The consequences of the troubled asset relief program (TARP) will be felt for a number of years. The death of the investment-banking model, the transformation of the domestic system of finance and the coming wave of regulation of what is left of Wall Street will have far-reaching consequences. This, however, will take much time to absorb and assess. What is of immediate concern, is how the proposed $700 billion TARP will impact the budget outlook for fiscal year 2009.
Looking at the -$486 billion deficit throughout the first 11 months of the 2008 fiscal year the primary catalysts for the sharp increase in federal spending have been the fiscal stimulus and decline in tax revenues caused by the economic downturn. We expect that the final month of the fiscal year will see a net surplus for the month near $46 billion. Thus, the fiscal year, which will come to a close at the end of September, should see a deficit of -$440 billion in contrast with the -$162 billion deficit recorded in fiscal year 2007.
Once one begins to take a look at the staggering problem at hand, the deficit that was previously projected by the Congressional Budget Office of -$438 billion could easily double. Our first cut estimate now expects that the deficit could reach as high as -$585 billion in fiscal year 2009.
We make that estimate based on the following assumptions.
- Tax revenues will continue to underperform on the back of a much rougher economic landscape than the CBO currently has penciled into their model
- We expect an additional fiscal stimulus of a minimum of $50 billion dollars, with risk to the upside
- Increased outlays to cover coming bank failures of a minimum of $30 billion in FY 2009.
- An extension of the Alternative Minimum Tax fix
- This does not account for any additional spending that may be put on the books in the first few months of the new administration in 2009
- It is unclear how much of the estimated $700 billion TARP will be allocated to FY 2009 spending. We expect that it will be valued as such that it does not significantly increase the overall budget.
- This assumes that the bailout of Fannie and Freddie are not put on the books in FY 2009
- According to the CBO no decisions have been made regarding how the funds pledged will be allocated
- CBO Director Peter Orszag believes that the bailout of Fannie Mae and Freddie Mac “should be directly incorporated into the federal budget.”
- Our initial estimate of $300 billion as the price tag for the bailout of Fannie and Freddie was based on an assumption of a 5% loss in the overall value of the GSE's. This may be on the light side and the cost could be considerably larger.
- Such a move would be quite contentious and could raise direct questions regarding the credit quality of the US.
- Depending on how the U.S. Treasury proceeds and how the outlays are valued and classified the FY 2008 debt could easily reach $885 billion with considerable risk to the upside once one adds in any spending during the early portion of the new administration.
The short-term consequences of the bailout are quite clear. The fiscal years 2009 and 2010 will see record deficits on a nominal and possible real basis. The debt to GDP ratio will increase from roughly 3.0% of GDP in 2008 to a possible 6.0% in 2009. The steps that are about to be taken will crowd out other spending priorities and may lead to a reassessment of current entitlement obligations, foreign operations, national healthcare system and levels of taxation.
Long term however, the consequences are unclear. The major issue that is rightly being discussed is; will the increase in federal outlays be inflationary? On first look, the increase in spending and rising public debt is not necessarily inflationary. The Fed can take steps via the federal funds rate to maintain price stability.
Unlike, in many developing countries the Congress, outside of printing coins, does not have access to the printing presses. As long as the Federal Reserve does not make the decision to monetize the debt, the inflation problem from the increase in outlays could plausibly be addressed. However, this will require the Fed to remain focused on price stability and to continue to make the case that stable prices are a precondition of maximum sustainable employment. This may require the Fed to impose higher rates on short-term borrowing than our political and financial classes are currently comfortable. Yet, that is a very tall order for even an independent central bank to fill.
While, there is theoretically no direct impact on the rate of inflation due to the increase in spending, there is the chance that the introduction of political logic into an otherwise economic process could alter the equation. One does not need to be able to recall Lyndon Johnson literally pressuring Arthur Burns into funding his foreign adventures and ambitious domestic spending initiatives, to imagine that the constellation of political forces inside Washington could begin to bend the will of the Fed.
Should the current financial crisis lead to significant deterioration in the economy or taxpayer losses exceed current estimates due to the sheer cost of the financial bailout, pressure could be brought to bear on the Fed in such a way that it may be difficult for the central bank to focus on price stability. The central bank might at some point in the not so distant future decide to tolerate a far higher rate of inflation than is consistent with a non-inflationary target rate. The temptation to keep the federal funds rate low and partially monetize the debt may prove irresistible to the central bankers that may run the Fed in the aftermath of the Bernanke tenure.
Past episodes of inflation have often begun under such conditions. Past deterioration in public finances have often led to unwise monetary policy. Today, the probability of the printing presses being cranked up to fund current obligations of the Federal Government remains low. However, for individuals and institutions engaging in long term investment decisions the risk of higher inflation over the long term due to the sharp increase in federal outlays and public levels of debt should receive serious consideration. It cannot be automatically dismissed out of hand.
Joseph Brusuelas
Chief Economist
Merk Investments