Only Markets Can Rein in the Deficits

Summary

The level of deficit spending will not be solved at the ballot box. It will be solved by the market imposing discipline. When this will happen is an open question. The UK mini-budget debacle in September 2022 offers a potent roadmap.

Comment

The chart below shows the U.S. federal deficit measured in two ways: absolute dollar amount in the top panel and as a percentage of GDP in the bottom panel. The latest data points are $1.60 trillion and 5.58% of GDP.

The deficit is higher than in any period except the Great Recession (2007 – 2009) and the 2020 Covid shutdown.

The government is borrowing as though the economy is trying to recover from a recession. The economy is in year four of an economic expansion.

The deficit (middle panel) is the difference between federal spending (blue, top panel) and federal tax receipts (orange, top panel). 

The bottom panel shows that tax receipts cover 75% of federal spending. The other 25% is borrowed, or the federal deficit.

The blue line in the chart above shows federal spending, currently at $6.43 trillion. As the chart below shows, this equates to 22.5% of U.S. nominal GDP.

Like the deficit chart above, the government has only spent this much as a percentage of GDP when trying to get the economy out of a recession.

Long Term Look

The Treasury Department has good data that goes back to the country's founding.

Conclusion

This level of deficit spending will not be fixed at the ballot box. Whoever wins the election will probably continue to borrow massive sums.

What stops this is the markets putting their foot down and imposing some discipline. This is a nice way of saying that the bond market blows up, bond prices plunge, and yields soar enough to force the government to rein in spending.

For an example of how this could play out, consider an episode from 2022 when the market rejected Liz Truss’s (UK PM) mini-budget. John Waldron of Goldman Sachs drew the same analogy.

• Bloomberg – Goldman’s Waldron Sounds Alarm Over US Debt Jolt to Markets Panic in liability-driven pension strategy rocked UK markets Waldron warns US political crisis could spark similar turmoilGoldman Sachs Group Inc. President John Waldron warned that out-of-control spending could expose the US to serious risk in the event of a political crisis. Waldron drew comparisons to the market jolts from the pension-fund turmoil that rocked the United Kingdom in 2022. UK pension funds used a strategy known as liability-driven investment, or LDI, to protect themselves from falling government bond yields. That move backfired when the government of Prime Minister Liz Truss announced unfunded tax cuts and increased state funding — sending yields soaring, and exposed a major risk at the heart of the country’s financial system.
• Bloomberg – (September 23, 2022) Liz Truss’s Historic Gamble With the UK Economy Is Already Unraveling Markets crash after UK unveils massive unfunded tax cuts Analysts warn that traders are losing confidence in the pound The market’s verdict on the £220 billion policy blitz set out by Kwasi Kwarteng was swift and devastating. Sterling crashed below $1.11 for the first time since 1985, taking its slump for the year to date to 19%. Five-year gilts posted their biggest ever daily decline.

Remember that the Bank of England has over 300 years of data. This happens when politicians cannot say no, and markets are forced to say no.

Liz Truss’ budget failed and she only lasted 47 days as prime minister. She became almost as famous for this meme as she did for being prime minister for a short period of time.