Smaller Than Expected Budget Deficit Could Stave Off Rising Interest Rates
By Jason Simpkins
President George Bush last week predicted that robust tax collections would cause the U.S. budget deficit to shrink to $205 billion this year, the third straight year of annual decline.
“The President’s pro-growth policies have worked,” the White House said in a statement released with the budget forecast, “Tax relief has been good for American taxpayers and the American economy, and the stronger economy has been good for the nation’s treasury.”
It could also be good news for the U.S. private sector.
President Bush, who failed to push a highly publicized immigration bill through legislation, in addition to being mired in criticism over Iraq, was eager to claim a victory for his 2001 and 2003 tax cuts.
In a speech in Cleveland on Tuesday, President Bush remarked, “We kept your taxes low, which caused the economy to grow, which yielded more tax revenues. And because we set priorities the deficit is shrinking.”
It should also be noted that initial budget estimates, like the one the President issued in February often underestimate revenue growth and overestimate deficits in an effort to cushion the blow later in the year. Also, many private forecasts anticipated an even lower budget gap, one closer to $150 billion. In June, the Congressional Budget Office predicted the deficit for the current fiscal year would total between $150 billion and $200 billion.
Democrats, equally eager to fan the flames of a besieged Republican administration heading into an election year, were quick to respond.
Senate Budget Committee Chairman Kent Conrad, was one of the first to respond pointing out, “[President Bush] has increased spending by nearly 50 percent since taking office, while at the same time cutting taxes primarily on the wealthiest.” Conrad went on to say, “Debt has exploded on his watch rising - from $5.8 trillion in 2001 to approximately 9 trillion by the end of this year.”
The shrinking expectations for the deficit can be attributed to a particularly prosperous period of tax collection, spurred on by bigger paychecks and larger capital gains from a strong stock market.
The U.S. deficit has trimmed enough fat this year to account for approximately 1% of the total U.S. GDP, a marked improvement from 3.6% in 2004 when the deficit reached an all time high of $413 billion.
While it’s not a surplus, a dwindling deficit is good news for the economy. As the U.S. deficit grows, particularly at the rate it has been growing in recent years, the risk of rising interest rates becomes more and more imminent.
Compounding that risk is the Fed’s mounting concerns about inflation. Chairman Ben S. Bernanke has held rates steady in recent months, but his repeated remarks about inflation have taken and increasingly ominous tone. Indeed, the possibility of a rate hike in the near future is very real, but made far less probable by positive news regarding the budget.
When government borrowing spirals higher - especially during periods of tight credit or high interest rates, it can create a “crowding out” effect, in which prospective private sector borrowers find it hard to raise capital.
It makes sense: The federal government is viewed as the best credit risk around, giving it first crack at the limited available capital. Whatever is left over is what the private sector has to wrestle over, and the credit-rating pecking order ranks the winners and losers. In periods where the deficit is high and the government is borrowing heavily, there’s often not enough capital left to go around, which can have a concretionary impact on the economy.
But with the deficit falling, the reverse will be true. And at a time when the credit markets have been roiled - as the subprime bubble has done of late - the shrinking federal shortfall may be just what the economy ordered.
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