Last night, after looking certain to proceed earlier in the day, the Senate tax bill stalled. That raised fears that, as unthinkable as it seemed at the start of this administration, we could get to the end of the first year of a Republican White House, Senate and House without any major legislation enacted. More importantly from a market perspective, it threatens the progress of tax cuts that were promised on “day one” and that the market has had priced in for a long time. The dissenting Republican senators are not all opposed to the bill for the same reasons, but at the core of the opposition is the potential effects of the bill on the deficit and national debt. Now would therefore seem to be a good time to look at the nature of debt and deficit, and its effects, if any, on the market.
First off, the two things are not the same, despite the common tendency to conflate them. The deficit is the difference between government revenue (taxes) and spending. The debt is the total that the government owes, or the cumulative result of deficits over the years. We are frequently told that the “deficit” is currently over $20 trillion, but that number is actually the total accumulated debt. That is not to say that there isn’t a deficit; the federal government will spend $666 billion more this year than it brings in, once again adding to the debt.
Those are both scary numbers, but do they matter? Most people’s answer to that question seems to depend on their own political affiliations and which party is in power at the time. Republicans who were up in arms about the increase to the debt under Obama have now mostly returned to the position espoused by Dick Cheney when the deficit was exploding under George W Bush that “deficits don’t matter”. Meanwhile, Democrats who went to great lengths to explain that the increase under Obama was no big deal are now very upset about a tax bill that adds far less.
Politics aside, though, most people instinctively think that deficits are bad. That is probably because in their own experience with a household budget that is the case, but governments, and the US government in particular, are different. US government debt is secured by the ability to tax the world’s largest economy, and government debt is used to benefit society in general rather than to buy a new pair of shoes, so can be seen more as an investment than an expenditure. If a household is spending more than it is bringing in the day of reckoning is never far away, and it is hard to get a meaningful increase in revenue. For the US government, however, exponential economic growth means that there is an ever-increasing pool of money that can be taxed, so that day of reckoning could in theory never come. In addition, the ability to create the means of repayment (dollars) means that, repayment could be made at any time. Complete repayment, however, as good as it sounds, would not be a positive thing. The world’s markets use US government debt (Treasuries) as the default, risk free investment against which all others are judged. Take them away and the resulting dislocation would be enormous.
Still, there is a point at which a large debt becomes a problem. Debt results in interest, and paying that interest takes money away from other needs. In the current environment, when interest rates are low, that is not too much of a problem, but if global market perceives debt as high enough to be an issue, they will start to demand higher interest from the government, and debt servicing could quickly become a problem. That would lead to a spiral of higher deficits, increasing debt, higher interest rates, etc. The other power that a government has that is not available to household, however, is the ability to print, or more accurately create, money to pay off their debt. That is inflationary by nature so is used sparingly, but it is always in the background.
All of this makes it sound as if Dick Cheney was right, and deficits really don’t matter. That, though, is not the case. Heavy government borrowing distorts capital markets and diverts money away from other, potentially more productive investment. That has traditionally been the basis of Republicans’ tendency to be more fiscally cautious and is the reason some deficit hawks, such as Bob Corker, the senator from Tennessee, have maintained that position. That said, it is logical that his opposition to this bill, along with Jeff Flake’s, is at least in part about revenge for Donald Trump’s insulting tweets rather than any principled stand on deficits.
Whatever their reasons, though, those two senators are opposed to the bill, and that is as many “no” votes as the Senate Republicans can afford if the bill is to pass. Senator Ron Johnson has also voiced opposition based on his view that the bill is unfair to small business, so there is a problem. This is however a bill that is favored by the Republicans’ supporters and big donors, so the most likely outcome is that at least one of those three can be convinced to vote yes.
According to the latest study by a non-partisan group, the bill as written will add around $1 trillion to the debt, even after allowing for likely growth, so if it does pass, some addition to the debt looks inevitable. The negative consequences of that are, however, a long way off, and the opinion of traders regarding the potential short-term benefits are already clear. In other words, for investors, on this occasion, neither deficits nor debt matter, at least for now…