bush administration, can be left for the next four years, if increasingly irresponsibly. Social Security is one of these. The Social Security Trust Fund will start showing a deficit in 2017, and will run out of money around 2035, but is very unlikely to run into a crisis before 2009. In the next four years, the social security system will run a surplus that is projected to increase by around $100 billion per annum.
This is one reason both President Bush and Democrat candidate John Kerry promised to halve the Federal budget deficit in the next four years. The way the accounting is done, the social security surplus is included in the Federal budget arithmetic. Thus the $422 billion Federal deficit in the year to September 2004 should really be increased by deducting the $153 billion off-budget surplus (almost all dedicated to the social security trust fund) for a “true” deficit of $575 billion. According to September 2004 Congressional Budget Office projections, the nominal Budget deficit will decline to $312 billion in the year to September 2009 (which doesn’t look like half of $422 billion to me, by the way) but this will be helped by a $242 billion surplus in the off-budget items, so the “true” deficit in fiscal 2009 will be $554 billion, still well over 4 percent of gross domestic product and only marginally below 2004’s $575 billion. Halving the Federal budget deficit by Fiscal 2009 is probably an unattainable target anyway, but “funny accounting” for a rising social security surplus is a great deal of help towards that elusive goal.
Reforming social security, one of Bush’s announced goals, will greatly help with the long run Federal deficit, but will make things worse in the short term. This is why reform made so much sense in 2000, when the Federal budget was in surplus, the annual social security trust fund surplus was smaller, and the stock market appeared an irresistibly attractive way for people to fund their retirement savings. While a measure of equity risk (assuming it’s accompanied by the generally higher equity return) makes a great deal of sense for those Social Security participants with average incomes or above and more than a decade to retirement, diverting part of the social security flows into equities will make the short term budget picture worse, unattractive when that picture is already so bleak.
The one advantage of social security reform, from the Bush administration’s point of view, is that it might divert a large savings flow into equities at a time when the stock market was weak (which it currently isn’t, but might be in a year or two). This sounds like funny accounting but isn’t entirely – if the Federal budget deficit and the U.S. balance of payments deficit are financed by foreign central bank flows, themselves motivated by their own countries’ economic picture rather than by return maximization, then debt markets are artificially advantaged as compared to equity markets, and it makes sense to direct a further portion of the domestic savings flow into equities. Such a diversion would prop up the stock market, make corporate financing easier to get, and, by increasing Treasury debt financing, raise long term interest rates, thus reducing the flow of U.S. economic resources into unproductive housing.
The Federal budget deficit itself has not so far been an economic problem, only a political one. It has had no discernable effect on the bond market, partly because of the inflows of foreign central bank funds. Over the next four years, this may change. Stanley Collender, managing Director of Financial Dynamics, speaking at the National Economists Club Wednesday, outlined the political and economic challenges facing the budget over Bush’s second term, and he was not complimentary about the attention paid to the deficit by either Bush’s economic team or the Kerry team. Since they cause few problems in the short term, budget deficits are given a very much lower priority currently by both the Administration and Congress than they were in the middle 1990s, when both President Bill Clinton and Republican Speaker Newt Gingrich took the problem very seriously indeed.
Collender expects a burst of spending authorizations in the impending ”lame duck” session of Congress, including $75 billion for Iraq and passage of a $300 billion Transportation Bill, well above the President’s initial request, that had been held up in Congress until after the election because of the potential unpopularity of so enormous a pork-barrel. Thus the CBO’s September deficit projections are already well out of date. The Medicare prescription drugs bill passed in December 2003, due to come into effect in 2006, will make the picture worse – for one thing history around the world has proved that medical entitlement spending always far outruns the up-front estimates for it. Extension of the President’s 2001 and 2003 tax cuts is also not provided for in the current CBO projections. Collender thus believes that the gradually increasing social security surplus is the only restraining factor against the budget deficit spiraling further upwards, even if the economy remains on a strong growth path.
Since the continuing overvaluation in the stock market, the increased overvaluation in the housing market, and the possible recurrence of inflation due to high oil prices are all likely to prove serious impediments to economic growth over the next 4 years, much as an equivalent set of problems proved an insurmountable obstacle to healthy growth in 1990s Japan, the chances of U.S. economic growth falling short of projections must be quite high. Should it do so, the budget deficit will increase sharply; experience in 2001-03 demonstrates that a $300-400 billion deficit increase in today’s $11trillion economy can happen very quickly indeed.
