Monetary Policy: The Next Four Years

George W. Bush and John Kerry would take radically different approaches to addressing the federal deficit.
Ronald FinkSeptember 27, 2004

How would four years of a John Kerry Administration differ from a second term under George W. Bush? Finance executives must soon wrestle with that question, and they must do so as corporate managers as well as individual citizens.

Their current inclinations are clear enough. According to a recent poll of 145 readers of CFO magazine, finance executives favor the President over his Democratic challenger from Massachusetts by 71 percent to 28 percent. And 75 percent thinks Bush will be better than Kerry for their businesses.

At the same time, most businesspeople subscribe to political views that were famously summed up as, “It’s the economy, Stupid.” Although Bill Clinton likes to take credit for the 1990s economy, most businesspeople also agree that the economy is driven less by the President than by the Federal Reserve. That view gains support from a new study by the CFA Institute (formerly the Association for Investment Management and Research), in Charlottesville, Virginia. The results show that from 1937 to 2000, the Fed’s monetary decisions had a much greater correlation with the direction of the financial markets than the fiscal and regulatory policies of the executive branch. “Monetary policy overwhelms everything else,” says CFA executive vice president Robert R. Johnson.

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But most mainstream economists believe that monetary and fiscal policies are intertwined, and that the state of the federal budget thus has a big impact on interest rates — and the economy. All things being equal, bigger federal deficits mean higher rates. And no one has a keener appreciation of the impact of the deficit on interest rates and the cost of capital than finance executives. CFO’s survey notes that a whopping 86 percent of CFOs are concerned about the size of the deficit, which the Congressional Budget Office projects will reach $2.7 trillion by 2014.

So far neither Bush nor Kerry has demonstrated much real interest in the federal deficit. (To be fair, Kerry did once vote for a balanced budget as senator, and in his Presidential nomination acceptance speech promised to cut the deficit in half. Bush promises to do much the same.) A closer look at the actions and words of both candidates and their advisers shows, however, that they would take radically different approaches to addressing this issue over the next four years. And the effectiveness with which either handles the deficit most likely will determine much of the next Administration’s agenda.

Leading economists in the Bush camp, from current advisers such as Gregory Mankiw and Stephen Friedman to former aides like Lawrence Lindsey and Glenn Hubbard, have argued that the United States can run large budget deficits without significant economic consequence, as long as the growth of the economy outpaces that of the deficit. “We’re generating a lot more [tax] revenue per dollar of GDP than we were in 2001,” notes Randall Kroszner, a former member of Bush’s Council of Economic Advisers and now a professor of economics at the University of Chicago Graduate School of Business. Kroszner contends that as long as that trend continues, a deficit that falls within the current projected range “isn’t a problem.”

But the prognosis for the economy remains guarded, despite assertions by the Federal Reserve that the current “soft patch” is temporary. The Office of Management and Budget projected a 2004 fiscal deficit of $445 billion, while GDP growth ran at a disappointing 3 percent annual rate in the second quarter. The deficit, which grew faster than expected in July, now stands at 3.5 percent of GDP. Jobs grew by an anemic 32,000 in July, and, all told, there are 1.1 million fewer jobs than there were in January 2001. That can hardly do much for the confidence of consumers, whose spending represents roughly two-thirds of GDP.

Eugene Steuerle, a former Treasury official in the Reagan Administration and now a senior fellow at The Urban Institute, a Washington, D.C.-based think tank, says that the rising personal-debt levels and their accompanying interest payments pose just as great a threat to recovery as higher interest rates — and perhaps a greater one. He concludes that relying on economic growth to shrink the deficit is not a viable option, because of looming increases in entitlement programs like Social Security and Medicare. The baby boomers’ coming retirement, Steuerle argues, will dampen consumer demand even as it adds to the burden already borne by the Medicare system. “We’re in a gigantic bind” because of the rise in both health-care costs and the number of workers soon to retire, he says. “You can’t grow your way out of it.” (For more, see “It’s the Deficit,…” in the September issue of CFO.)