On March 20, 2009, the bipartisan Congressional Budget Office (CBO) released its latest forecast in an effort to take into account the impact of the recently released Obama budget. The verdict? A whopping $1.8 trillion deficit for 2009, approximately four times larger than the all-time record established in 2008 ($455 billion).
The concerns raised by this latest forecast are many:
- A mere two months ago, the CBO's estimate for 2009 was "only" $1.2 trillion. They have already grossly underestimated a deficit that will most likely continue to balloon in the coming months.
While the new administration
- has focused its attention on the spending side of the budget, it has paid little attention to the other side of the equation. What will happen when tax revenue comes in much lower than current projections?
- Even ignoring the likely expansion of the projected deficit, where will we get the $1.8 trillion needed to cover the CBO's estimated deficit? Foreign investors? Higher taxes? Or that old standby, the printing presses?
Buried in the latest CBO forecast are numerous reasons to be alarmed, chief among them the authors' admission that they have no idea what the future holds for the economy. They state:
"Both the magnitude of the contractionary forces operating in the economy and the magnitude of the government's actions to stabilize the financial system and stimulate economic growth are outside the range of recent experience. The forecast assumes that financial markets will begin to function more normally and that the housing market will stabilize by early next year. The possibility that financial markets might not stabilize represents a major source of downside risk to the forecast."
To cover themselves when their forecasts fall flat, the CBO members offer the following caveats:
"Households' and businesses' confidence is also difficult to predict."
"CBO's forecast incorporates the middle of the range of the agency's estimates of ARRA's impact on GDP and employment, that range is quite large."
These statements are somewhat disconcerting when we remember that in January 2008, it was this same CBO that predicted the U.S. government's fiscal year deficit would be $250 billion. What did we end up with? A $455 billion deficit. They weren't even close.
What also worries us is that while the CBO clearly states that its forecast includes the impact of the currently approved programs, it fails to take into account any further bailouts of various industries, any new stimulus packages, or any additional programs proposed by the administration.
While the current CBO forecast is the result of very scientific economic models put together by a multitude of experts, our economists at Casey Research question many of its basic assumptions by applying the same logic that allowed us - more than three years ago -- to correctly predict the subprime crisis and its expansion into a widespread financial disaster. We knew then that the models supporting the valuation of many derivatives were flawed, even as other analysts were claiming that real estate values were never going to decline and that securitization of subprime mortgages could magically eliminate default risk.
Applying this basic logic, let's look at some of the core assumptions in the CBO forecast:
The Consumer Price Index is expected to drop from +3.8% in 2008 to -0.7% in 2009 (good news), while unemployment is projected to grow from 5.8% in 2008 to 8.8% in 2009 (it could be worse). The cost of borrowing record amounts of money will decline from 1.4% to 0.3% for the 3-month T-bill and from 3.7% to 2.9% for the 10-year T-bond (convenient).
In The Casey Report our Chief Economist Bud Conrad compared data from the current recession with those of serious crises in the past. His conclusions? Although the impact of the current financial turmoil has been serious, we are nowhere near the average bottom experienced in other serious recessions.
The unemployment rate is expected to bottom at 8.8% in 2009 (we are almost there), only two years after the start of the current recession. Unfortunately, history tells us that these forecasts may be far too optimistic. Looking at trends of the past, on average, unemployment peaked about four years after the start of a serious recession. In the worst case, the peak occurred 11 years after the start of the decline.
In addition, a rate of 8.8 % unemployment would look pretty good if compared to the figures in past crises. Historically, the average bottom was reached at 11%, while the worst-case scenario saw 27% unemployed.
Currently, Gross Domestic Product has only contracted by 1.5% (conveniently, the CBO estimates the GDP's contraction to bottom at precisely 1.5% in 2009 before expanding again in 2010). What does history tell us? In previous recessions, the GDP dropped by 9.3% on average and by 28% in the worst case.
Based on its projected 1.5% reduction in the GDP, the CBO estimates that tax revenue will fall by as much as 13.4% (with part of this decline due to planned tax reductions for lower-income Americans). A more realistic, 5% reduction in GDP could have a far greater impact on revenue and cause a significant increase in the deficit.
