I have been asked a lot recently by Wall Street economists about where Washington fiscal policy is headed. In short, I don’t expect much change. We’ll stay stuck at around $1 trillion of annual deficits in FY10, FY11, and probably FY12.
I say that because Congress has so far been unable to pass the extenders bill without fully paying for it. Although I expect unemployment insurance, another federal contribution to state Medicaid, and expiring tax provisions to pass eventually, it has taken far longer than I expected. Similarly, large deficit reduction is off the table as evidenced by Congress’ failure to pass a budget resolution with the reconciliation instructions necessary to take a bite out of the deficit. If the Republicans take the House in November and gain 5 or 6 seats in the Senate, Congress will be even more polarized next year. I see offsetting demands for spending cuts and tax cuts that leave the deficit essentially unchanged. The largest source of deficit reduction this year and next may well be whatever President Obama can do on his own administratively. Yesterday, Defense Secretary Robert Gates pledged to shed $100 billion from the Pentagon budget over the next five years. That’s a start, but it’s not much in the face of trillion dollar deficits and a weak economy.
Today’s 3% market decline reflects a lot of forces, led by fears over lower world growth resulting from a potential string of European defaults, but I believe it also reflects new thinking that our economy will hit another rough patch late this year and early next year. The American Recovery and Reconstruction Act stimulus will wear off quickly from now on. State budget deficits will force substantial new layoffs. Home foreclosures will hit with ever increasing force — 7 million are in process, and another 5 million are on the way out of a total of 56 million mortgages overall. GDP growth has been too weak to create many jobs, and it will get weaker. At some point, probably next year, even a modest rise in interest rates will put another large burden on the economy. Today’s sharp drop in the Conference Board’s consumer confidence index seems to be the coup de grace.
What more can Washington do? We’ve already done about everything anyone can think of to stimulate the economy. It’s had some beneficial effect, but it may not be enough. I am still haunted by Robert Schiller’s statement to the National Economists Club on May 5, 2010, “The real worry is that we’ll grow slowly until we run into the next recession.”