- The Washington Times - Sunday, June 27, 2004

This week, the Federal Open Market Committee meets to discuss monetary policy. Financial markets assume the FOMC will begin raising short-term interest rates and continue doing so for some time. This will begin to change the terms of debate on fiscal policy, increasing the likelihood of a budget deal next year that will involve tax increases, no matter who is elected president in November.

Since fiscal 2000, the federal budget has gone from a $87 billion surplus to an estimated $675 billion deficit. In the last four years, the national debt has increased almost $2 trillion and will continue increasing for many more years even under the most optimistic scenario, absent legislative changes.

Democrats and good-government types have lamented this situation for some time without arousing much public interest. Sure, public opinion polls say everyone thinks deficits are bad and something should be done about them. But they are unwilling to pressure members of Congress to actually do anything to cut the deficit. On the contrary, most people still more spending for education, health and other programs.

The reason the deficit has been an impotent issue politically is that the two principal negative effects of deficits — inflation and high interest rates — have been nonexistent. People also understand the economy has recently gone through a recession and that deficits are not inappropriate in those circumstances. Indeed, up until now, slow growth has been a major cause of deficits, as federal revenues fall automatically from lower corporate profits and unemployment.

But all this is about to change. The Federal Reserve has pumped money into the economy at a high rate for more than three years now, to keep interest rates low and help stimulate investment and growth. Were this policy maintained too long, it would eventually lead to roaring inflation like we had in the 1970s. Therefore, the Fed must tighten monetary policy, which will lead to rising interest rates.

For some weeks, Federal Reserve officials have signaled their intention to raise rates gradually. They believe the economy is on a sustainable upward course and the risk is greater of inflation than an economic relapse. Financial markets have been forewarned they must adjust their portfolios and avoid the squeeze that comes when institutions have borrowed short and loaned long. That caused the savings-and-loan crisis at a taxpayer cost of $150 billion.

If the Fed is able to keep to a gradual tightening, financial markets should be able to adjust without trouble. But there is always the danger of mistakes or unexpected circumstances that will trap the unwary and create a crisis. The risks include:

c Fannie Mae and Freddie Mac are now such huge mortgage market players that their combined debt is close to $3 trillion, as millions of Americans have refinanced their mortgages to take advantage of low interest rates and rising housing prices. This also means even the tiniest mistake by these organizations could massively disrupt financial markets.

c The U.S. increasingly depends on foreign capital inflows to finance the federal debt and domestic investment. Indeed, foreigners now own more than 50 percent of liquid Treasury securities. Even a slowdown in foreign Treasury purchases, perhaps due to fears of a fall in the dollar, would also be massively disruptive.

c Among the largest purchasers of Treasury securities has been China, whose economy has been booming. But some analysts believe the Chinese bubble may soon burst, just as the telecom and dot-com bubble of the late 1990s burst here. That could force the Chinese to stop buying and start selling Treasuries. Once again, this would be massively disruptive.

Any of these scenarios would produce a sell-off in the stock and bond markets as great or greater than the stock market crash of 1987. At that point, policymakers would be forced to significantly reduce the deficit. They would have no choice because it would be the only action in their power to take and they would be strongly pressured by public opinion to do so.

They would have to reduce the deficit by at least 2 percentage points of gross domestic product annually to meaningfully affect financial markets and restore confidence, and it is unrealistic to think this could all be done on the spending side. Therefore, taxes would be on the table.

Voters need to ask themselves which party they prefer to manage this process when the time comes.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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