Backgrounder Update #59
November 10, 1987
(Archived document, may contain errors)
THE DEFICIT SUMMIT: OVERLOOKING THE REAL CAUSE OF THE MARKET CRASH
(Updating Ba@under Update No. 56, "An Eight-Point Presidential Agenda for the Budget Summit," October 26, 1987)
In their desperation to reach a settlement at the White House-Congress budget summit, negotiators seem determined to ignore the true causes of the October 19 stock market crash. Fingers quickly pointed to the size of the federal budget deficit and Ronald Reagan's reluctance to back off on his no-tax-increase pledge. But these fingers, it turns out, have been pointing in the wrong direction. The truth is that recent news on the federal budget deficit has been very encouraging. Real progress has been made in paring federal red ink. The Administration in January 1987 projected an FY 1987 deficit of $173.2 billion. In August, the Administration lowered its estimate to $158.4 billion. Yet figures released in the last week of October reveal that the actual deficit is $148 billion--a dramatic reduction from the $213.6 billion deficit of fiscal 1986. As important, the federal deficit as a proportion of gross national product (GNP) has fallen from 5.0 percent to 3.4 percent during the past fiscal year. It is strange logic to argue the crash was due to the deficit when that deficit is in rapid decline.
'Me budget deficit did not cause the markets to drop, but the proposed solutions to the deficit problem have led to continued jitters on Wall Street. Worrying that Reagan may accept some new taxes, the stock market promptly plunged 156 points October 26. Clearly, Wall Street is not screaming for new taxes. Not an Accurate Pictum Many budget summiteers, moreover, are misreading the numbers. In particular, they assume that the federal deficit is an accurate picture of the government's need to borrow from the private sector or foreign investors. It is not. Federal borrowing is not the same thing as government or public sector borrowing. Confusion persists as to the size of government's demand on the credit markets because of severe deficiencies in the measurement of the deficit. The budget deficit is commonly thought of as government outlays minus government revenues, which gives the amount the government must borrow in the capital markets. According to this conventional measure, the fiscal year 1987 federal budget deficit of $148 billion consumed 3.4 percent of the nation's GNP.
But a much more accurate and relevant measure of government borro the impact of public sector borrowing on credit markets--is the dollar value Of government activities. 11is includes state and local as well as federal net borrowing. By this measure, the conventional federal budget deficit grossly overstates total government borrowing. Ile reasons:
In 1988, state and local governments are almost certain to run an aggregate budget surplus of approximately $61 billion. By law, much of the state and local surplus is invested in Treasury bills, notes, and bonds. Thus nearly half of the published deficit is the federal level of government channeling cash through block grants to lower levels, which promptly invest it back with Uncle Sam. There is no net impact on the private credit market. ** The federal government holds an estimated 22.1 percent of its own debt in government trust fund accounts. Although the federal budget as currently constructed does not recognize this, the holding of government debt in its own accounts effectively cancels out $43 billion from the federal deficit. The interest and principal payments on this part of the debt thus are merely a transfer from one government agency to another with no net impact on the capital markets. A True Deficit Figure. Taking these two factors into account, the FY 1987 budget deficit falls from the estimated $148 billion to just $44 billion. Economist Warren Brookes notes that merely coupling the recent improvement in the budget deficit with the $61 billion state and local surplus would mean a true public sector deficit of below $90 billion--or only 2.1 percent of GNP for FY 1987. The federal deficit figures thus send wrong signals to the capital and credit markets, and to policy makers. To correct these signals, the federal government should adopt the procedure used in Britain and other advanced countries: a Public Sector Borrowing Requirement (PSBR). Ile PSBR in Britain includes the conventional national government budget deficit as well as the equivalent of state and local deficits or surpluses, debt held by government agencies, and the annual cost of off-budget debt. By publishing a PSBR, the U.S. government would provide a far more accurate calculation of government demand for credit.
Measured as a percent of GNP, federal tax revenues, as a result of economic growth spurred by cuts in the tax rates, are at an all-time high. Federal spending is at its lowest level since 1981. These two factors have combined to reduce the federal budget deficit to its lowest level in six years.
Unsettling Solutions. What really worries the financial markets are the "solutions" suggested to reduce the deficit further--in particular, proposals to raise revenues through increased taxes. The House Ways and Means Committee proposal to tax the financing of corporate takeovers, for example, jolted capital markets. The economic director of Prudential Bache Securities, Inc., Edward Yardeni, says that such a proposal could cut takeover asset values by 25 to 35 percent. Interestingly, the 23 percent crash in stock values on "Black Monday' followed just a few days after Committee approval of the tax measure.
The deficit can be reduced further without resorting to taxes on America's economic growth. Freezing domestic spending would save $20 billion; reducing the capital gains tax rate would generate an extra $4 to $8 billion in federal revenues. And selling federal assets, such as government loans and the Naval Petroleum Reserves, could provide approximately $20 billion in revenues without increasing business costs or discouraging entrepreneurship. It is this type of an approach that should be taken by the budget summiteers, not new taxes.
John E. Buttarazzi Policy Analyst