By Roy C. Smith
For as long as we can remember, Republicans and Democrats have been divided by their economic policies. Republicans have been the party of low taxes, fiscal discipline, and champions of the private sector as the country’s growth engine. Democrats have been supporters of Keynesian economic theory that says when things slow down, its OK to promote growth by government spending programs and subsidies that require substantial additional borrowing, even if that leads to unbalanced budgets, increased inflation and a weaker dollar.
These may be the party’s basic economic platforms, but in reality, they are ignored. That’s because politics and other things invariably get in the way. As Dick Cheney once said “principle is okay up to a certain point, but principle doesn't do any good if you lose.” So, when Mr. Trump wins an election, the Republicans have a tax cut, even though the economy had already returned to a low unemployment growth mode and could only be inflated by further stimulation, which would raise inflation and interest rates, and threaten future growth. If Republicans weren’t worried about this, why should Democrats? Everybody likes a tax cut.
Anyway, all the bad things didn’t happen, at least not right away. Though the US was running a big fiscal deficit (4% of GDP), and total government debt held by the public reached 78% of GDP in 2018 (a post-war record), with prospects following the 2017 tax cut of the ratio exceeding 100% within ten years, no one seemed to care very much. The debt, after all, was repayable in dollars and we could always print more of them, like Japan has done for years (its debt to GDP ratio is 236%). This is a key argument of the Modern Monetary Theory now being promoted by some Democratic presidential candidates as an explanation for how their platform of new social programs will be paid for.
Nor were markets very bothered by the debt. The low prices of consumer goods resulting from the US trade deficit with China and other countries, kept inflation down and generated sizeable financial flows into the US that funded new capital investments and boosted bond prices that kept long-term interest rates relatively low. Stock prices rose too, to new records during the first two Trump years (despite two high-volatility setbacks). Because US international trade has risen to represent 27% of its total GDP, trade affected the economy significantly by slowing the rate at which the direct effects of deficit spending might otherwise have occurred.
So, when Congressional negotiators announced agreement yesterday on a budget bill that would increase the deficit by $32 billion over ten years, the markets only shrugged.
Should they be more concerned?
Well, maybe not. The markets are about expected outcomes over time, and these are indeed determined by underlying theory, but also by other stuff, especially politics and markets forces. When Ronald Reagan’s deficit financed tax bill passed in 1981, economic growth shot up to average 4.3% from 1982-1990, and unemployment fell from 11% to 5.6%. Debt to GDP, which was only 32% in 1980 left room for leverage so the ratio rose to 54% in 1990, helping to kill the boom. When George H.W. Bush, Reagan’s successor, ran for reelection in 1992, the economy was in recession and the deficit had ballooned from 2.7% to 4.7% of GDP, and growth slowed from 1990-1992 to 1.7%. When Bush, ignored Dick Cheney’s other great economic pronouncement (“Reagan proved deficits don’t matter”) and went back on his promise of “no new taxes,” many in his party deserted him for Ross Perot and he lost the election to Bill Clinton, whose economic policy was to reduce the deficit ratio further (to 33%) so bond market rates could go down even more (“everyone wants a lower cost mortgage”) and the economy improved to average 4.5% growth from 1997 to 2000 and the deficit turned to surplus, the first one in 28 years,.
But, when the deficit chickens fly away, it is just a matter of time before they come home to roost. We end up paying for the benefits of the deficits at a later time, in one way or another – in a financial crisis, a recession, inflation, high unemployment, or a meaningful change in voter perceptions about economics.
The slow-moving, but powerful give-and-take between economic theory, politics and markets one day requires a price for today’s neglect of the deficits. Most likely it will be in the form of lower GDP growth, which the Federal Reserve is now forecasting to fall to 1.9% for 2020 from its cyclical peak of 3.1% (in 1Q 2019, but it dropped to 2.1% in Q2), back towards the average US GDP growth since 2000 of 2.0%. And, Trumpian uncertainties, well known to the markets today, could make things worse.
It may not, however, because other things such as a brilliant trade deal, that could change the game. But if it does, the system will adjust over time. Even at 20% interest rates, US debt was refinanced in financial markets after the Volcker Shock in 1979. Political sympathies for unchecked deficits may change and markets will discount future stock prices for lower growth or other concerns. Market power is now enormous, with more than $300 trillion in market capitalization of all tradeable stocks and bonds in world markets. And, other factors, unknown to us now, may also affect long-term outcomes. But even then, fear of deficits, won’t last for long, and deficits will come back in style.