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Federal budget update

The Federal budget numbers for July came in a bit better than expected, with the result that the 12-mo. deficit fell from $1.26 to $1.23 trillion. Thank goodness for small favors: the budget deficit is now running at about 8.2% of GDP, which is down from a post-War high of 10.4% at the end of 2009. The improvement is due to the fact that revenues have grown at just under 9% over the past year, while spending has grown by just under 3%.

Note to would-be optimists: the recently concluded budget deal would allow for spending to rise by at least 4-5% per year going forward (contrary to press reports, nobody was ever talking about actually cutting spending). Thus, the main hope right now for continued improvement in the budget outlook is for the economy to continue adding jobs, since a rising employment base is generating more income taxes. As the chart above shows, it is not unusual at all for revenues to rise at a fairly strong pace as the business cycle advances; it doesn't take higher tax rates to generate rising tax revenues—just a bigger economy will do the trick.

With the Fed in hyper-expansive mode, and given the inability of monetary policy to create growth out of thin air, what we are likely to see in the next few years is an acceleration of nominal GDP growth (e.g., modest real growth plus faster inflation). While this won't push living standards up by much, it should result in higher federal revenues as incomes rise and as people find themselves moving up to higher tax brackets. And of course, higher inflation will erode the burden of our $9.9 trillion of federal debt outstanding, even as it pushes Treasury yields and borrowing costs higher. So there is some reason to think that the budget outlook won't spiral out of control, as long as Congress takes steps in coming years to rein in the growth of entitlement spending (e.g., by raising the retirement age, by indexing social security payments to inflation rather than nominal wage growth, by privatizing social security, and by introducing market incentives to healthcare market and eliminating tax preferences and deductions).

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