The Independent Market Observer

2/28/14 – The Future of the U.S. Budget Deficit

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 28, 2014 5:34:12 AM

and tagged Politics and the Economy

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Add another to the list of “best since 2008” stats (although a better phrase might be “least worst since 2008”). The federal budget deficit for 2013 should come in around $680 billion, down from about $1.1 trillion in 2012.

As a citizen, I can’t help but applaud the drop. We are moving in the right direction. If we consider the deficit as a percentage of the economy as a whole, the improvement is even more substantial, since, in dollar terms, the economy has grown even as the deficit has shrunk. For 2013, the deficit is about 4.1 percent of the economy, down from more than 10 percent at the peak. In 2014, there’s a good chance it may shrink further, to a level below that of economic growth—which means the debt could actually start to shrink as a percentage of the economy. This is exactly where we need to be headed.

As an analyst, though, I am less encouraged. Make no mistake, the news is good. The question is whether these positive trends will continue, or whether the current good results are likely to change.

The improvement in our budgetary situation comes from the tax increases that took effect at the start of 2013, the spending cuts that took effect with the sequester, and, to a larger extent than many realize, from the recovery of the housing market. The government has pocketed the profits from FNMA (Fannie Mae) and FHLMC (Freddie Mac), the mortgage companies that it nationalized, to the tune of billions of dollars.

All of these are one-time hits, and the substantial improvements they created won’t be repeated. Indeed, the next round of sequester spending cuts were eliminated in the recent spending and budget agreements, and government spending is set to tick up a bit in the next two years, not down. The slowdown in the housing recovery can reduce the government’s take from the mortgage market over the next couple of years, and further tax increases are politically very unlikely. What we have now is what we’re going to get.

The ongoing economic recovery should help tax receipts, so we can expect to see continued revenue growth, just not as fast as we did in the past year. Spending, also, stands to grow more slowly than normal, but not to shrink like last year. There’s even the prospect for some kind of tax reform, as I wrote earlier this week, although that’s much more likely for 2015.

We can expect continued improvement, then, but not like in the past year—and the underlying trends may reverse that improvement in a couple of years unless something is done.

The Congressional Budget Office (CBO) is the nonpartisan referee in budget debates and prepares the most reliable projections available. Below is the most recent set of figures from the CBO.

1

I’ll dig more into this chart next week, but for the moment, note that the total deficit is expected to decrease as a percentage of the economy in 2014 and 2015—before starting to rise again. The current improvements, while positive, haven’t solved the longer-term problem.

Note also that the primary deficit—that is, the deficit before interest expenses—is expected to decrease through 2020. The projected growth in the deficit from 2015 through 2020, then, isn’t due to direct government spending but to rising interest expenses on the accrued debt. This is a key point, as it starts to show the growing effect of interest on the U.S. budget. We’ll take a more detailed look at it next week.

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