Balanced Budget Cuts Two Ways For Wall Street

If the federal government should ever somehow balance its budget, imagine what the stock and bond markets might do!

Well, that’s precisely what some Wall Street analysts have undertaken lately - imagining the likely effects on the markets of the latest efforts to clean up Uncle Sam’s finances.

They have come up with some tentative conclusions that aren’t quite as simple and enthusiastic as a casual onlooker might expect.

Just about everybody agrees that a successful effort to narrow, if not eliminate, the deficit between the government’s income and its outlays would have important long-term benefits for the economy.

Indeed, many observers say the strong advance in stock and bond prices since late 1994 has owed a lot of its inspiration to the prospect of progress against the deficit, which has been debated and decried for much of the last 25 years.

But analysts also caution that the stock market, in particular, might not be immune to the painful side effects of deficit reduction, which would reduce a major source of stimulus to business and consumer activity.

“A balanced budget by 2002? Under this scenario, long bond interest rates could fall to 5 percent from about 7 percent today,” says Sung Won Sohn, economist at Norwest Corp. in Minneapolis. “Sharply lower interest rates would boost capital spending and productivity, reducing inflation.”

However, he adds, “the budget resolution would create fiscal drag, slowing economic growth. Consumer spending would be the biggest loser.”

A similar ambivalence shows up in discussions of the prospective impact of deficit cuts on the dollar in currency markets. Any progress on the deficit would stand to shore up the dollar against leading foreign currencies, providing Wall Street with a morale boost.

But stocks of many multinational companies have been thriving against the backdrop of a weak dollar, since it works to increase the dollar value of their overseas earnings.

How, analysts ask, could a strong dollar be expected to help a market that has prospered on dollar weakness?

By the same reasoning, the great Wall Street bull market of the 1980s and early ‘90s has occurred concurrently with wide and worsening budget deficits. It stands to reason that a lot of the spending power created by deficit spending has found its way into the markets.

So to assume that deficit reduction would automatically be bullish for the markets smacks a bit of trying to have it both ways.