Washington didn't take much time to celebrate the dramatic reduction in
federal deficits announced by congressional budget analysts a week ago, but Wall
Street saw it as reason to cheer and send stocks to record highs. For many
investors, the more than halving of the deficit from a high of $1.55 trillion
during the depths of the recession is the latest sign that the economy finally
has turned the corner and is on a solidly upward path.
Nearly all of the improvement in the government's finances is a result of the economy, most notably a surge in revenue on corporate bonuses, stock dividends and capital gains payments at the end of last year that was timed to beat the Jan. 1 start date for higher tax rates on wealthier citizens. That helped fill the Treasury's coffers with a surge of nearly $100 billion in revenue to a monthly record of $407 billion when the tax bills came due in April. At the same time, the government got a big boost from $95 billion in dividend payments from Fannie Mae and Freddie Mac, the two bailed-out mortgage giants that turned profitable at the end of last year amid a rebounding housing market.
The combination of windfalls enabled the Congressional Budget Office to slash its deficit forecast by a record $203 billion for this fiscal year to $642 billion -- the deficit's level before the crisis broke out in 2008. The CBO's projections show further significant improvement in the next five years as the deficit falls to $378 billion, or 2.1 percent of economic output by 2015 -- a fraction of the worrying 11 percent peak hit in 2009 -- before turning up again.
While some argue that the April surge in revenue was only a one-time affair, and the long-term deficit problem generated by fast-growing entitlements is far from solved, there are some promising long-term trends. For one, higher tax rates put into place this year ensure that revenue will continue to pile in at higher rates and hit 19.3 percent of economic output by 2015, up substantially from the recession-induced low of 15 percent in 2009. Moreover, while a portion of the spring dividends from Fannie and Freddie were results of one-time tax factors, the mortgage giants must continue to turn over the billions of dollars they make in profits to the Treasury unless and until they are reformed or eliminated.
Perhaps most important, on the spending side of the ledger, Congress and the administration -- with help from the slowly mending economy -- have made significant headway at reducing outlays from a high of 25 percent of economic output in 2009 to 22 percent today. The CBO outlook even contained a kernel of good news on entitlements: A trend toward slower growth in enrollments and health care spending prompted the nonpartisan budget office to slash its deficit forecasts for the next decade by nearly $200 billion -- a promising turn of events that could help solve the long-range deficit problem.
Wall Street notices
The reversal of fortunes has not been lost on Wall Street.
"The most threatening artifacts of the financial crisis -- financially damaged households and destabilized public finances -- are to a very large extent history," said Michael Gavin, an analyst at Barclays Research, noting that the combination of economic growth and vigilance by Congress has pushed down the deficit to pre-crisis levels. "We think it is likely to get better before it
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