Barnett and Company

Deficits Don’t Matter, Until They Do: Parsing the Current Thinking

This year, the federal government will run up a deficit of $900 billion. The total amount of debt outstanding is about $22 trillion, which is about the same size as the entire economy. Two outstanding obligations of the federal government, Social Security and Medicare/Medicaid, are slated to run out of money in the next 10-15 years. State governments have, in many cases, similar liabilities with their state employee pension plans.

Once upon a time, such data would be a cause for concern. In fact, the birth of the Tea Party in this country a decade ago was originally to publicize the deficits and advocate for their extinguishment. However, after the Tea Party coalesced around Donald Trump as its standard-bearer and he, in turn, dismissed deficits as irrelevant. The Tea Party members followed suit. The alliance has created the suspicion that the goals of the Tea Party were not so much fiscal restraint as to limit the ability of the Obama administration to respond to the greatest fiscal crisis since the Great Depression by denying them the deficit spending used by Roosevelt to address the crisis of the 1930s.

Be that as it may, the deficit marches on. The tax cuts of 2017, which helped most corporations, small businesses, and the wealthy, has yet to generate offsetting revenue to pay for themselves. The non-corporate part of the tax cuts is to be slowly reversed in stages so that by 2027 rates are back to where they were before 2017. Corporate rates will be permanently reduced, or until Congress makes a change. In the meantime, government estimates of the deficit put it at over a trillion dollars per year as far as the eye can see starting in 2020. The revenue growth attained is being swamped by expenditures for Social Security and Medicare.

At one time, this would have mattered. A debt clock was started in 1989 by Seymour Durst, a real estate developer. Several countries copied the idea, especially Germany, who suffered hyperinflation in the early 1920s. But beyond their progress in terms of numbers, there is little talk or concern about the federal debt.

The principal reason given for the laxity about the debt is the lack of inflation. Since the implication of deficits is higher inflation, as more printed money circulates without an offsetting increase in assets, one would have expected higher inflation before now. Aside from an uptick in wages seen in the data last month, to speak of there has been no increase in inflation. While inflation in services has been far higher than inflation in goods, the overall effect is to keep the government-generated numbers fairly low.

There is a school of thought that inflation, once ignited, will be difficult to contain. The primary way to contain inflation is to raise interest rates above the inflation rate. Paul Volcker stopped inflation in the early 1980s in this way. The better idea is to cut off inflation before it gets out of control.

The problem is that once interest rates increase and credit is restricted, people get upset. We have already seen the President accuse the Federal Reserve of raising interest rates needlessly, which, coming from him, is an attack on the independence of the Federal Reserve to operate without political pressure. Trump has mused about firing Jerome Powell, the Fed’s Chairman, although he cannot do so.

The best way to reduce the risk of increasing interest rates would be to reduce the deficit, but this would require either raising taxes or reducing spending. The only taxes under discussion to be raised by this administration are tariffs on imports. While such taxes would raise revenues, they would also be directly inflationary, increasing the price of imported goods. Citizens pay for the tariffs of the country mandating them. As for reducing spending, almost 70 percent of government expenditures are for Social Security, Medicare, or other means-tested programs.

An effort to reduce these benefits would be seen as calloused at best and would be subject to ongoing legal challenges. Reducing benefits would also have direct economic consequences, as these funds usually are spent immediately. Perhaps the Tea Party should have stuck to its original mission, and not let politics deflect it from its goal of deficit reduction, assuming that was its original goal.

The Economy

Economic data is continuing to show signs of the disruption from the government shut down in December and January. Still, the trend is for slower real economic growth in 2019 compared to 2018, in the order of 2.3 versus 3.1 percent.

The rate of growth is forecast to slow further to 1.7 percent in 2020. Contrast this to the assumptions of the President’s budget, which assumes 3.0 percent real growth each year for the next fifteen years, to result in a balanced budget by 2034.

Inflation

While inflation in goods and services is moderate, wage inflation is beginning to take off. A tight job market, no relief from immigration, and an aging population are combining to send wages up 3.4 percent over the same time last year.

Wage inflation is important, as much of the expansion of corporate profit margins have occurred as the result of wages rising more slowly than revenues. Should this trend be reversed, companies will find themselves spending more on labor and not recovering the increase in prices. The result is a squeeze in profit margins that can only be made up by increased revenues. When the economy slows, rising revenues are harder to come by.

Interest Rates

The current stock market is being fueled by an expectation that the Federal Reserve will keep interest rates unchanged, which is to say below the rate of inflation. Also, the program to liquidate the government’s massive portfolio of bonds, called “quantitative tightening” will be stopped soon, so speculators will have sufficient funds to indulge in their craft of buying assets to resell at higher prices.

Should either of the above assumptions be challenged, the atmosphere of the market will be sure to change, and not necessarily for the better.

The Stock Market

After staging a quarter that defied the naysayers who were predicting a recession last December, and citing the justification of the stock market’s direction for doing so, the market roared back in the first three months of this year to almost matching the levels of last fall.

Where the market goes from here is anyone’s guess, but a long list of Initial Public Offerings (IPOs) for such companies as Uber, Lyft and any number of hot concepts is slated for release soon. In the eyes of some, this should signal a market top, as the original inside investors sell off their holdings to less knowledgeable outsiders. The result will also potentially mark the reversal of the shrinkage of stock outstanding, as new supply offsets corporate buy-backs. Even Levi Strauss, the venerable jeans maker, is public after being private for several years. Usually, when the companies become public, the stock exchange has some of its officials ring a bell. How appropriate.

Meanwhile, the President has discovered a correlation between a high stock market and his popularity. Get ready for a King Canute performance, perhaps in reverse, should the stock market not deliver for him.

Warren M. Barnett, CFA

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