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The Deficit: No Longer Quite So Scary

By Ryan Brecht On the surface, it sounds bad alright. The U.S. Treasury reported that despite a September budget surplus of $26.4 billion, the government was left with a record $374 billion deficit in fiscal 2003, ended Sept. 30. It's likely the deepening budget gap will cause a renewed round of doom and gloom from political pundits.

But a reality check is in order: The shortfall is actually well short of the deficits that were originally anticipated. Moreover, although the impending passage of another sizable spending bill would worsen the fiscal 2004 deficit, recent trends in government outlays and receipts suggest that concerns over deficits ballooning well into the future are considerably overdone.

IMPROVING ECONOMY. Government outlays for fiscal 2003 failed to show the rapid growth that had been feared with the buildup for the Iraq war and subsequent strengthening of domestic security. The major concern early on was defense spending, which were seen as the most likely epicenter of budget shock. However, these fears weren't realized in fiscal 2003, as growth in this crucial component stabilized at around 15% to 16% on a fiscal year-to-date basis. Moreover, total outlays expanded 7.2% year-over-year during 2003. While this is at the higher end of spending increases seen during the 1990s, it's well below the huge spending gains of the 1980s.

In the case of money that Uncle Sam took in, the figures for the year confirm that the erosion wasn't the catastrophe that many had feared. Receipts fell almost 7% during the last fiscal year, with much of the decline due to the recent round of tax cuts, which had a sharp negative impact on the final quarter of the fiscal period.

Moreover, receipts slipped a mere 0.5% in September as an improving economy helped shore up Treasury's coffers. And the modest dip in September income came despite an important component of the new tax package that allowed businesses to delay paying 25% of their quarterly payment due during October.

WRONG BY A LONG SHOT While the fiscal 2003 deficit of $374.2 billion exceeds the previous record $290 billion shortfall in 1992, it lands well short of earlier estimates that were in the $450 billion ballpark. Indeed, it appears that many analysts overestimated the deficit's extent by a remarkable margin.

Surprisingly, the most prominent overshoot came from within the government itself. The Office of Management & Budget (OMB) sounded the alarm last summer when it raised its deficit estimates to $455 billion and warned that deeper red ink was in the cards. That miscalculation brings into question the OMB's renewed warning that the deficit could climb above $500 billion in fiscal 2004.

If economic growth through 2004 is as robust as we at MMS anticipate, the deficit should be nowhere near the OMB's estimate. We expect that improving receipts would take the deficit down to $320 billion this fiscal year, though the virtually certain passage of President Bush's spending package for Iraq would push the gap back up to just above the $400 billion threshold.

LESS THREATENING RATIO. Still, the fiscal 2003 deficit and the budget outlook are less threatening when viewed as a percentage of gross domestic product. The deficit accounted for 4.7% of GDP in 1992 -- more than a percentage point higher than the 3.5% ratio implied by our forecasts for fiscal 2003 deficit growth. And despite pending legislation raising the risk that $87 billion in extra Iraq-related costs will boost the deficit above $400 billion, the debt-to-GDP ratio would rise only 0.1 percentage point from 2003.

Even if it turns out that the OMB's unlikely worst-case scenario of a $500 billion deficit comes to pass, the ratio would be left at 4.4%. This would be well short of the 5.7% peak reached in 1983. So as it stands, the deficit isn't particularly onerous by historical standards. And with the economic recovery expected to solidify in the months ahead, bolstering government receipts, a shrinking tide of red ink after 2004 should sharply reduce the share of GDP taken up by the deficit.

The bottom line: An improving deficit picture will put less pressure on Washington to tap the credit markets during 2004, soothing market fears that an oversupply of government debt will help push interest rates higher. And that's good news for the economy and Wall Street -- especially a Treasury market already jittery about the potential for Federal Reserve-engineered interest rate hikes in the months ahead. Brecht is a senior economist for MMS International in Belmont, Calif.

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