Budget Balancing Act: Navigating America’s Fiscal Future
Financial markets can sometimes instill fear even in the highest echelons of Washington, but the recent turbulence in stocks and bonds may not elicit the response that investors hope for.
There was a notable instance in the early 1990s when bond yields surged during the Clinton administration in reaction to budget deficits. Back in fiscal 1992, during President George H.W. Bush’s last full year in office, the deficit reached a then-unprecedented $290 billion.
Running on a platform of fiscal responsibility and dire warnings of impending disaster, Ross Perot shocked the political establishment by winning 19% of the popular vote in the presidential election that year.
Bond Market Vigilantes: A Historical Perspective
The bond market vigilantes, a term coined by economist Ed Yardeni to describe traders who express their views through actions, soon made their voices even louder than Perot.
While history tends to repeat itself in some ways, it’s unlikely to do so precisely this time around. The 10-year yield has once again surged by 3 percentage points in just a year, reaching its highest level since 2007. However, in the absence of a crisis or recession, the budget deficit stood at $1.5 trillion in the first 11 months of the recently concluded fiscal year. Considering that the gross federal debt is now more than seven times higher than it was three decades ago, the bond vigilantes could potentially wield significant influence once again.
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However, this time, the vigilantes might find limited success in Congress. Of the projected $6.4 trillion in federal outlays for fiscal 2024, only $1.85 trillion is discretionary, excluding mandatory spending and net interest. A significant portion of that discretionary budget is allocated to defense, which is often difficult to trim, even during peacetime.
Congressional Challenges: Tackling the Deficit Dilemma
Increasing taxes could make a more substantial impact, but this proposal faces challenges. The Center for American Progress, a left-leaning think tank, highlights that if the U.S. were to raise taxes to the average level seen among developed economies, it could generate an additional $26 trillion in revenue over the next decade, according to CBO projections.
Furthermore, the CBO’s projections may be overly optimistic, as they assume average interest rates will remain low and do not factor in recessions. Based on calculations by The Wall Street Journal, just a one-percentage-point increase in their assumed interest rate could contribute approximately $3.5 trillion to the federal debt by 2033.
Government Intervention: Inflation vs. Repression
So, what options remain for those concerned about the growing deficit? One avenue is the federal government’s intervention. Strategists at GlobalData TS Lombard point out that historically, unsustainable government debt has been addressed through orthodox methods involving austerity and reform or unorthodox measures such as default, inflation, or financial repression.
For the U.S., outright default is not a realistic option because it borrows in its own currency. However, a combination of inflation and repression might become necessary if deficits and interest rates remain at current levels.
Inflation, often referred to as the cruelest tax, erodes the savings of individuals, including those who rely on their savings for income. It can also artificially boost government revenue and reduce the real value of debt.
George Goncalves, head of U.S. macro strategy at MUFG Securities, notes that bond bulls are starting to capitulate. He believes that if interest rates remain at their current levels for an extended period, the cost of servicing the debt will strain government finances.
However, rates could also decrease without the need for repression, driven by the drag they currently exert on the U.S. economy, which could force the Federal Reserve to implement easing measures.