There isn't alot of good economic news to go around these
In the finalyear of President George W. Bush's second term and
in the first two years of President Barack Obama's first term,
the U.S. government spent at least $1.3 trillion more each year
than it collected intaxes . By 2010, things looked quite bleak,
and it appeared as though Washington lacked thewill to take
At the time, I suggested a series of hard choices facing
lawmakers that could have a meaningful impact.
Sure enough, despite the lack of a broad formal agreement
(known as the "grand bargain") between Republicans and Democrats
to cut spending and boost taxrevenue , progress has been made
According to the U.S.Treasury Department , total federal
outlays (on a rolling 12-monthbasis ) are actually lower than
they were two years ago. That's the first time the U.S. has
actually reduced spending since the late 1940s.
In light of this progress, investors should be quite pleased.
After all, the nationaldebt still stands as one of the greatest
long-term threats to oureconomy . Falling deficits (and hopefully
eventually falling debt levels) reduce the risk of an economic
calamity, and lower risk means thatstocks can afford to trade at
higher valuations. Indeed, the recentrally in U.S. markets may
already reflect reduced debt concerns.
That doesn'tmean it's time to celebrate. Total debt is still
rising. Perhaps of greater concern, smaller deficits means
reduced government spending and higher tax receipts, both of
which can create a drag on economic growth. So it's crucial the
U.S. economy grows at a pace much greater than the fiscal drag
thatdeficit reduction entails.
Thanks to a combination of spending cuts and tax hikes, the
deficit fell to $1.1 trillion infiscal year 2012, and while many
expected that figure to dip slightly below $1 trillion this year,
we're doing a lot better than that.
It now looks as if the budget deficit will be under $800
billion this year. According to Goldman Sachs, it could shrink to
$600 billion next year and $475 billion in fiscal 2015.
Source: Goldman Sachs. Note: Fiscal year ends in September.
'"This slowdown has occurred with essentially no effect from
sequestration, which is expected to reduce spending by $42
billion in fiscal year 2013 but probably had very little effect
on outlays through March," note Goldman'seconomists .
The forced spending cuts from the so-called budget sequester
are expected to trim the deficit by $89 billion on a full-year
basis in fiscal 2014. The 2.4% drop in spending in the first six
months of fiscal 2013 is the result of shrinking
governmentpayrolls and a wind-down of the wars in Iraq and
For much of the past year, monthly employment reports have
been characterized by robust private sector jobgains ,offset by
government job losses. That means our nation's employment picture
would have been even better by now were it not for the government
employment shrinkage. And it's a hopeful indicator that we'll see
the nationalunemployment rate move lower when the government's
employment levels stabilize.
Yet the realcredit for the shrinking deficit goes to the
revenue side of the ledger. In the first six months of fiscal
2013, governmentrevenues are up 12.4% due to changes in the tax
code and more robust economic activity, which fuels greater tax
The trend appears intact into April, with personal and
corporate tax payments trending 34% higher than a year ago. "The
last time April tax-filing season payments gained this much over
the prior year was in 2005 and 2006," Goldman's economists
As further hikes in tax rates appear politically impossible
(and perhaps unwise), look for lawmakers to focus on closing
loopholes. In October, I outlined several ways that could reduce
the deficit to zero.
Frankly, our nation's lawmakers have no choice but to take
further steps. As I noted in my December 2010 column, we're still
"sitting on a whopping pile of unpaid bills that has been run up
for the past decade." According to the U.S. Treasury, our total
national debt is $16.8 trillion and still rising.
Some economists suggest that we can sustain moderate budget
deficits in perpetuity, as we have done for many decades. But
that's foolhardy: The interest expense on our total debt will
eventually become unmanageable when interest rates start to
As I noted in December, our annual interest expense on the
debt seems manageable now in the $350 billion to $400 billion
range. However, that expense would rise to nearly $700 billion a
year if interest rates were to return to 2005 levels.
In effect, we're hoping that interest rates stay low for a
very long time to come. Ideally, the government would be selling
only 20- or 30-yearbonds now, and paying off the short-term debt
obligations, to buy more time to fix the problem. But the U.S.
remains vulnerable to a rise in interest rates, and that would
force the government to slash cherished programs -- or we would
see our deficit swell anew.
Risks to Consider:
Forecasts of further drops in the deficit are based on
moderate economic growth expectations. But if the economy slumps,
so will tax receipts, and the deficit will start to rise
Action to Take -->
The shrinking deficit is clearly good news and may help partially
explain why stocks have fared quite well in recentquarters .
Washington deserves some credit, but this is no time to step off
the gas pedal. The U.S. economy appears to be taking the tax and
spending changes in stride, and as the economy gets stronger,
policymakers should be emboldened to seek out further steps to
close the budget gap.
These further steps won't be easy, but we have a pretty clear
sense on how they'll play out. Higher tax rates appear unlikely,
but both political parties appear willing to close tax loopholes
to raise revenue. Areas such ascredits for research and
development,mortgage interest deductions, charitable deductions
and other sacred cows may come on the chopping block.
On the spending side of the equation, there is also more pain
ahead. The Department of Defense is coming under pressure to do
more with less, which means it's risky to invest in defense
stocks right now. This is a good time to determine the amount of
exposure to government spending for eachstock in your portfolio.
Long-held federal contracts are coming under greater scrutiny and
can't be counted on in the future.