All eyes will be on President’s budget proposal

President Bush will release his budget in early February, and the experts tells us there will be cuts in spending – appropriate given the current budget deficit of around $500 billion. The question is, will the cuts be articulated in the budget, or will the President leave the hard work of identifying specific cuts to members of Congress?

Either way, balancing the budget over the next several years will be a monumental task. Scott Brown, the chief economist for the investment firm of Raymond James and Associates, explained it like this: The on-budget deficit is larger than the total amount of non-defense, discretionary spending. That means you could cut out all non-defense, discretionary spending completely, and you’d still be running a deficit budget.

The deficit and the country’s mounting debt is one problem, complicated by another problem – our ability to service that debt. Historically, the country has financed its debt by selling long-term securities, but in recent years the government has shifted toward short-term debt instruments. Given the low interest rate environment, that move has paid off handsomely; the honeymoon, however, may be coming to an end. The Federal Reserve controls the short end of the interest rate curve and it is beginning to edge rates up. After dropping rates 13 consecutive times to a historic low of 1 percent, the Fed began raising rates last year. The federal funds rate now stands at 2.25 percent and nearly every expert expects the Fed to continue raising rates until it reaches a rate somewhere between 3.5 percent and 4.5 percent. This is a rate the Fed has called “neutral” – that is, a rate that neither helps nor hurts the economy.

A doubling of interest rates, however, would substantially increase our country’s cost of servicing its debt. That means the government could substantially reduce its budgeted expenses but still see its debt servicing costs increase. That’s because those costs are directly tied to interest rates, which have little to do with the budget. The government could revert back to issuing long-term debt, but that could prove costly as well. Debt on the long end of the yield curve is more market sensitive than short-term debt; rates on the long end of the curve would likely increase if there were suddenly a greater supply of long-term securities due to increased government selling.

Brown explained that long-term rates have held low primarily because foreign governments are buying so much of our debt. The United States is running a huge trade deficit – 5.6 percent of GDP in the third quarter, probably around 6 percent in the fourth quarter – which foreign investors are financing to the tune of $2 billion per day. China has been buying U.S. debt at a tremendous rate. Chinese foreign currency reserves increased by $200 billion last year. If China were to slow down its purchase of U.S. debt, long-term interest rates would rise.

And that would be bad for our country’s economy. Mortgage rates are low because long-term interest rates are low. Low rates encourage home building, buying and selling. Most of the country has enjoyed a substantial increase in the value of homes. People are tapping into their home equity at a rate never seen before. People are spending that money, stimulating the economy. Even those who are not tapping into their home equity are reacting to the “wealth effect” that many people are feeling from the increased value of their homes.

Brown does not expect the housing bubble to burst, but it is a worry that most economists are aware of. Particularly frightening is the international nature of the housing market. Brown said home prices all around the globe are up, and that if they come down in the United States, housing markets in other countries are likely to suffer as well.

Fortunately, the jobs picture in the United States is encouraging – certainly better than it is often portrayed in the media. Brown noted that the U.S. economy created 186,000 jobs per month in 2004. “That’s pretty good, that’s better than a sustainable pace,” said Brown, noting that the economy needs to add 145,000 jobs per month simply to keep pace with the increasing size of the nation’s working age population.

Brown also said capital spending at corporations is improving. Spending was robust at the end of the 1990s, and there was a strong correction in 2002-2003. “Since then, things have bottomed out and have started to improve,” Brown said. “We are seeing corporate cash flows improve, and that is supportive of improved capital spending going forward.”

Brown acknowledged uncertainty caused by high oil prices, but he said the situation is not nearly as serious as it was in the 1970s. “If you look at energy consumption as a percentage of personal spending, it accounts for a much smaller portion of personal spending than it did in the 1970s,” he said. “In the 1970s, the magnitude of the oil shocks was much greater than what we are seeing today.”

Brown, speaking to a business group in Minneapolis on January 19, was optimistic about the strength of the U.S. economy, notwithstanding the potential problems associated with the government’s budget deficit. It will take great effort to craft a budget that reduces the deficit yet does nothing to slow the momentum that seems to be building in our economy.