While all eyes were turned to the American version of Kabuki theater–otherwise known as the State of the Union address —  a less auspicious announcement was taking place. The Congressional Budget Office (CBO) the official score keeper for the federal budget, announced the deficit for fiscal 2011 is now likely to total approximately $1.5 trillion, or approximately 10% of GDP. To the extent the forecast is accurate; along with 2009’s $1.4 trillion deficit, this will represent the largest deficit relative to the size of the economy since 1945!

To add to the problem, despite all the promises of fiscal probity emanating from Washington, the trend is getting worse. According to the CBO, if you exclude the impact of TARP, the underlying trend in the deficit since 2009 is upward. This is strange. While the recovery has been anemic, the economy is getting stronger. For 2011 US GDP is likely to be around 2.5% to 3.0%.

This begs the question, if the economy is getting stronger – which implies higher revenue and less spending on economic stabilizers – why is the deficit getting worse? The CBO’s response: “Although outlays for some programs are projected to decrease relative to what was spent in 2009, spending increases in several other areas are projected to more than offset those declines in 2011.” Spending restraint, while much heralded, including in the State of the Union address, has yet to arrive.

Outlays in 2011, excluding TARP, will be $3.7 trillion, or nearly 25% of GDP.  This year government spending will be nearly $200 b, or 11% higher than it was in 2009.  About 70% of that increase represents additional discretionary spending, with most of the rest coming from higher interest payments courtesy of the ballooning federal debt.

On the revenue side, the deficit has obviously been exacerbated by the weak economy, which has pushed government revenue down to around 15% of GDP, well below the 40-year average of 18%. Further contributing to the drop in revenue, as well as adding to spending, was December’s tax and stimulus compromise. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 will add approximately $390 billion to the deficit in 2011 and another $407 billion in 2012.

So what is the significance for investors? In the short term, the extension of tax relief and unemployment benefits is ironically a positive for risky assets as it will contribute to stronger economic growth in 2011. Longer term, the failure of the U.S. to address its long-term fiscal solvency is a significant risk for investors. While investors are rightly focused on fiscal problems in Europe, they are ignoring similar if not worse problems closer to home. In the near term, the U.S. is likely to get away with chronic deficit spending, partly because private demand for capital is weak so interest rates are lower than they would otherwise be. However, over the long term, deficit spending of this magnitude is likely to result in slower economic growth and higher real interest rates; neither will help stocks.

Source: Congressional Budget Office