Should Investors Worry About the Massive Deficit and Debt?

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College and NFL teams have been playing for a while, but for politicians, football season began last week with the release of the budget results for fiscal year 2018. It is impossible to play football without an object to kick and throw around, and the deficit and debt numbers are politicians’ objects of choice.

The most recent release prompted a week of Democrats, who told us repeatedly under the last administration that deficits were not important, expressing shock that there was gambling in the casino, while Republicans, who had spent eight years swooning at the size of the debt up until a couple of years ago, returned to the Bush era view that “deficits don’t matter.”

Both political parties embrace deficit spending when in power and decry it when in opposition, but given that the national debt of the U.S. is at record levels as a result, should investors be worried?

Before we attempt to answer that question, it is important to define a couple of things.  A lot of people, including many who should know better, use debt and deficit as interchangeable terms.

They are not.

The deficit is a number that expresses by how much government spending exceeds receipts each year, while the debt is the total owed by the government, the cumulative result of deficits past. Last year’s deficit was $780 billion, bringing the debt to around $21.5 trillion and growing.

Those are scary numbers, but when considering them it is important to understand that the budget shortfalls and resultant debt of nations are not analogous to those of households. Both result from spending more than you are bringing in, but national governments have two important advantages over the rest of us. They can, to some extent at least, control their income by raising and lowering taxes and can, if all else fails, create money to repay their debt at any time.

That doesn’t mean, however, that raising taxes or printing money are always a good idea. When you print more money to cover a deficit, you devalue the existing currency. That is the essence of inflation, with Venezuela being a good current example of what happens when you print money to pay for excessive spending.

On the other hand, if you increase taxes, you take money out of the economy and that will negatively affect economic growth, possibly even prompting recession.

The other side of the coin in the budget equation is spending, but once again there are no simple answers. Cutting spending may seem like an obvious solution to a deficit, but that too can have a negative effect on the economy, not to mention the political cost of making cuts to popular programs.

The real problem is that addressing deficits has immediate political consequences, while the negative consequences of not doing so are deferred. Politicians therefore tend to spend and cut taxes with abandon, confident in the knowledge that the negative consequences will be SEP: Someone Else’s Problem.

Those problems come in one of two forms. Either unpredictable, possibly unrelated events push the economy into recession, decreasing tax revenues while simultaneously causing increased spending on social programs like unemployment pay and welfare benefits.

Or, the debt gets so large that lenders become wary of the nation’s ability to pay it, and demand higher interest to compensate for the perceived risk. That creates a vicious cycle, where higher interest costs increase overall government spending, which makes the problem worse and forces rates even higher, increasing costs, etc.

Neither of those things look to be imminent, which is why the current administration and congress, like those that came before, feel that they can cut taxes and still spend freely. The real irony is that that is being done to make them more popular, when in fact it should have the opposite effect.

What they are doing is ensuring that when the inevitable problems do come, they will be far worse than they need to be.

To return to the original question of whether investors should be worried, the answer seems to be yes, but not yet. Economic recoveries should be times when the deficits caused by recessions are reduced and some debt is repaid to prepare for the next downturn.

Indeed, following the last recession, deficits did fall dramatically, until 2015, then began to climb again. Depending on your politics, you probably think that some of the things that have caused that are good, while others are bad.

You may, for example, think that Obamacare is worth the trillions of dollars of extra spending, or that defense spending that totals more than that of the next ten countries combined needed to be raised, or that wealthy people deserve to keep more of their income, or even that some or all of the above will pay for themselves, but don’t kid yourself: there will be a price to pay at some point.

That point looks a long way off right now, and a true attack on US Treasuries by the bond market seems unthinkable. I have worked with bond traders in the past though and can assure you that if there is blood in the water, no prey is too big. With every tax cut and spending increase the day of reckoning gets a little closer, and last week’s release suggests it may not be as far off as we think.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , US Markets , Bonds , Credit and Debt , Government , Politics , Taxes

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Martin Tillier

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