- While the debt crisis in Europe may lead to a series of rolling recessions across the continent in the next few years, the U.S. budget deficit poses a significant risk to long term economic growth as well.
- The Washington blame game is certainly in high gear, but the problem is a result of long-term neglect on both sides of the aisle, and the solution will require bi-partisan accommodation.
- U.S. equity markets, we believe, are poised to continue their strong advance into 2011; however continued neglect of the looming budget crisis in Washington could damage investor sentiment.
It took the United States more than 200 years for the cumulative Federal deficit to reach $1 trillion in 1981. Today, 30 years later, our nation’s debt has skyrocket 14 fold to more than $14 trillion. With the exception of a brief period under President Clinton, budget deficits have come in significantly worse than the projections of our political leaders. Although many people are playing the political-party blame game such action will not solve our chronic budget deficit problem: the problem has been caused by both parties, and the solution is simple, but not easy. The U.S., like most of the developed world, especially southern Europe, has been and is continuing to live beyond its means. Are the Republicans correct that we need to cut spending? Yes. Are the Democrats correct that we need to raise revenue? The answer here is also yes. With a likely $1.5 trillion annual Federal budget shortfall and with just a bit more than $2.5 trillion in projected revenues we can’t dramatically close the budget deficit gap unless we operate on both sides of the ledger.
The release of the President’s budget in the second week of February, an upcoming party-line battle to pass a variety of appropriations bills from last fall, and the possible need to expand the debt limit as soon as late March, will provide a painful reality check on our nation’s financial obligations. We may have an interesting battle over tax and spending policies reminiscent of the fiscal policy battles of years past, but such action could actually be a positive development, as it would be a hint that at least some fiscal policy discipline is returning to our Washington officials. The first widespread test of a potential change in fiscal policy should come when President Obama delivers the State of the Union address on January 25 to a vastly different Congress than two years ago. The election results of last fall and the increased challenges on the financing front on the federal, state, local, and international level appears to have shifted our President towards a more centrist stance reminiscent of what unfolded with President Clinton after the 1994 mid-term elections. Accordingly, we hope that a major portion of the State of the Union address will focus on a comprehensive plan for addressing our fiscal deficit issues.
Yes, in the early 1980’s the Federal budget deficit was viewed as a runaway freight train. Fiscal policy actions to try to stimulate the economy helped to end the early 1980’s recession, but failed to capture the revenues that were targeted by Administration officials of that time. By the mid-1980’s annual Federal budget deficits continued to set new records and significant concern surfaced that the U.S. Treasury would have a difficult time financing itself. A bipartisan group of Congressional officials got together in 1985 to pass the Balanced Budget and Emergency Deficit Control Act, more commonly known as the Gramm-Rudman-Hollings Act (after the names of its principal sponsors). This law specifically targeted a mechanism to reduce the federal deficit by setting rigid deficit limits and authorizing mandatory, across-the-board spending reductions to reach them if Congress and the President could not negotiate an agreement. Unfortunately, the Supreme Court later ruled that a key part of this mechanism was unconstitutional. The concepts embodied in the statute helped to briefly bring much needed fiscal policy discipline to Washington, but Congress quickly went back to its old ways after the Supreme Court ruling.
A few weeks ago, the House of Representative began the year with the reading of the Constitution on the House floor. They might have been well-served to have also read The Canadian Century: Moving out of America’s Shadow. The book addresses many of the hard decisions that were made by our northern neighbors that formulated the basis of the great fiscal policy turnaround in Canada. At the time, the actions implemented by Canada were painful, controversial, and unappreciated by many around the world, including a significant amount of Canadians. However, the policy changes helped to make Canada one of the great success stories of the last 10-15 years.
Figure 1. Governmental Structural Balance
In the mid-1990’s Canada faced a budget dilemma that might have been even worse than what we face today. Government spending accounted for more than 50 percent of Canada’s GDP; more than 30 percent of Canada’s revenue was used to cover the interest expenses on debt; and the combination of national and provincial government debt had soared to 120 percent of GDP. The Canadian dollar had weakened so dramatically that is was termed by some as “the Northern peso”. The situation was so challenging that The Wall Street Journal touted that Canada was “an honorary member of the Third World in the unmanageability of its debt problem” and the country lost its AAA credit rating. Interestingly, Canada took dramatic fiscal policy action that reduced spending, adjusted taxes and put Canada on a path that resulted in a massive improvement in their fiscal situation. The Canadian government cut federal employment by 14 percent, reduced Federal grants by 14 percent and forced the provinces to pony up 50 percent of the funding that was appropriated to them. Spending cuts exceeded tax increases by more than a 4 to 1 margin, but several taxes were in fact increased. The welfare system in Canada was revamped, payroll taxes for the Canadian Pension Plan (CPP) were adjusted to increase revenues and make the CPP fiscally sound. Finally, a highly unpopular general services tax (a fancy word for a value added/consumption tax) was implemented. Although these actions were controversial, the results were impressive. The Federal deficit in Canada, as well as most of the provinces, was balanced within three years. Accordingly Canada has been the only developed country that has been able to have basically balanced budgets during the latest decade. Despite misplaced fears that spending cutbacks and tax increases would hurt the economic activity real GDP in Canada has come in about 0.5 percentage points above the developed world average growth rate since 2000.
In our “Changing Seasons Part II” InSite commentary (November 17, 2010), we praised the work of the President’s bipartisan Commission on Fiscal Policy Responsibility and Reform under the direction of Erskine Bowles and Alan Simpson. We stressed that the commission’s proposal “to cut defense spending, raise the social security retirement age, cut the federal workforce by 10 percent, cut farm subsidies, scrap the deduction for mortgages over $500,000, raise gas taxes, lower corporate taxes (but eliminate deductions), raise capital gains and dividend taxes, simplify individual taxes, implement medical malpractice reform, and eliminate Congressional earmarks are bold moves that might just be what our budget process needs.” Although the proposal fell short of the overwhelming support vote need to force a congressional discussion, we still believe that this plan represents an excellent starting point if our fiscal policy leaders want to back their deficit cutting words with actions. We might be wise to learn some lessons from Canada and cut Federal appropriations and adjust tax rates. Maybe in 15 years we will be able to pen The United States Century: Moving out of Canada’s Shadow.
Statements concerning Commonfund Group’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group’s policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information.