The Grand Old Party, which has branded itself the party of fiscal responsibility, keeps writing checks. The GOP-controlled Congress and White House aren’t just ramping up spending, but slashing taxes — a fiscally untenable combination that could bring permanent $1 trillion annual deficits as soon as 2020, if not sooner.
As for the national debt, it’s also out of control, at roughly $20 trillion and counting.
When numbers get that large, they become meaningless and impossible to comprehend. So brass tacks: What do ballooning debts and deficits mean for the economy and the stock market?
A quick breakdown of the deficit and the national debt. For the U.S. government, revenue comes in the form of taxes, and its expenses are outlined in the annual budget. Social Security, Medicare, Medicaid, military spending, education, roads, foreign aid, public services like police and fire departments — they all cost money.
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If the federal government spends more than it earns in a given fiscal year, it runs a deficit. If revenue exceeds spending, it enjoys an annual surplus. Deficits add to the national debt, while a surplus would bring it down.
When the federal government spends more than it earns, it has to borrow the rest. Instead of the local community bank, it has to tap public debt markets, which it does by issuing Treasury bonds. Foreign countries, as well as companies, funds, pensions and investors from around the world buy U.S. debt of different maturities, which the Feds pay back over time, with interest.
What a soaring deficit and national debt does to the economy. President Donald Trump has promised GDP growth of 4 percent, and his administration seems to be OK running massive deficits to get there.
But economists are starting to worry that $1.5 trillion in tax cuts, combined with the $400 billion in new spending just approved in the recent budget deal, could inject enough money into the economy that inflation starts becoming a problem.
“That’s not to mention the $1.5 trillion infrastructure initiative being proposed in the president’s budget,” says David McClain, professor at Shidler College of Business, and president emeritus at the University of Hawaii.
“All promise to inject a substantial amount of fiscal stimulus into an economy already operating at full employment,” Shidler says. Many are worried this combination will spark extra demand, resulting in rising inflation.
Regardless of whether inflation hits hard or remains manageable, interest rates are definitely rising; most on Wall Street expect at least three rate hikes from the Federal Reserve in 2018.
Like the restaurant that has to keep borrowing money to stay afloat, it’s bad news for the federal government when rates rise. With both total debt and interest rates rising, this means a larger and larger percentage of the federal budget each year goes to paying off interest to creditors instead of education, medical research, or Social Security.
In the short term, rising interest rates are a handicap on economic growth, discouraging borrowing and investment.
And if the U.S. wants to get its debt under control in the long term, the government will have to cut spending, or raise taxes, or both. Either policy, especially if done too suddenly or at the wrong time, could slow the economy or throw it into recession.
Rates look especially ominous. Higher rates appear impossible to avoid as the deficit expands and the economy strengthens.
Remember, those $1 trillion deficits around the corner have to be financed by federal borrowing, i.e., Treasury issues. Unfortunately, there are multiple factors on the immediate horizon “that could reduce demand for U.S. Treasurys,” says Tendayi Kapfidze, chief economist at LendingTree.
Less demand means lower prices for Treasury bonds, which means Treasurys pay higher interest rates. The federal government is staring down higher-interest loans if it wants to keep the country running.
The first and most visible factor reducing Treasury demand is the Federal Reserve, which is starting to sell its assets after a buying spree to shore up the economy after the 2008 recession.
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“The Fed is reducing demand via its balance sheet normalization process. The Fed’s plan should result in a $420 billion decline in its balance sheet in 2018,” Kapfidze says.
The second, more obscure source of declining Treasury demand stems from the $1.5 trillion tax cut.
“The repatriation provision in the tax plan will see further reductions in Treasury demand as much of the money to be repatriated is held in U.S. Treasurys, corporate and mortgage-backed-security bonds,” Kapfidze says.
He estimates over $520 billion in corporate funds will be repatriated, “which in practical terms is a removal of demand from the bond markets.”
Thirdly, the Trump administration’s cavalier attitude toward the value of the U.S. dollar — Treasury Secretary Steven Mnuchin recently signaled the country was OK with a weaker dollar — could also put downward pressure on U.S. government debt.
Foreign investors don’t want to be paid back in a weakening currency, and at the very least, they’ll demand higher interest rates for doing so.
Long-term effects. The U.S., nine years into a protracted bull market, is now gambling on continued growth. Not only that, but blockbuster growth — GDP needs to grow by at least 3 percent over the next decade to finance the tax cuts alone, leaving spending increases and the proposed $1.5 trillion infrastructure plan out of it.
GDP growth has not exceeded 3 percent annually since 2005, and has not regularly topped 3 percent since the go-go days of the 1990s.
Debt-to-GDP, a common ratio that puts a country’s debt into perspective by comparing it to the size of its economy, is already out of control at 1.03. That’s higher than countries like France, Spain and Jamaica.
In the fiscal 2018 budget, Uncle Sam paid $315 billion in interest on the national debt. Those interest payments alone accounted for 6.5 percent of all spending, which was more than spending on Education, Veterans Affairs, Housing, State, NASA, Justice, and Homeland Security departments combined.
Longer-term, foreign nations may charge higher rates still to lend to the U.S. if our debt/GDP ratio gets too out of whack.
Higher rates — and inflation, if it comes in earnest — can easily slam the brakes on economic growth as businesses face higher input costs for materials and higher wages, all while credit tightens.
In the intermediate term, stocks can weather modest rate increases, but at a certain point it puts a stranglehold on growth. And since rising rates mean falling bond prices, both the bond market and stock market risk turning bearish at the same time.
Where rates have to get to cause this inflection point, no one knows exactly. But soaring deficits are only digging deeper long-term holes for the country. Truly, the biggest casualty is everyday Americans.
Dedicating more than $300 billion to interest annually is a huge handicap for America in today’s global economy.
The severe fiscal shortcomings of the United States mean fewer, lower-quality education opportunities, less money for government-funded research to move technology and medicine forward, and the troubling and inevitable — at this rate — long-term insolvency of social programs like Medicare, veterans benefits and Social Security.
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“That is the real problem — and we’d better get on it as soon as possible or a lot of promises to seniors, veterans, and workers will be broken over the next 20 years,” says Sean Flynn, associate professor and chair of the economics department at Scripps College.
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How Soaring Deficits Affect Rates, Growth, Stocks and More originally appeared on usnews.com
