Economic Outlook for 2004: Interest Rates and Tax Hikes

Despite improving economic and budgetary news, there is rising pressure to do something about the budget deficit. I expect this pressure to grow rapidly over the next year. By early 2005, I believe such pressure will be irresistible. It’s not too soon to start thinking about where this could lead.

The main reason why I see pressure building for a budget deal is that interest rates are going to rise sharply over the coming year. Following are some reasons:

  • Economic growth is accelerating. Many economists are now expecting 4 percent to 5 percent growth over the next year. This by itself will raise interest rates because it means that the rate of return to capital will be rising. If a firm can make more on a new investment, it will not mind paying more to borrow to capitalize on this opportunity. Thus increased business borrowing will raise rates.
  • Inflation is likely to re-emerge. For the last several years, deflation or falling prices have been the economy’s biggest problem. In response, the Federal Reserve has increased the money supply and added a lot of liquidity to the banking system. I believe that this has finally reversed the deflation problem. But inflation raises long-term interest rates by adding an inflation premium to rates.
  • The dollar is likely to fall. The Bush administration seems convinced that forcing other countries, especially China and Japan, to raise their currencies is the key to reducing manufactured imports and raising exports. This is part of its electoral strategy for appealing to blue-collar workers. But raising foreign currencies is just another way of saying that the dollar will fall. While this may improve the trade balance, it will also reduce the willingness of foreigners to invest here. Reduced foreign capital inflows will raise interest rates.
  • Finally, the Fed will eventually see that inflation and a falling dollar require a tightening of monetary policy. This will raise short-term rates.
  • These are the most important reasons why interest rates will rise. But politicians and the media are likely to focus on only one thing: the federal budget deficit. Even though serious economic research shows little impact by deficits on interest rates, all of the rise in rates will be blamed on the deficit and only the deficit. This will be hyped in the liberal media ceaselessly in order to hurt Republicans and aid the prospects of whatever Democrat gains the presidential nomination.

    I expect to see Democrats start to talk more and more like Ross Perot in 1992 about the danger of deficits and the need to take action. They will shift their criticism of President Bush’s Iraq policy almost exclusively toward its budgetary implications. This was also the way they responded to the Vietnam War initially — questioning only its cost, not its basic wisdom. Later, after making it harder and harder to prosecute the war effectively, they turned toward attacking the war itself. They will try the same thing with Iraq.

    Of course, Democrats will also sharpen their rhetoric on taxes, blaming the tax cuts as primarily responsible for the deficit and therefore rising interest rates. All of the Democratic presidential candidates are on record as favoring some scale-back of the 2001 and 2003 tax cuts. Only Howard Dean favors their total repeal. Lately, he has even endorsed other tax increases on top. He hopes to paint himself as a fiscal conservative in order to offset his image as the most left-wing major candidate running for president.

    Already, Dean has fooled a few Republicans like Steve Moore of the Club for Growth into thinking he really is a fiscal conservative. In fact, none of the Democratic candidates care anything about the deficit except as an excuse to raise taxes. They want higher taxes to soak the rich and raise spending, not to reduce deficits. But they may be successful in forcing President Bush to respond to the challenge and put forward some sort of deficit reduction plan next year.

    By early 2005, I expect the pressure to reduce deficits to be inexorable. While Republican control of the House and Senate may cause any budget deal to focus more on budget cuts and less on tax increases than they usually do, the latter are inevitable. It is simply unrealistic to think that a large deficit reduction plan can rely solely on budget cuts. Revenues will be on the table.

    Remember that Ronald Reagan signed major tax increases in 1982, 1983, 1984, 1985, 1986 and 1987. By 1988, he had taken back almost half of the 1981 tax cut. But at the end of the day, he cut taxes more than he raised them. That is why conservatives forgave him and why they will probably forgive Bush, as well.