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Wednesday January 26, 2005 - 14:50:35 GMT
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Forex: US Budget Deficit Reduction New Dollar Metric...Be Careful Of What You Ask For

US Budget Deficit Reduction New Dollar Metric...Be Careful Of What You Ask For

I am still dumfounded that everyone from President Bush and Treasury Secretary Snow to ECB President Trichet are in agreement that the future strength of the dollar is a function of US budget deficit reduction.

The track record here is poor...poor in the first term and poor historically. President Clinton did well on this front, balancing the budget and actually paying down debt. But this was a function of the uber economy of the 1990's and record capital gains in the US stock market and hence record capital gains tax receipts. Clinton and Congress should get some credit as well for cutting spending and raising taxes (no I am not a hikes actually increase tax receipts). The peace dividend, however illusionary as 9-11 proved, helped cut defense spending dramatically. However, the track record of other presidents on cutting the budget deficit in peace time and war is nothing you would want to base the dollar's valuation on.

Napoleon did not announce to Wellington before the battle of Waterloo that he had poor communications, weak generals and lapses in judgment despite superior troop strength. In other words the dollar is facing its own Waterloo and G7 has exposed a key weakness. Why any official would tie the dollar to deficit reduction is beyond me?

Even the Congressional Budget Office, a revered non-partisan government think tank on all matters fiscal, concluded the dollar would weaken in the next two years as foreign investors shun US assets at current levels of US interest rates and level of the dollar. Moreover, the CBO lifted its forecast for the budget deficit in FY2005 by $20bln to $368bln and this number did not include the $80bln supplemental budget expense request the Bush administration has before Congress to fund the war in Iraq and nation building in Afghanistan which is sure to pass.

Meanwhile the White House said the deficit for FY2005 (end-Sept) will widen to $427bln including the $80bln defense supplemental from $412bln in FY2004. Based on the economy growing the deficit as a share of GDP, according to the White House, will fall to 3.5% from 3.6%, though this is arguably optimistic and it is conceivable that the def/GDP hits 4% or more. Medicare expenses have mushroomed, in part behind the prescription benefit bill that Congress passed. Additionally an ambitious tax and Social Security reform agenda from the White House pose major risks to the deficit, even if they end up being accounted for in a different set of ledgers. Making tax cuts permanent, extending child tax credits (already done), ending the Alternative Minimum Tax, privatizing Social Security ($1-2trln transition cost) and declining inheritance tax (still momentum to end entirely) suggest major fiscal liabilities ahead unless they are financed with spending cuts.

The White House has proposed putting a cap on discretionary spending but when has Congress and the White House shied away from raising spending caps when they are reached? And Bush never put a veto pen on any spending bill in his first four years in office.

The cost of the war on terror in inflation adjusted terms has already exceeded the cost for the US of World War One and is now approaching the cost of the Korean War. World War One and the Korean War were conventional wars with attainable ends. The war on terror is an open book and an open checkbook at that.

And even if the Bush administration has done a 180 on fiscal policy and really does want to impose politically painful spending cuts, Congress may not go along...even a Republican controlled Congress. Sure this could work two ways on the deficit such as nixing expensive privatization of Social Security. But this is one dollar metric that you would not want to wish on your worst enemy. It could bring the dollar to its knees much faster than even the CBO has imagined and no Fed tightening can prevent. I hope my cynicism is unjustified and the US budget deficit is cut in half (from a real starting point) by 2009. But the truth is US budget progress is nearly always a function of tax hikes...under Reagan, Bush41 and Clinton...and at times behind above trend growth rates.

What if borrowing costs rise significantly? Not unreasonable given flat yield curve and some quarters at the Fed worried about future inflation and current low inflation expectations. Or Asian central banks find currency management (dollar buying) unsustainable and buy fewer US bonds (look at the debt market mess in Korea now caused by FX intervention bond issuance and heavy gvt debt financing). Or a dollar crisis (risk not a forecast) would drive up bond yields. Higher borrowing costs could explode the US budget deficit.

ECB's Wellink today called on the US to raise taxes on energy consumption to reduce the deficit (US federal and state tax on petroleum for instance is a fraction of what it is across Europe, including the UK). While I am not eager to send my earnings to the Treasury, higher tax rates and cuts in entitlements are the hard reality of balancing the budget. I just don't think Washington and the public for that matter are ready to face hard choices. Necessity (crisis) is the mother of invention and we are just not there. By making credible deficit reduction the metric for valuing the dollar, G7 has exposed the underbelly of the currency and invited new selling.

David Gilmore


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