To properly calculate the decrease in tax revenue, the following factors must also be considered:
1) A 5% drop in GDP equates to a much greater drop in tax revenue. Tax receipts are based mainly on income, and most companies will see a far greater than 5% decline in net income for a 5% decline in sales;
2) As incomes go down, many taxpayers will drop into lower brackets, thereby dropping the average tax rate collected;
3) If businesses/individuals anticipate a decrease in income for the coming year, it can be expected that they will not pay their full quarterly payment obligations, instead taking the risk of estimating what their exact tax liability will be;
4) Some taxpayers may be in such dire financial straits that they are unable to pay their taxes or quarterly estimates;
5) After the losses accumulated in 2008, investors are unlikely to be paying much in the way of capital gains taxes for 2009 and probably for several years to come;
6) The underground economy - signified by an increase in cash transactions not reported to tax authorities -- tends to thrive when recession hits. People have an extra incentive to save their precious dollars and are willing to take more risk, rather than hand over their money to the government.
In the midst of the Great Depression, the 1931 federal tax revenues had fallen by 52% from their 1929 highs. While we do not expect anything that dramatic in 2009, it would not be unrealistic to see a 20% to 25% reduction in cash flow from tax collections this tax season. Such a drop would pose significant challenges given that spending commitments are off the charts and climbing.
From September 2008 to January 2009, the monetary base more than doubled from $800 billion to $1.7 trillion, while M1 increased by 15%. Since then, the Fed has committed to buying an additional $300 billion in long-term Treasury bonds and to printing whatever it will take to jump-start the economy.
Is it reasonable to forecast zero inflation and historically low interest rates for this year and the foreseeable future?
While the credit freeze of the fall of 2008 triggered powerful deflationary forces, especially in commodities and real estate, we expect the impact of monetary expansion to have a measurable inflationary effect as early as the second half of 2009.
The U.S. government needs to roll over $2,596 billion of outstanding Treasury bills and notes coming due in 2009 before it can add any new borrowing to finance the expected deficit. In previous years, foreign investors have invested most of their trade surpluses - to the tune of $200 billion to $500 billion per year - in Treasuries and agency debt. We cannot expect this trend to continue as we go forward, especially given that China, Japan, and the Middle East are experiencing a sharp decline in their exports and have indicated that they will have to support their own economies with massive stimulus packages. These actions will further reduce their propensity to buy U.S. debt. The Treasury Department recently reported that in January 2009, international sales and purchase of U.S. assets showed a net outflow of $148 billion. This could be a sign that "the times, they are a-changin'."
Assuming that foreign investments will not represent a large source of financing for the $4 trillion plus of U.S. Treasuries our government needs to sell this year, we will be forced to rely on domestic institutional and private investors. The problem here is that a great deal of institutional and private money has already fled from riskier categories of assets into lower-yielding Treasuries. If anything, these funds will be looking for higher-yielding investments as soon as possible.
In the absence of sizeable increases in tax revenues, it is quite clear that the lion's share of the planned sales of Treasuries in 2009 cannot be met by demand from the market. Either the Treasury will have to raise interest rates significantly, or the Fed will need to step in very aggressively to support the planned auctions. Our expectation is that both will happen. Auctions will fail and the Fed will step in. The market will react to more printing by anticipating inflation and demanding higher interest rates. Once the cycle starts, it will be very hard to pull interest rates back.
We continue to stand by our December forecast that the 2009 budget deficit is more likely to widen to levels between $2.5 and $3 trillion rather than the CBO's $1.8 billion forecast. We also believe that inflation could start setting in as early as Q3 of 2009 and will accelerate sharply by 2010. Treasury rates will start climbing and the era of cheap money will end, making it harder for overleveraged consumers, businesses, and governments to service their debt.
Monetary devaluation will be the only way for the U.S. government to shift the cost of irresponsible spending into the future. Our politicians are betting on the fact that this will happen after the next elections, thereby allowing them to continue to blame others for their reckless stewardship of the economy.
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