Such an increase would take the Federal budget deficit close to $750-800 billion, 6 percent of GDP, at which point historical precedent and the example of other countries that have got into trouble suggests that financing it through the bond markets will become a real problem, causing a further rise in interest rates and “crowding out” other needs. At that point, the political classes would presumably once again take the budget deficit seriously. Rectifying the problem would however be exceptionally painful, both politically and economically, with sharp tax increases (from this administration, maybe a much higher gasoline tax or even a value added tax) being an inevitable part of the equation.
The other problem that is going to bite the U.S. economy in the next four years is the balance of payments deficit, currently above $600 billion and rising. To some extent, this is an inevitable consequence of Federal budgetary laxity and the utter unwillingness of the U.S. consumer to save – if the Federal budget deficit needs financing, the money has to come from somewhere.
The payments deficit will probably cause a further decline in the dollar, which Friday hit an all time low of $1.294 against the euro. This won’t be a major problem if it happens in an orderly fashion; eventually, after a delay caused by the “J-curve effect” U.S. exports will rise and imports decline sufficiently to bring the payments deficit back towards balance. There are however, three major risks. First, if foreign central banks get fed up with continuous losses on their dollar holdings, they may stop buying Treasury bills and bonds, in which case a financial crisis would follow, with consequent disruption and much higher U.S. interest rates. Second, a continual decline in the dollar, towards $1.60 or $1.70 to the euro, may cause excessive deflation in the already sluggish euro-zone economies, with consequent political pressure in those countries towards protectionism. Third, if the dollar slide continues, then apart from foreign travel becoming prohibitively expensive, imports to the U.S. as a whole will tend to rise continuously in price. This will be good for the profit margins of domestic producers of e.g. automobiles but might well cause inflation to become endemic in the U.S. system, requiring a period of draconian interest rate rises to wring it out.
It seems unlikely that all three of these risks will be avoided; hence one should be thoroughly bearish on the U.S. bond market and consequently, on the housing market.
Immigration is an important economic issue in that it marginally improves the profitability of low-wage employers, by increasing the supply of cheap labor, at a cost of impoverishing the lower end of the U.S. education distribution. As I set out in detail earlier this year, real per capita incomes for those with a high school diploma or less have declined by about 8 percent since 1973, in a period of rapidly rising overall prosperity. Bush and Kerry were both committed to freer immigration, but the election showed even more clearly than before that such a position ranks with gay marriage as anathema to the great bulk of the U.S. population.
Consequently, in spite of pressure from the Chambers of Commerce, it can be hoped that Bush will tighten rather than loosen immigration restrictions, slowing the enormous volume of immigrants, legal and illegal, that have entered the U.S. in the last decade. If there is any kind of recession, such a tightening could provide vital protection against the unemployment and/or immiseration of much of the American blue collar workforce, with the accompanying social ills that would bring.
Finally, the election brought good news for world trade. Not only was the more protectionist of the Presidential candidates defeated, but the administration managed to avoid the strong political temptation pre-election to delay the removal of U.S. textile quotas, scheduled to take place on 1st January, 2005. Further, a free trade Republican, Jim DeMint, won the open Senate seat in South Carolina, a major textile producing state, replacing the long serving, highly protectionist Sen. Fritz Hollings (D.-S.Ca.) – thus protectionist pleas from South Carolina’s textile manufacturers, inevitable as quotas are removed, are likely to be only modestly effective.
Even if after January spurious “anti-dumping” duties are imposed on most textile imports from China, such duties will have little effect beyond damaging U.S. – Chinese relations, because textiles and garments from numerous other Third World countries can replace any blocked Chinese goods, and will still generally undercut domestic production. South Carolina’s textile production is thus mostly history, but this is a very important step indeed in expanding world trade and reducing Third World poverty.
There may even be some chance of resuscitating the stalled Doha round of world trade talks, particularly if U.S. Trade Representative Robert Zoellick remains in place to advance the Doha agenda, although the chances of major progress in this area must still be rated fairly slim. Nevertheless, the U.S. election result is good for world trade, more so than is at first sight apparent.
There are thus some positive features in the current economic picture, but one cannot help believing that navigating the rock-infested economic waters of the next four years will require a skill level from the Bush economic team far greater than it has so far shown.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.