Impact on the fiscal deficit

One of the factors that will help mitigate the economic impact of Hurricane Katrina is the new spending by the federal government. Two new spending bills have been approved for about $62 billion, which is about the annual cost of the U.S. military operation in Iraq. A third spending bill is likely in October.

The total cost to the Federal government has been estimated at $150-$200 billion. Almost half the $62 billion is being spent on temporary housing and financial assistance for the 1.1 million households that have been displaced by the storm. This includes direct cash assistance.

About an eighth of the funds already approved will be spent on rebuilding the state and local infrastructure. However, some of this is really payback for being under funded in recent federal budgets. Reports indicate, for example, the Louisiana Army Corps of Engineers had identified about $18 billion in projects to shore up levees in New Orleans after hurricane season last year. None of these projects were funded. Since 2001, the budget of the region’s Army Corps of Engineers has been cut by 50 percent. And prior to Hurricane Katrina, President Bush was seeking another 20 percent reduction in next year’s budget.

The fiscal stimulus could be even greater. Often when the federal purse is opened, special interests and their legislative representatives seize the opportunity to press for funding or tax breaks for pet projects. This is what happened following 9/11 and helped account for the sharp increase in discretionary spending in 2002. With Congressional elections next fall, the risk is that politicos become fiscally lax again under the cover provided by Hurricane Katrina and the initially slow federal response.

The net effect will be the federal budget deficit will widen on both the direct costs of providing disaster relief and increased unemployment benefits, as well as the indirect costs of reduced federal tax revenues and increased pork barrel spending to grease the legislative wheels of progress. The fiscal deficit is likely to top 4.0 percent of GDP in 2005, and could exceed 5.0 percent of GDP in 2006 depending on the extent of indirect costs as well as second round economic impact.