Oct. 14 (Bloomberg) -- The U.S. budget deficit will surge to a record $600 billion in the fiscal year that began on Oct. 1 as the government increases spending on Iraq and election-year programs such as a proposed prescription drug benefit, some of Wall Street's biggest bond trading firms said. Economists at Merrill Lynch & Co. and two more of the 22 firms that are required to bid at Treasury debt sales said the deficit will be at least $125 billion higher than the Bush administration predicts. Some Republican and Democratic lawmakers blame the widening budget gap on a breakdown in fiscal restraint and say the shortfall may provoke an increase in interest rates that impedes economic growth. Congress has been spending more even as tax receipts decline due to $1.7 trillion in tax cuts and sluggish economic growth.
``When it comes to the budget and spending the thinking in Congress is, `I'm not going to wear my bikini anyway, so I may as well eat another piece of pie,''' said Representative Christopher Cox of California, chairman of the Republican House Policy Committee. Economists at the 22 so-called U.S. government securities primary dealers have been at odds with the Bush administration on the budget. In May, they forecast a $373 billion deficit for 2003 when the White House projected $304 billion. In July, the economists said the Bush administration's prediction of a $455 billion shortfall for 2003 was more than $20 billion too high. The government will pay more to finance the deficit as it competes with other borrowers for cash, said Ian Morris, chief U.S. economist at HSBC Holdings Plc in New York. Morris is the most bearish on the deficit, predicting a $630 billion shortfall in 2004. In July he saw a $550 billion gap.
Economic Fallout
``A higher cost of capital means lower investment, lower output and lower productivity, so the economy could suffer over the longer term if these kind of deficits persist,'' Morris said. Higher interest rates may show up within 18 months if companies increase bond sales as the government borrows more, he said. Interest rates may also rise should foreign central banks, the largest non-U.S. holders of Treasuries, balk at buying more of the securities, some economists said. In the week ended Oct. 8, the Federal Reserve held a record daily average $798.7 billion of Treasuries for foreign central banks. At the end of July, the Treasury said about one-third of the more than $3.4 trillion of government debt was held by foreign investors. Japan held the most with $443.8 billion, as total foreign holdings rose 3.2 percent in July to $1.39 trillion.
Foreign Effect
Foreign Treasury debt buyers are concerned about the so- called twin deficits, Kathleen Bostjancic, a senior economist at Merrill in New York, said. The current account deficit, the widest measure of trade and investment, climbed to record $138.7 billion, or 5 percent of gross domestic product, in the second quarter. ``Any little change in foreign investors' preferences has the potential to raise rates,'' she said. Merrill raised its 2004 deficit forecast to $600 billion from $470 billion in July. The federal budget in 2002 swung to a $157.8 billion deficit from a $127.3 billion surplus after the U.S. boosted spending to fight terrorism and finance wars in Afghanistan and Iraq, and as a recession and falling corporate profits sapped tax revenue. Just a year ago, the Bush administration said the U.S. would return to a surplus by 2005. Now it plans to cut the deficit in half by 2008. In September 2002, not one of the economists surveyed by Bloomberg News thought that was feasible, and three said the U.S. wouldn't be in the black until after 2010. Now, three say a return to surpluses is unforeseeable.
Spending Restraint
Getting fiscal improvement ``will have to come through substantial reductions in spending, and that will be extremely difficult to achieve,'' said David Rosenberg, chief North American economist at Merrill. Henry Willmore, chief U.S. economist at Barclays Bank Plc, said the shortfall will swell to $600 billion this year largely because of $87 billion in extra spending for Iraq's reconstruction and a Medicare drug benefit that would cost $400 billion over ten years. The 22 primary dealers increased budget deficit forecasts for next year to an average of $524 billion, according to a Bloomberg News survey. This is an 11 percent increase from the average forecast of $471 billion in July. The dealers also trade with the Federal Reserve.
