Investors Are the Guinea Pigs in U.S. Fiscal Experiment
(Bloomberg View) -- In a span of less than two months, the U.S. Congress passed substantial tax-reduction legislation and agreed to a major increase in federal spending. Estimates are that the U.S. Treasury will at least double its debt sales this year to more than $1 trillion to make up for the lost revenue from the tax cuts and pay for this extra spending.
How long can the U.S. go on this borrowing binge before it matters to the credit-ratings firms and global investors? And does it matter at all?
The two-year budget deal passed early Friday authorizes an additional $300 billion in spending for defense and non-defense programs over the next two fiscal years. Bloomberg News reports that the nonpartisan Committee for a Responsible Federal Budget, analyzing a report from the Congressional Budget Office, said the deal would add a net $320 billion to deficits over a decade, or $418 billion counting the additional interest costs. That’s in addition to the estimated $1 trillion added to the deficit over a decade by the Republican tax-cut legislation passed in December.
Even before the tax cuts and spending bill, the CBO estimated a budget deficit for fiscal 2018 of $563 billion and a shortfall of $689 billion in fiscal 2019. The projected revenue loss from the tax cut alone is about $100 billion in fiscal 2018 and $250 billion in 2019.
S&P Global Ratings, which cut the U.S.’s AAA credit rating in August 2011 to AA+, had this to say in June 2017:
Disagreement across and within political parties has resulted, in our view, in slower decision-making and has limited the government’s ability to enact forward-looking legislation. These factors, along with the government’s high level of debt, constrain the ratings. Some of the Administration’s policy proposals appear at odds with policies of the traditional Republican leadership and historical base. That, coupled with lack of cohesion, not just across, but within parties, complicates the ability to effectively and proactively advance legislation in Congress, particularly on fiscal policy. Taken together, we don’t expect a meaningful expansion or reduction of the fiscal deficit over the forecast period.
S&P has yet to weigh in on the tax cuts and spending deal, but Moody’s Investors Service said Friday that the U.S. stable credit profile is likely to face downward pressure in the long term due to meaningful fiscal deterioration amid increasing levels of national debt and a widening federal budget deficit. Moody’s gives the U.S. a rating of Aaa.
When S&P stripped the U.S. of its AAA rating in 2011, the government faced a debt-ceiling crisis before passing legislation that “promised” future spending cuts. Nevertheless, S&P said lawmakers "failed to stabilize the government debt term dynamics.” The downgrade triggered a large selloff in equities over a period of several weeks and a sharp decline in 10-year Treasury yields as investors worried about the potential negative effects on the already uneven and weak economy.
Regardless of whether the latest spending and tax-cut policies lead to a downgrade, investors must be aware that the economic and policy environment today is much different than in 2011, and therefore the impact on various asset classes will be different as well.
In 2011, Congress agreed to reduce future spending, or place spending caps on defense and nondefense programs if no deal was reached. In 2018, Congress voted for a big increase in actual spending for the next two years. Also, in 2011 the Federal Reserve promised to continue to hold official rates near zero and increase its purchases of debt securities. Today, the Fed is raising rates and letting its holdings of debt securities run off. Perhaps most importantly, the economy in 2011 was expanding at a less than 2 percent pace and the jobless rate stood at 9.1 percent. Now, the economy is growing near 3 percent, which is above its potential, and the jobless rate is at a 17-year low of 4.1 percent and heading lower.
Increases in federal spending, even more so than tax cuts, change the direction of liquidity flows since every dollar goes directly -- and sometimes immediately -- into the economy. The combination of tax cuts and federal spending increases could push nominal gross domestic product growth to the 5.5-percent-to-6-percent range in 2018 and 2019, sending yields higher across the Treasury curve.
The wild card is how foreign investors and the dollar react to the fiscal policy changes. Based on improved growth dynamics, higher market rates, and the prospect of a large repatriation of foreign earnings due to a change in the tax law, one would have expected a strong dollar performance in early 2018. But that hasn’t happened.
The fact that the dollar is not responding to stronger economic growth might be a signal that foreign investors are concerned about the U.S.’s steadily rising debt-to-GDP ratio, which stands at 77.4 percent, and that the U.S. might welcome a weaker dollar to make it easier to pay for its rising debt burden. If that proves to be the case, even though interest rates are relatively high today versus other industrialized countries’, they will need to go even higher to attract the needed savings to balance the U.S. accounts. Stay tuned.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Joseph G. Carson is the former global director of economic research at AllianceBernstein.
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