Taxes, Higher Rates May Derail Recovery

NEW YORK (TheStreet) -- President Barack Obama's 2011 budget brings with it increasing anxiety over the direction of fiscal policy and the yawning federal deficit.

This concern is clearly well-placed and, in fact, the issues regarding fiscal policy are likely more severe than what the top-line budget submission indicates. The bottom line is that the fragile recovery the U.S. is now experiencing will, at some point, be derailed by fiscal actions. It's merely a question of when and to what degree.

To understand why this potential derailment looms, it is important to first frame the problem.

The magnitude of the projected deficits in excess of $600 billion a year is troubling, but we need to adjust this number to accommodate a number of factors.

First, the deficit assumes a pace of economic growth and spending restraint that is not likely to transpire. The "real deficit" over the next few years is likely in excess of $800 billion. This gap is largely due to a spending spree that has gone unchecked -- consider the 32% increase in the latest fiscal year.

Second, the federal-deficit projection does not include the immense budget shortfalls at the state and local level, which run at about $200 billion a year.

Finally, the deficit continues to ignore the lingering unfunded obligations that federal, state and local authorities keep "off budget" that come due over the next decade.

Given the realities of budget pressures, something is going to have to give and the required actions will potentially disrupt the recovery at some point. It is merely a question of degree.

The level of structural deficits will require tax increases, starting with the lapsing of the Bush tax cuts. In fact, the Obama budget projects that revenue will grow by a whopping 67% between 2010 and 2015. Increasing taxes in a fragile recovery is a clear recipe for slower growth and a high probability of stalling the recovery at some point.

An alternative outcome is to try to finance the deficit and cope with the impact in financial markets through higher interest rates. Higher real rates are also a depressant on growth. Coupled with tax increases, we may be facing a double whammy.

Alternatively, governmental entities theoretically could cut spending and deal with a lesser economic impact but be forced to face the political hardship from reducing politically popular programs.

We expect the recovery to gain momentum in 2010 and perhaps into the second half of 2011. Taking a longer view, though, there are troubling signs beyond the next 18 months. The fiscal woes of governmental entities will likely derail the recovery at some point, maybe not to the point of a double-dip downturn, but certainly sub-trend growth.

For investors, it is essential to recognize these risks and work with their financial advisers to balance risks.

Paul Ballew is senior vice president of customer insights and analytics at Nationwide Mutual Insurance in Columbus, Ohio. Ballew previously served as a Fed economist, a partner for J.D. Power and a senior executive at General Motors.

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