Bad Moon Arising

Max B. Sawicky

August 25, 2005

Max B. Sawicky is an economist at the  Economic Policy Institute. He can be reached at his blog, MaxSpeak, You Listen!

While last week we were distracted by some euphoric fluff about this year's budget deficit, serious problems are brewing. The U.S. economy is facing two giant imbalances: the projected gap between tax revenues and federal spending, and the current, growing gap between what the U.S. buys and what it sells to the rest of the world. The measure of our political system's vacuity, fed by a brainless commercial media, is the inability or unwillingness to put these issues on the table. Consequently, when forced to deal with a crisis, the remedies are likely to be short-sighted, panicky and stupid.

In light of the interesting times that lie ahead, whatever happens to the 2005 or 2006 deficit is not even a sideshow; it's a flea circus.

There is some good news to be found. We're finally getting a glimpse of the long-promised job growth, and unemployment is a respectable 5.0 percent, but there is evidence of slack remaining in the labor market. Some who have left the labor force—and are therefore no longer counted as unemployed—would prefer to be working. Is there really a sudden rash of yearning for higher education or for the pleasures of hearth and home? Possible, but not likely. Such changes in behavior patterns typically take time to unfold, and the shifts since the 2001 recession seem relatively sharp.

Yet even that recent progress on jobs belies the overall awful record since the end of the recession in 2001. This recovery compares very badly to the 1993 recovery, which was no great shakes in its own right. One of the federal government's most important tasks is to alleviate employment slumps, and the Bush administration's neglect of this task has been its greatest domestic policy debacle.

The most important indicator that workers are chasing jobs, rather than the converse, is the dismal progress of wages. The Labor Department's most recent monthly report shows an increase in hourly pay of 0.4 percent. The annual equivalent, 4.9 percent, ain't bad. Except, unfortunately, the Consumer Price Index increased 0.5 percent in the same month, so inflation-adjusted wages decreased. Falling wages do not signal a robust job market.

The other dubious triumph of the moment is the federal budget deficit. The deficit for Fiscal Year 2005, in a victory over pessimistic expectations, turns out to be lower than previously expected, though still high compared to previous years. The difference was a surge in revenue that is attributed by you-know-who to supply-side effects of the tax cuts—greater investment, work effort and economic growth.

The bulk of the revenue surge was actually in the corporate income tax, and the bulk of that increase is due to the expiration of a temporary tax cut that had increased the deficit in previous fiscal years (2003 and 2004). It did not increase investment, it merely changed the timing of investment. This cut was part of the second Bush tax cut package enacted in 2002, which included a speed-up in depreciation deductions for business. By deducting sooner rather than later, you pay less taxes in '03 and '04, but more afterwards. Voila! Look how fast tax revenues went up! The Congressional Budget Office does not expect this revenue surge to persist.

The budget outlook darkens as we look forward. Estimates of falling deficits depend on unprecedented discipline in discretionary spending growth, and completely implausible cancellation of the Bush tax cuts after 2010. There is also the matter of a couple of wars. If military expenses grow, that's another ding in the fiscal fender.
 
These facts notwithstanding, little political advantage is likely to be found in the budget situation. The deficit outlook is not healthy, but it is probably digestible in the short term. No negative impact of the run-up in federal debt since 2001 can be found in the economy. Interest rates remain low enough for investment to go forward, not to mention housing market mania. Thus far, the tax cuts have been a free lunch for politicians. The real trouble comes later: Our economic future hinges on the fate of the dollar in international currency markets.

Quarter after quarter, the United States racks up record trade deficits. As we buy more from foreigners than we sell to them, the difference is made up by growing foreign ownership of financial assets denominated in dollars, including federal government debt and dollars themselves. Without this support from foreigners, particularly from the central banks of Japan and the People's Republic of China, the U.S. economy would be in a very different place.

Most economists feel this situation cannot go on indefinitely. But it does go on, and as long as it does, there will be no negative economic repercussions in the United States and no grist for anybody's political mill. On the other hand, if and when foreigners become reluctant to buy as much U.S. federal debt, or to draw down their dollar holdings, there will be bloody hell to pay here at home. This could begin to happen most any time. Even if there is never any crisis, that debt will require repayment out of U.S. economic output, putting a drag on domestic consumption and investment.

The famous housing boom has helped to fuel consumer spending. People watch their homeowners' equity blossom. They borrow against that equity to finance spending that their annual incomes could not support. They take out "nothing down" or interest-only mortgages, leveraging themselves up the wazoo. When housing price inflation slows down or even reverses in "frothy" regional markets, consumer spending will take its lumps, and employment will suffer. At worst, people in over their heads will be unable to carry their mortgages. In the wake of legislation passed this year, bankruptcy won't be as easy a transaction as it used to be.

Further mucking up the picture are energy prices. Even though gas is still cheaper than it has been in some years past, the longer, 80-year trend of falling gas prices may have reversed decisively. At any rate, spikes in energy prices preceded each of the five previous recessions. Consumers spend more on fossil fuel, which benefits foreigners who sell us their oil, and less on other things that support domestic employment. Rising gas prices weaken consumer confidence, dampening purchases across the board.

Looming a bit further down the road is another problem: the chasm between projected increases in federal health care spending (on Medicare and Medicaid) and tax revenue. We are talking about a gap equivalent to 8 percent or more of the Gross Domestic Product. Current total Federal tax revenue is about 17 percent of GDP. Note that health care won't get any cheaper in the private sector either, where it now increases by double-digit rates annually. So we are looking at a choice between unprecedented tax increases and the gutting of health care benefits.

This should be a period of preparation for possible adversity and planning for future, inevitable contingencies. Neither is being done. We're stuck in a misconceived war. We neglect genuine terrorist threats and foreign policy challenges. We are embroiled in debates with antediluvian minds over issues of gender, science and culture. Our public debt rises faster than our GDP.

Meanwhile, we expect foreigners to hold our IOUs.