Trillion dollar budget deficits now loom in the United States. At 5-5.5 per cent of GDP, these will be the highest peacetime deficits since the end of the second world war, save only for the deep recession periods of 1981-83 and 2008-09.
While age-related Federal spending is the structural problem which Congress hasn’t addressed, tax cuts for companies and the better off are the current cause for concern about the budget. We can argue the merits of variants of overdue tax reform, but this is the worst possible time for unfunded and ideologically-driven “supply side” tax cuts.
You can see how trouble might be brewing for financial markets—and for the economy—by looking at what happened last week.
After a surge in the US stock market, for which President Trump and Republican law-makers were quick to take credit, the Standard and Poor’s 500 index dropped by just over 2 per cent last Friday, and over 4 per cent in the week, the largest weekly fall for two years. Yesterday, the market dropped another 4.1 per cent—the second biggest points plunge in history.
Yet the stock market fall was most likely noise, especially given the still feisty earnings being generated by US companies. But look a little deeper.
Understanding the fall
The proximate reason for the stock market’s wobbling has been the rise in bond yields. The US government’s 10-year borrowing rate closed last Friday at 2.84 per cent, up 40 basis points since the turn of the year, twice the level of last summer’s trough and the highest it has been since late 2013.This move, the mirror image of what normally happens to stock prices, has persuaded many that the bonds have changed from a trading to a trending market (down, since prices and yields are inversely related). There are two reasons for this.
First, the economy is doing pretty well, as suggested by the January jobs report. Average hourly earnings growth rose to a respectable 2.9 per cent. Earnings growth for production and non-supervisory workers didn’t budge from 2.4 per cent, and total hours worked slipped, but markets saw enough in the report to expect the Federal Reserve to raise interest rates again soon.
Second, the Tax Cut and Jobs Act, recently passed by Congress and signed by the President is predicted to boost investment, adding perhaps 0.7-1 per cent to GDP growth in 2018. Yet the unfunded tax cuts will also push up the Federal government’s deficit at the most inopportune moment, just as America’s age-related, government spending surge is about to begin.
Trillion dollar deficits are just over the horizon, which will cause US government debt as a share of GDP to rise in the next several years to over 100 per cent. While debt levels alone cannot predict what will happen to bond yields, the markets fear that significant unfunded government borrowing—especially when the economy is doing well—will cause the Federal Reserve to carry on raising interest rates, in turn pushing bond yields higher.
On current trends, this cyclical shift will eventually, maybe in 2019, puncture the stock market, corporate profits, and most likely the economy.
The timing will prove to be a crucial factor as President Trump gears up for the 2020 Presidential election. A cyclical downturn that extends into election year might dent his chances.
The Reagan example
Supporters and opponents of the Republicans’ tax policy both look to the Reagan tax cuts and deficits in the 1980s for reference. President Reagan was elected when US debt was 31 per cent of GDP, and left office eight years later after it had risen to almost 50 per cent. His legacy was to have increased the US dollar value of Federal debt by more than all the Presidents from George Washington to Jimmy Carter added together. The deficit itself rose from 1.5 per cent of GDP in 1979 to 5.7 per cent in the aftermath of recession in 1983, and then stayed around 3-4 per cent of GDP.Supporters say that US fiscal developments were a small price to pay for the collapse of communism and sharply lower personal tax rates. Opponents argue that the recklessness of the programme was demonstrated by the fact that taxes had to be raised again by Congress between 1983-84, and again in 1987 and by George H Bush in 1990.
Both sides should be able to agree that those years were quite different. Double-digit inflation, and the intense monetary and interest rate squeeze deployed to slay it, low absolute levels of debt, and the sharp 1981/82 recession all contributed in different ways to the deterioration in the budgetary situation.
Today, with decent economic growth, there are strong reasons for tax reform in the US, but macro-economic strategy would be better designed to ensure its broad neutrality, strengthen Federal support for infrastructure (totally forgotten), and prepare for the mandatory age-related spending programmes.
The Committee for a Responsible Federal Budget, a nonpartisan, non-profit organisation, using the baseline projections made by the bipartisan Congressional Budget Office last June, estimates that the Federal deficit is likely to rise to over $1trn in 2019 and 2020, a 50 per cent rise over the level in 2016. It could be higher as Congress may lift the spending caps on disaster relief after last year’s hurricanes, defence, and “dreamers,” the 800,000 children of undocumented migrants.
Social security and healthcare spending set to surge
Moreover, as 2020 looms larger, Federal spending on social security and healthcare is set to surge. Between 2018-2027, annual spending on these mandatory programmes is predicted to rise from $988bn to $1.trn, and from $1.2trn to $2.trn, respectively.Together, these two programmes are estimated to cost almost $13trn between 2018-22, and $17trn between 2022-27. The additional $4trn of spending in these areas alone plus the $1.5trn of lost revenues from the tax cuts will drive fiscal deficits and debt higher.
As this happens, annual net interest costs will rise too, from roughly $300bn a year at the moment to over $800bn a year by 2027. That $500bn rise alone could buy a lot of publicly-needed goods and services.
The timing and scale of these unfunded tax cuts could hardly be more reckless. They look like they will provide additional cover for the Federal Reserve to raise interest rates, and contribute to higher bond yields, which will not sit well with equity investors or eventually the economy.
The one thing that they should do, as in the 1980s, is change the US dollar's fortunes for a while after a disappointing 10 per cent or so fall this year. The oxygen at Sterling's rise to over $1.40 is feeling very thin.
