- The Washington Times - Thursday, June 1, 2006

“There still are a number of yellow flags out there,” Goldman Sachs CEO Henry Paulson, who has just been nominated to be Treasury secretary, told USA Today in an interview published in February 2004. Asked about the budget and trade deficits, Mr. Paulson elaborated: “There’s no doubt that the twin deficits are significant problems that everyone needs to be concerned about. But I believe that they both are manageable. The best antidote for a budget deficit is a strong, growing economy.” He said that the trade deficit is “really worth focusing on, but these things have a way of adjusting, and it just takes awhile. And it’s going to take awhile for the trade balance in this country to adjust to the declining dollar.”

Well, let’s see how the twin deficits have fared since Mr. Paulson identified them as “significant problems.” In February 2004, the budget deficit was moving toward setting a nominal record of $413 billion in fiscal 2004. Four years earlier, in fiscal 2000, there had been a budget surplus of $236 billion. So, given that the nation’s annual fiscal balance had deteriorated by nearly $650 billion over four short years, Mr. Paulson’s concern was clearly justified. The 2001 recession ended near the beginning of fiscal 2002, during which the economy slowly recovered, growing at a tepid pace of 2.2 percent.

However, during the three and a half years since the end of fiscal 2002, in which the budget deficit was $158 billion, the economy has grown at a compounded annual rate of 3.5 percent. Yet the deficit in the current fiscal year is not likely to be much different from the fiscal 2005 budget deficit of $318 billion, which was more than twice the size of the fiscal 2002 deficit. In other words, when fiscal 2006 ends on Sept. 30, following what will almost certainly be four years of growth averaging 3.5 percent per year, the budget deficit will be twice the size of the deficit before growth accelerated.

Moreover, if we remove the huge surplus in Social Security, which will total about $180 billion this year, the resulting on-budget deficit will be close to $500 billion. That’s not much different from the 2004 on-budget deficit of $568 billion, and it is nearly 60 percent higher than the on-budget deficit of $317 billion in fiscal 2002 — before four years of 3.5 percent annual growth. It’s fair to say that Mr. Paulson has his work cut out for him dealing with the budget deficit.

Dealing with the trade deficit will likely be far more problematic. In February 2004, Mr. Paulson was right to consider the trade deficit a “significant problem.” By the standard he enunciated then, however, the “significant problem” has become indisputably worse, much worse. The trade deficit, which increased from $108 billion in 1997 to $494 billion in 2003 (hence, the “significant problem”), totaled $724 billion in 2005. During the first quarter of this year, the trade deficit, measured at an annual rate, reached $794 billion. That’s $300 billion higher than it was in 2003, when Mr. Paulson called it a “significant problem.” The trade deficit is now more than 6 percent of GDP; it was 1.3 percent of GDP in 1997 and 4.5 percent of GDP in 2003. Even more alarming, according to the latest (fourth quarter)data,thecloselyrelated current-account deficit, which is a broader measure of America’s international position, now exceeds 7 percent of GDP, compared to 4.7 percent in 2003 and 1.7 percent in 1997.

When Mr. Paulson said in February 2004 that “it’s going to take awhile for the trade balance in this country to adjust to the declining dollar,” the dollar had been depreciating for two years, having lost 13.5 percent of its value according to the price-adjusted broad dollar index compiled by the Federal Reserve. By the end of 2004, the dollar had fallen another 2.8 percent. Over the first 10 months of 2005, the dollar reversed course and appreciated by 5 percent before resuming its descent. Since then, it has dropped 4 percent. The net effect has been a decline of more than 15 percent since its cyclical peak, which was reached in February 2002. Between the first quarter of 2002, when the dollar was strong, and the first quarter of 2006, when it was significantly weaker, the annual rate of the U.S. trade deficit has soared from $373 billion to $794 billion.

Considering these budget- and trade-deficit trends, Mr. Paulson should be asked at his confirmation hearings: (1) what he thinks about an on-budget deficit hovering around $500 billion per year during the last four fiscal years, while the economy has been growing at a 3.5 percent annual clip; (2) what his new time frame is for America’s worsening trade deficit to “adjust to the declining dollar”; (3) how much further he thinks the dollar might have to fall before the trade deficit even begins to adjust (he won’t answer, but he should be asked anyway); (4) whether he considers $300 billion total budget deficits, $500 billion on-budget deficits, $800 billion trade deficits and soon-to-arrive $1 trillion current-account deficits to be major structural imbalances in the U.S. economy; and (5) what, if anything, he intends to do about them.


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