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The Problem With Budget Cuts

January 6, 2011

A new Congress has been sworn in and in the House of Representatives a sizable block of new and old members ran on the pledge to cut spending by the government. If they are like past Congresses they will make a perhaps heroic effort to do just that. When we are running an annual deficit that is about 10% of Gross Domestic Product, or GDP, then cutting spending certainly seems like a virtuous thing to do. It is when the practical issues emerge that things get messy.

In the process of setting up the rules, one of the issues that has emerged is a budget cut that will make the deficit lower but probably will not be in anyone’s long term interest. According to a story in the Wall Street Journal, one of the rule changes passed on the first day was to remove the “fence” around highway funds. Federal highway repair and maintenance funding has for many years come directly from the federal highway tax paid from a surcharge on all motor fuel purchases. Next time you fill up at the pump take a look and you will see it displayed. For the past couple of decades one of the rules of the House was that all the money that was collected from the highway tax was to be used for maintaining and building highway infrastructure. Now that funding can be included in the general budget.

Toward the end of last year the highway fund started accumulating money as highway projects were either canceled or simply not approved. As a result of that surplus, a simple rule change suddenly reduced the budget and appeared to cut the cost of government. Unfortunately, funding for expanding and maintaining the federal highway system was already insufficient to keep up with traffic growth. Spending has been cut, but the need for maintenance and expansion has not gone away.

Another area that appears to have died is the assistance that was being provided to state and local governments to help reduce lay-offs of teachers, police, firemen, etc. Once again, spending is being cut, but with property valuations down about 13% nationwide and still falling, the property taxes that local communities rely on so heavily to fund operations have also fallen. Without the federal subsidy and with the public generally opposed to any form of tax increase, expect to see local governments and school districts reducing employment. In a practical sense, that will mean fewer police on duty, fewer fire fighters, and a class size increase in schools.

As a (for me) fascinating aside, the laying off of the local government employees that has already started will tend to accelerate the home mortgage crisis and further lower the local real estate values. That will then create even lower tax revenue for the local governments which will result in further lay-offs. Let’s just hope that businesses can pick up the slack and reverse the trend.

The big crisis is yet to come. A fairly substantial block of new members of Congress pledged to vote against an increase in the federal debt ceiling. In the next few months we will either need to increase that debt ceiling or the government will effectively not be able to pay its obligations. At that point we could see the federal government shut down or, far worse, an interruption in the interest payments on Treasury securities. Now that has the potential to be an interesting scenario.

There is absolutely no doubt that we will need to bring the budget into a balanced or near-balanced condition in the not-too-distant future. The present situation is not unlike a high daily medical cost that is increasing the debt of a critically ill person. If the person can recover and go back to work, it may make good financial sense to continue to run up ever more debt to keep him alive long enough for his system to recover. Cutting medical care costs while he is still not recovered might wind up being a less than ideal savings plan. That highway money redirection may result in many fewer highway workers being employed. Keeping people employed tends to increase private business receipts and thereby revenue to the governments.

It is a hard decision and I am glad I am not the one who must make it!

Jeff