February 11, 2004
Probably the most significant single document produced by
any administration is the budget. It
shows economic assumptions that lead to policy conclusions and borrowing or
taxing needs. It also shows the
spending priorities that identify the concerns of the existing administration.
The State of the Union outlines some of these concerns and
proposed solutions, but the budget quantifies what that speech only verbalizes.
For example, going to Mars sounds good.
Adding a half percent to the NASA budget suggests that you do not need to
Because of the importance of the budget document, I will
use two columns to discuss its significance.
In this one, I will explore the economic assumptions, their
reasonableness, and what they and proposed economic policy suggest for the
In the next one, I will explore the spending priorities.
First, despite all contrary claims, the budget no longer is
structurally in balance. That means
that economic growth will not be sufficient to remove deficits without changing
spending and/or revenue programs.
The budget assumes that unemployment will converge on 5
percent by the end of the decade (presumably the new definition of full
employment) with potential growth of 3.1 percent per year.
Yet, in 2009 the deficit is projected to be $237 billion. Virtually no
improvement is projected after 2006.
Second, even the improved deficits in 2005 and 2006 are the
result of unusual events. A tax
stimulus of $159 billion in 2003 and $272 billion in 2004 disappears in 2006.
After the lapse of the accelerated depreciation and one time additional
payments by corporations to pension programs in 2004, before tax corporate
profits are projected to surge by more than 30 percent in 2005.
I certainly will not bet any deficit reduction on that happening.
Now, the administration's assumption of 2.3 percent
productivity gains over the next five years is conservative.
I certainly am assuming something closer to 2.8 percent.
(Since the beginning of 2000, the productivity gains have averaged 4.4
percent, but some of that certainly is the result of cyclical cost shaving.) Therefore, the structural deficit might be lower.
However, the administration shows no concern that a
structural deficit exists. Indeed,
they propose making tax cuts permanent. That
adds to the structural deficit in the subsequent decade.
The assumption that 91 day treasury bills will average 1.3
percent in 2004, means that the Federal Reserve will increase their targets to
1.5 percent by the end of this year. A
target of 3.5 percent on the federal funds rate by the end of 2005 and 4.5
percent before 2006 ends also is implied.
I have no qualms with the 1.4 percent growth in the
consumer price index assumed for 2004. After
all, energy prices probably will subtract slightly from underlying inflation,
which I am assuming at 1.7 percent by the end of the year.
However, the 1.5 percent, 1.8 percent, and 2.1 percent subsequent price
gains assume either that underlying inflation will not grow further even as the
gap between capability and actual performance narrows or that energy prices will
continue declining relative to inflation.
Certainly, the administration's assumptions are possible,
but I would expect about a percentage point more inflation than their 2.1
percent by 2007.
Frankly, I see a Federal Reserve trying to preserve low
inflation by pushing rates up in 2006. A
near recession is possible in 2007 with short term rates rising several
percentage points higher than inflation. The administration assumes that short term rates will exceed
inflation by 2 percentage points in about two years and stay there.
Not only can they be right, but I hope they are.
Nevertheless, I would be skeptical.
The administration actually assumes long term rates (10
year government bonds) will rise relative to short term rates in 2004.
The spread between the two is expected to be a near record 3.3 percentage
points. (By the way, I concur with
that). Then the spread should
narrow to 1.4 percentage points by 2007. (Again,
a reasonable assumption).
According to the budget, maximum economic stimulus occurs
in 2004, when real GDP should expand 4.4 percent.
Then stimulus changes abruptly in 2005 and beyond but economic growth
slows only modestly. While this is
an assumption that many economists will question, I can see it happening.
Indeed, I think most of the administration's assumptions, except
inflation, are reasonable or even conservative.
What I do not understand is how the President can be unperturbed by the structural deficit that his economic assumptions reveal.