I do not, as a rule, care about the United States budget deficit. This is for three main reasons:
- the United States issues dollar-denominated debt, and so has no risk of default, short of political (versus economic) catastrophe;
- the United States spends such an extraordinary amount on national defense that we have a “peace dividend” available on demand should we choose to spend less on our periodic wars of choice;
- the United States has an overall tax burden far lower than the OECD average, giving us a lot of headroom to increase taxes should budget deficits become a problem in the real economy.
But of course the financial solvency of the US government is not the issue of concern to an individual American; the question is, what do accelerating budget deficits mean for your own finances — the ones you need to pay the rent, buy gas, send your kids to college, and retire with dignity?
Accelerating budget deficits can have two effects
As the budget deficit accelerates, part of the increased nominal economic activity will be absorbed by previously unemployed workers joining the workforce and adding to the nation’s total economic activity.
But in addition to that, part will be absorbed through higher interest rates, as the increased supply of Treasury bonds forces down their price, and part will be absorbed through inflation, as more money chases an amount of goods and services that doesn’t keep up with the supply of money. Whether inflation or higher interest rates predominates is completely up to the Federal Reserve’s Open Market Committee. They can raise interest rates faster and keep inflation muted, or keep interest rates depressed and allow inflation to run ahead of their target.
What do accelerating budget deficits mean to a worker?
The single most important effect government fiscal and monetary policy has for individual Americans is the effect on their income and livelihood. If inflation accelerates, workers’ incomes will fall in real terms unless they’re able to negotiate raises that keep up with their cost of living (economy-wide this would have the effect of accelerating inflation even more).
If interest rates rise, companies will lay off workers and consolidate their operations.
For the average American, this is the overwhelming consequence of accelerating deficits: either a lower standard of living, or a more precarious existence.
What do accelerating budget deficits mean to an investor?
As an investor, the picture is somewhat different, depending on whether you think the condition is temporary or permanent.
If you think accelerating budget deficits are a permanent feature of American economic life, then American firms will be in constant competition with risk-free Treasuries for financing, and experience a consistently higher cost of capital, reducing the present value of their future income. In that case, you might consider investing in international companies, who will see their currencies depreciate and exports increase as the US dollar attracts additional capital inflows from abroad.
If you think accelerating budget deficits are a temporary feature of American life, then temporarily higher interest rates are a short-term buying opportunity for US equities, whose depressed valuations will bounce back once a comprehensive fiscal solution is found.
But I think investors in general fail to take investing literally enough. If your best guess is that your retirement goals require a 6% real return for the next 30 years, and 30-year Treasury inflation-protected securities are returning an inflation protected 6% return, why would you own anything else?
To be clear: 30-year TIPS aren’t earning 6% today. But if US deficits continue to accelerate, and we manage to avoid another global financial crisis or recession, they will be within the next 3-6 years. At the point, the question will be, do you want to lock in sufficient inflation-adjusted savings to meet your retirement needs, or do you want to swing for the fences by gambling on US or international equities?
After all, long-term US Treasuries have underperformed US equities in the current bull market, but they haven’t underperformed bonds. They’ve performed exactly as you’d expect long-term bonds to perform.
Conclusion
So that brings me full circle: if you’re worried about accelerating US budget deficits, what, exactly, are you worried about?
- are you worried about losing your job? You can prepare by saving more, studying harder, learning a trade, or making more friends.
- are you worried about inflation? You can buy international equities or inflation-protected bonds.
- are you worried about high interest rates? You can hold more cash or reduce the average duration of your bond holdings.
- are you worried about a stock market crash? You can pay for a put strategy that protects you from big downside losses.
- are you worried about the Republican Party gutting Social Security and Medicare? You can vote.
In other words, there’s no worry that doesn’t have a solution, but if you can’t identify what, exactly, you’re worried about, you’re not going to be able to deal with it in a way that lets you get on with the business of actually living your life.
So what happens when interest rates rise and the debt service surges. Wont this take away monies away from other services? Is there any point that you would care about deficits?
SumOfAll,
As I try to explain in the post, debt service can’t “take away” money from other services since the United States pays its debts in dollars, which it can print in unlimited quantities. The risk is that inflation will be too painful, or that interest rates will make investment unaffordable for private businesses (who don’t have the luxury of printing their own currency).
So to answer your question directly, deficits will never be the problem worth worrying about. You can conjure up all sorts of threats: if Democrats win back the House or Senate in 2018 and refuse to lift the debt ceiling unless Trump signs a comprehensive immigration bill, you could imagine a US default that destroys the global economic order. That’s a real threat, but it isn’t a threat that has anything to do with deficits.
Likewise you could imagine Republicans continuing to hold onto either the House or Senate and refusing to either cut defense spending or raise taxes, causing the Federal Reserve to raise interest rates so high that the US enters a long, painful recession with wages and investment grinding lower and lower.
Those are real potential problems, and I suspect we’ll see some combination of them in the coming years, but they’re different problems from “the deficit.” That is to say, you can engineer a debt ceiling crisis at any level of deficit spending, and you can cause the Federal Reserve to raise interest rates at any level of debt service (interest rates were high in the 70’s and 80’s with outstanding debt much lower as a percentage of GDP, even taking into account the Reagan deficits). I would personally prefer taxes had been modestly increased, rather than drastically reduced, at this late stage in the recovery, in order to give the Federal Reserve more room to keep interest rates low, which is the fundamental driver of private economic activity. But the deficits themselves will never be the problem: it’s the higher inflation, higher interest rates, and lower future levels of economic activity that are the problem, so this post offered suggestions for ways workers and investors can ameliorate those problems.
—Indy
Why would anyone want “taxes to be raised”? I guess if you were selfish and wished others the hardship of less assets wouldnt it be harder for us all to “ameliorate those problems”?
SumOfAll,
I don’t think I understand your question. The federal deficit is the difference between revenues and expenditures. I think taxes should be raised late in an economic recovery (reducing the deficit) to give the Federal Reserve as much time as possible to keep interest rates low, fueling ongoing investment in the economy.
—Indy
You sound like a “tax cuts” cost too much money guy to me.
LOL. Why are you even reading a blog like this if you don’t even understand basic economics….
You sound like a “I’m not a mathematician, but…” and a “I’m not a scientist, but…” kind of guy to me.
“In other words, there’s no worry that doesn’t have a solution, but if you can’t identify what, exactly, you’re worried about, you’re not going to be able to deal with it in a way that lets you get on with the business of actually living your life.”
What if we didn’t have to worry about this at all because politicians became responsible adults and only spent as much money as they have?
Hah! That was a good one!
I work for a bank. I worry about my job when interest rates go down.