Upside
Only Banc of America Securities didn't raise its estimate, holding at $510 billion largely because an economic recovery will spur tax revenue growth, said Peter Kretzmer, a senior economist for the firm in New York. ``It's much harder to get outlay discipline in the environment we've been in with the legislative branch so closely divided,'' Peter Fisher, who on Oct. 6 stepped down as Treasury undersecretary for domestic finance, said in an interview. ``Every man is a king -- every appropriations chairman, every senator.'' While the largest in dollar terms, a $600 billion deficit would be equivalent to about 5.3 percent of GDP, below the 1983 record of 6 percent. Deficits usually impede the economy when they persist above 3 percent of GDP, Morris said. The Congressional Budget Office, which by law can only use appropriations already passed by Congress, estimates the fiscal year 2004 deficit will hit $480 billion and decline by 2008 to $197 billion.
`A Lot Going On'
While federal revenues will rise to $1.82 trillion in 2004 from $1.77 trillion in 2003 and interest costs will fall $2 billion to $155 billion, spending for defense, homeland security and other discretionary programs will increase to $900 billion compared with $826 billion, the Congressional Budget Office said. Outlays for Medicaid, Social Security, Medicare, veterans' benefits, and other mandatory spending will rise to $1.25 trillion in 2004 from $1.18 trillion in 2003, the non-partisan group said. ``A lot is going on, both on the tax side and the spending side, that will dig the hole deeper,'' Comptroller General David Walker said in an interview. Walker heads the General Accounting Office, the investigative arm of Congress. The 2004 budget deficit will be the peak, the Bush administration said. The shortfall will decline to less than $200 billion by 2008. The Congressional Budget Office said on Oct. 9 that the 2003 deficit will be $374 billion as spending to rebuild Iraq and the prescription drug plan were pushing into the 2004 fiscal year. Consecutive years of high deficit spending gradually corrode economic growth and living standards, said Edward McKelvey, a senior U.S. economist at Goldman, Sachs & Co. ``It's like air pollution -- it's in the atmosphere and it makes you worse off.''
`Creep In'
Official estimates for 2004 are too low, says Stephen Stanley, senior economist at RBS Greenwich Capital in Greenwich, Connecticut. With the slim Republican majority in the House and Senate, ``you end up with a stalemate on new bills and they break it by giving everyone everything they want,'' Stanley said. His firm raised its 2004 deficit forecast to $500 billion from $415 billion in July. ``We all want to spend more,'' said Representative James Moran, a Virginia Democrat on the budget committee. ``That's the main thing we do up here on the Hill.'' Prospects for rising deficits have ``started to creep in'' to debt markets, RBS Greenwich Capital's Stanley said. ``If we believe we will have $500 billion deficits for as far as the eye can see, we could have real problems with interest rates.'' Fisher said investor concern that the government will increase borrowing causes only a slight rise in interest rates. ``People can measure it, but they're busy arguing whether it's 3 or 30 or 60 basis points.'' A basis point is 0.01 percentage point.
One Bill
Congress this year will probably merge most appropriations measures into one large omnibus bill, complicating efforts to pare spending, said Representative Adam Putnam, a Florida Republican on the budget committee and joint economic committee. ``Bush will end up with one bill funding 80 percent of the government plopped on his desk all at once,'' RBS Greenwich Capital's Stanley said. ``He can't veto it because it's so complicated and big.'' Bush and Congress will lean toward fiscal excess in order to revitalize the economy and employment prior to the November 2004 election, Merrill's Rosenberg said. Since President George W. Bush took office in 2001 the U.S. has lost about 2.6 million jobs. ``If I were running for office, I'd be doing everything possible to get the job market improving and the economy running again,'' Merrill's Rosenberg said. ``You won't find too many politicians running on a platform of fiscal restraint.''
`Fragile Consensus'
Former Treasury Secretary Robert Rubin blames the Bush administration's tax cuts for the plunge into red ink. Starting in 1989 ``what we had was a very fragile consensus around fiscal discipline,'' said Rubin, chairman of the executive committee at Citigroup Inc., the world's largest financial services company. ``Once you had these enormous tax cuts, then I think it became impossible to continue with this fragile coalescence.'' The surge in expenditures predates Bush, said Chris Wiegand, an economist at Citigroup. Discretionary spending has annually increased by 3 percent since 1999, compared with a 1 percent rise from 1991 until 1998, he said. Next year, outlays will swell by 10 percent, he added. ``There is no willingness or appetite for spending restraint by anyone in Washington,'' Wiegand said. ``Until that returns, we'll have deficits of at least $400 billion.'' //www.bloomberg.com