Surplus, Anyone?

The short-run implication of federal budget surpluses may be a need for an even tighter monetary policy.
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For anyone whose memory goes back more than 10 years, it is almost surreal that the

Congressional Budget Office

, a nonpartisan and apolitical technical staff, now projects federal budget surpluses totaling more than $3 trillion over the next 10 years. Three trillion. U.S. dollars.

This is a double shock to the memory of geezers whose storage is cluttered with leftovers from the 1980s, or even earlier. They are still dealing with the astonishing disappearance of the Evil Empire. Nothing seemed more permanent and dead-weight depressing than the Soviet Union, unless it was federal deficits. And now -- poof! -- gone, both of them. The evaporation of deficits is actually related to the demise of Stalin, Brezhnev, et al, but that's a different tale than this one.

You may not have seen this $3 trillion figure elsewhere. I arrived at it by taking the $838 billion operating budget (i.e. non-Social Security) surplus now projected by CBO under "realistic" assumptions, and adding it to the $2.3 trillion it foresees for surpluses within the Social Security system. And rounding, of course. There aren't many calculations available to the typical analyst where rounding to the nearest trillion is well within one standard error and therefore close enough. With $2.3 trillion extra in Social Security funds seeking investment in

Treasury

securities, and $838 billion in operating surpluses available to absorb the publicly available supply of those same issues, the entire $3.6 trillion of "the world's safest investment" might be bid away from the investing public within little more than 10 years.

What is the significance of these estimates? For one thing, they demonstrate that times change. Ten years ago, CBO and its sibling in the executive branch, the

Office of Management and Budget

, were diligently forecasting deficits "for as far as the eye can see". Lasik corrective surgery has been developed within the past 10 years, so maybe that explains these numbers, or perhaps CBO managed to recruit

St. Jude

, the patron of lost causes. Or maybe it is simply that the concept of "automatic stabilizers" has turned out to be something more than a textbook anachronism. The burgeoning inflow of tax payments that has turned federal ink from red to black is a direct result of the personal income, corporate profits and capital gains generated by a booming economy.

More meaningful, however, are the implications, both longer-term and more immediate, for economic policy and investment strategy in these new numbers from CBO.

In the long term, defined here to mean CBO's 10-year horizon, these projected surpluses constitute the flip side of the "crowding out" case that was debated at length when the federal budget began to hemorrhage red ink in the early 1980s. Back then, the concern was that federal operations would push to the head of the line in capital markets, absorb a disproportionate share of national savings, and stunt the economy by raising the cost of capital for private investment. As it happened, that fear proved misplaced because foreign savings supplemented domestic; good ideas got financed in U.S. markets despite the hoggish behavior of the Treasury.

Presuming we now face the opposite "problem" -- that is, the presence of Treasury in the markets as a

source

of funds rather than a user -- the implication is that capital will be abundantly available, almost without limit. Therefore, its cost will fall and virtually any raggedy brainless idea will be able to find funding -- think of something like the IPO market lately. Too low a cost of capital doesn't sound like much of a problem, but a lack of discrimination among investment projects may lead to overbuilding of capacity and a trivializing of national investment -- think of something like today's McMansion phenomenon.

Given both the current degree of economic internationalization and the take-away from the 1980s experience, it is reasonable to consider that excess national savings, if any, that develop as a result of federal budget surpluses will flow overseas in search of useful employment. The flip side of the trade deficits of the 1980s, the "twins" of those federal budget gaps, may be the trade surpluses of the 20-naughts, or whatever the coming 10 years is to be called. If the Treasury can become a net supplier of funds to the markets, maybe it is not unthinkable for the United States to become a net supplier of goods and services to the rest of the world.

In the shorter run, however, this budgetary good news will be received with some nervousness by the

Fed

. First, it is just more evidence of the momentum of U.S. domestic demand, that it can produce 4% GDP growth despite the drag of federal surpluses and current account deficits. Second, it suggests the Fed will be left alone to effect the necessary but politically unpopular braking of U.S. momentum. These surplus projections will prove to be irresistible on both sides of the aisle in

Congress

. Tax cuts? Spending increases? Sure, why not? There is enough for everyone -- we're talking trillions here. Log-rolling may become the national pastime.

The short-run implication of federal surpluses may prove to be a need for an even tighter monetary policy than is now built into market expectations. The textbooks' "automatic stabilizers" didn't anticipate discretionary tax cuts at the top of the cycle any more than the CBO expected to revise its huge deficit projections by simply changing the sign. With presidential and congressional campaigns heating up in this Olympic year, you'll have no trouble keeping a running tally of the number of times that tax hikes will be proposed.

CBO's numbers haven't exactly galvanized market thinking, but their implications are wide-ranging and deep. The sheer scale of the projected surpluses makes tax cuts irresistible, thereby reducing the degree of fiscal drag that has been exerted on the economy. That leaves the braking responsibility even more fully in the hands of the Fed. If for no other reason than contingency planning, strategists ought now to be conjuring with interest-rate outlooks significantly higher than the bearish cases currently in the market.

Jim Griffin is the chief strategist at Hartford, Conn.-based Aeltus Investment Management, which manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at

GriffinJ@aeltus.com.