Late Friday, the Treasury Department released the budget deficit for August. It came in at $111.4 billion, which was far better than the $140 billion monthly shortfall that had been expected.

It was also slightly less than the budget shortfall in August 2008. And it was a huge improvement over the $180.7 billion deficit in July. However, don’t get too excited about the month-to-month decline as the monthly budget deficit numbers are extremely seasonal. Although that seasonality is reason to be very optimistic.

Not long ago, the projections for the fiscal 2009 budget deficit were running at about $1.8 Trillion. With 11 months now under our belt (the Government’s fiscal year ends in September), the cumulative deficit is now $1.38 Trillion.  Thus if September were to come in at the same level as August, the deficit for the year would end up at $1.49 Trillion.

However, it is extremely unlikely that September will come in at the August level. It is almost a sure thing that the September deficit will be significantly less than the August deficit. As a matter of fact, since 1980, the Federal Government has run a surplus in September with only four exceptions, the last of which was in 1991 (the others being 1989, ’86 and ’82). Thus, having a balanced budget for the month is actually a fairly conservative estimate. In 2008, the September surplus was $45.7 billion.

Now if we do run a surplus in September, don’t get too excited — we will be back to running a deficit in October. However, there is a very real possibility that the budget deficit for fiscal 2009 will come in at under $1.4 Trillion — a $400 billion improvement from where we thought it was going to be at the start of the summer.

The key is that the stabilization of the economy has led to a stabilization in tax revenues. It looks like the fears about near-term budget deficits were way overblown.

Now, I don’t want to suggest that $1.4 Trillion is small — it isn’t, and it is a record any way you cut it. It is almost 10% of GDP. However, it is one heck of a lot smaller than $1.8 Trillion.

I am not particularly worried about short-term deficits. In an economic downturn, we need them. Remember the old Y = C + I + G + (X-M) equation:  in a downturn, C (Consumption) shrinks — and this time around C has to shrink by much more than normal given the huge overleveraging of consumer balance sheets. We have allowed C to become far too large a part of the economy at 71%.

It was not always thus: since the end of WWII, Consumption has only averaged 64.7% of the economy. If consumers are not spending, then businesses are not going to invest to increase capacity. And anyway, in recent decades when businesses have invested to increase capacity, they have not done so in the U.S. — they have spent the money in Asia. Thus I (Investment) also falls.

We have made good progress on improving the (X-M) or net exports part of the equation, even if we have seen a little bit of back-sliding in the last two months. However, with so much of our imports (M) being oil, it is hard to see how over the medium-term we can make up the difference entirely through slowing imports and expanding exports (X).

A weak dollar will help in that regard, but unless we have a complete collapse of the dollar (which has lots of other problems) I don’t see it doing the trick, especially given the magnitude of the needed consumer deleveraging.  However, dollar weakness will greatly benefit U.S. exporters such as Boeing (BA) and those firms like Coca Cola (KO) and Aflac (AFL) that get most of their earnings from abroad.

By process of elimination, then, G (Government) must increase as a share of the economy. Cutting spending or raising taxes in this environment would be economic suicide. That is exactly the policy that Hoover carried out that got us into the Depression. It is also the policy that FDR tried in 1937 and caused the economy to fall back after one of the more robust periods of economic growth in our history (albeit off a very depressed base) from 1933 through the first half of 1937.

A budget deficit can help to stabilize the economy. The stimulus package has been extremely effective in that regard. Back on Presidents Day, very few people thought that we would be looking at the possibility of economic growth in excess of 2% in the third quarter, but now that seems likely.

Fiscal stimulus is sort of like, well, a stimulant. A cup of coffee can be very useful in the morning (I sure know it is for me), and there are medical situations where a doctor would want to give a massive dose. However, if you take stimulants for a long time in high doses, well, you might end up being addicted.

It is the long-term structural deficits that pose the real danger. As President Obama pointed out on Wednesday, over the longer term, the deficit problem is the health care problem. The relentless rise in medical costs is the principal factor in the structural budget deficits going forward. Nothing else even comes close.
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