"The Economy Picks Up - States Benefit, But So Does Risk of Inflation"

Sydney M. Williams

Thought of the Day

“The Economy Picks Up – States Benefit, But So Does Risk of Inflation”

February 2, 2011

When the Congressional Budget Office, or its equivalent within state governments, project the effect of new programs or tax changes on their budgets, they are required to use the data supplied them, which is generally politically motivated (i.e. Healthcare Reform) and they utilize static accounting, which does not allow for behavioral changes. Not surprisingly, the data supplied tends to favor the parties introducing the legislature.

On the other hand, as economies recover, revenue projections can be misleading in a positive way. (This phenomenon is not unlike analysts who tend to be too positive as earnings and markets cyclically peak and too pessimistic as earnings and markets cyclically trough.) Official forecasts do not allow for worsening or improving economies. It is the way the numbers must be calculated, for otherwise optimism, a common infliction of politicians, would always prevail. Nevertheless, while the long-term outlook for most states “is still ominous,” state officials had to be encouraged with the release yesterday of a report from the Rockefeller Institute of Government indicating that tax revenues strengthened in each of the four quarters of 2010 – up 6.9% in the fourth quarter. However, and despite that GDP is now at record levels, tax collections continue to lag where they had been three years ago.

For almost thirty years, state revenues steadily increased. In 2008 and 2009, they declined – the first such instances since state budget officials began tracking the numbers in 1979. Thirty years of gradually increasing streams of revenues created an attitude of imperviousness among budget officials, as to potential problems, and complacency among the people. It created a sense that any over-spending in one year would be bailed out in the next. While it is pleasing to read that tax collections are up, and a continuing improving economy should augment that trend, tax collections for the 41 states tracked by the Rockefeller Institute are still 0.8% below where they were three years ago. Spending is only now being curtailed.

It has long been obvious that the least painful method of extrication from the budget mess is to grow the economy and let the increased revenues reduce the deficits. In part, this is the thinking behind the numbered QEs the Federal Reserve has been promoting, a task which Chairman Ben Bernanke might claim is algorithmic, but which Dan Pink, author of Drive would likely characterize as heuristic – think left brain versus right brain. Inflate the value of speculative assets (stocks, commodities, etc.) and assume that a pick up in personal confidence will result in an increase in consumer purchases. The risk to this program is that while the value of risk assets is inflating, “safe” assets (Treasuries and the U.S. Dollar) are being deflated, as the dollars required to buy and carry each asset increases. Ultimately, this program risks emulating the 1970s stagflation – a time of below average economic growth, persistent unemployment, high inflation and high interest rates.

Perhaps we will get lucky.  The economy may recover faster than expected. Mr. Bernanke may be able to orchestrate a change from QE to QT (Quantitative Tightening) smoothly and trouble free.  It is “a consummation devoutly to be wished.” But the longer rates stay artificially low and the higher commodity prices rise, the greater becomes the risk to the economy and the potential for inflation/stagflation.