Saturday, November 05, 2005

How Low Interest Rates Partially Mask the Bush Spending Spree

Last night, the Congressional Budget office came with its monthly budget review, with preliminary numbers for October 2005 and definite numbers for the 2005 fiscal year (October 2004-September 2005). Aside from minor adjustments, the numbers for fiscal year 2005 were already known. They showed the first decline in the budget deficit since fiscal year 2000, but not because of lower spending. Spending continued its 5-year trend of rising relative GDP. The explanation was instead a surge in tax revenues, casused by three factor: rising asset prices (boosting capital gains tax revenues), rising corporate profits and the expiration of depreciation incentives . Because of this government revenues reversed the trend of declining relative to GDP and rose from 16.3% to 17.5%. And as spending "only" rose from 19.9% to 20.1% of GDP, the deficit fell from 3.6% to 2.6%.

One spending item that deserves more attention then it have been given in most recent analysis of the U.S. Federal budget is net interest on the public debt. This is because it is only partially controlled by the President and the Congress. It is perhaps even more controlled by the Federal Reserve. Net interest expenditure is a function of two variables: the level of the public debt and the rate of interest. The former is basically controlled by the President and Congress while the latter is basically controlled by the Federal Reserve. While both (Just like any revenue and spending item) are also influenced by external factors of course, it is still fair to
say that the President/Congress and the Federal Reserve respectively controls them as they could if they wanted to cancel out the effects of the influence of those external factors through discretionary measures.

What we can see when taking interest expenditure into account is that Bush have in fact increased spending far more than the increase from 18.5% of GDP in 2001 (Clinton's last budget) to 20.1% in 2005 would suggest. In 2001 federal net interest payments was 2.1% of GDP but in 2005 it was only 1.6% of GDP. This decline was of course most definetly not the result of a debt reduction from Bush. Indeed,the federal debt increased from less than 33% of GDP in the second quarter of 2001 to 37% in the second quarter of 2005. Instead it was the result of a Fed-engineered decline in average interest rates from 6.4% to 4.3%. The savings that the Federal government have made from the Federal Reserve's easy money policy have thus served to partially mask the trend in non-interest spending.

If average interest rates on the federal debt had been unchanged, then interest expenditures would have been 2.4% now instead of 1.6% and federal spending would have been 20.9% instead of 20.1% and the deficit 3.4% instead of 2.6%.

The implication of this is that the much talked about spending spree from Bush and the Republican congress have in fact been underestimated when one only look at total federal spending (or even worse total non-military federal spending). If we only look at non-interest spending, it have increased from 16.4% in 2001 to 18.5% in 2005, the by far biggest increase during any president since at least FDR. And again, it gets even worse if we factor in the interest expenditures that the deficits during Bush have created.

Looking forward, interest expenditures looks likely to increase both because of the continued increased of the federal debt caused by the deficits and because interest rates have started to recover as a result of the Federal Reserve again starting to tighten monetary policy.

The preliminary results for October 2005 indicates very rapid spending growth and slowing but still strong revenue growth. Revenues increased 9%, which is slower than in fiscal year 2005, but still higher than nominal GDP growth. Spending increased at first glance only 2.5% (lower than inflation), but taking calendar effects into accout it too increased 9%, meaning that the underlying budget deficit also increased 9%. It is unclear to what extent these numbers are affected by Katrina.


Blogger Kathy said...

Hi, Stefan -- I've written a piece that examines the budget deficit/debt ... and links back to your article.

7:38 AM  
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11:14 PM  

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