Do deficits matter? A closer look at the growing budget shortfall

A perspective from E*TRADE Capital Management, LLC

07/20/18

How are your finances looking? If you’re gainfully employed, fully invested, and paying down debt, you’re probably on the right track.

So what gives with Uncle Sam?

Despite an economy going at full throttle, the US federal budget deficit is projected to approach $600 billion in the first half of 2018 alone, according to the Congressional Budget Office (CBO), a nonpartisan government agency that provides economic information to Congress.1 This continues the reversal of a trend that saw the deficit shrink by nearly two-thirds, from a post-financial crisis high of $1.4 trillion in 2009 to $438 billion in 2015.1 At this pace, the CBO is projecting deficits to easily pass $1 trillion within two years.

Should investors be alarmed? Or should they shrug it off? After all, the US has run budget deficits in excess of $1 trillion before. How much do deficits really matter?

US budget deficits: actual and projected

Deficits and debt—related, but not the same

First, it’s important to differentiate between debt and deficits. The federal debt reflects what the government owes its creditors. Because debt accrues interest and is necessary to fund the government, it tends to grow over time, much like a credit card balance that isn’t paid down.

The deficit, on the other hand, is the difference between what the government generates in revenue and what it spends in a given time period. Because tax revenue and spending fluctuate with changes in the economic cycle, deficits tend to rise and fall over time.

To illustrate, consider that in 1996 the United States ran a then-record budget deficit of $290 billion. By 2000, the deficit had morphed into a surplus of $236 billion.2 During that same period, total government debt continued to grow.

Putting deficits into context

Economic theory dictates that budget deficits matter because of a “crowding out” effect. That is to say, if borrowing increases substantially, interest rates will rise to the point that they discourage—or crowd out—private investment. While that theory could’ve passed the sniff test in the late 1970s, since 1984 interest rates have fallen into the single digits—even as federal budget deficits have risen in absolute terms.

A more relevant way of considering deficits is as a percentage of gross domestic product. This metric puts deficits in context by showing how much debt the nation can afford to service. By this measure, the current deficit is no greater than it was in 1975 and is actually less than it was in the late 1980s.2

Does this mean we have nothing to worry about? Not quite.

Effects of the 2017 tax cuts

In late 2017, Congress passed the Tax Cuts and Jobs Act of 2017, which cut the top corporate tax rate from 35% to 20% and doubled the standard deduction for individuals. The bill also limits the amount of state and local taxes that can be deducted, disproportionately affecting high-tax states.

Proponents of this massive tax cut proclaimed that the bill would supercharge the economy and shrink the budget shortfall, while opponents predicted sharp increases in the federal budget deficit. And though the tax stimulus has likely given a nudge to an economy already essentially at full employment, many companies have opted to return tax cuts to shareholders in the form of special dividends and stock buybacks rather than hiring more workers. Meanwhile, the deficit has ballooned and could exceed $800 billion by the end of the year.1

And that could be where the problem lies.

When it comes to deficits, economic conditions matter

In theory, one would expect deficits to shrink when the economy is expanding because tax revenues are rising, thus reducing the need for deficit spending to stimulate growth. Conversely, the deficit could be expected to increase during periods of economic weakness, when tax revenue shrinks and the government ramps up spending as a fiscal stimulus.

But that’s not what is happening. The federal budget deficit is rising during a period of economic expansion.

Why is that an issue? Because economists believe it neutralizes the power of fiscal policy (i.e., changes in taxes and government spending) as an economic stabilizer. Think of it like blowing through your income and maxing out your credit card while you’re fully employed. You’ve run up debt during the good times. What happens when things go south?

When the economy weakens—and it will, eventually—odds are that the deficit will expand further, which could prompt calls for fiscal austerity just when government spending is needed the most—potentially exacerbating the effects of a recession. That’s why economists believe it’s critical to make a dent in the deficit at a time like this.

Takeaways

There’s not much investors can do to prevent rising deficits, but they can position their portfolios accordingly.

•  Keep an eye on inflation. The very factors that have contributed to rising deficits could also trigger inflation. Under this scenario, investors may wish to consider equities issued by companies with strong pricing power or a willingness to increase dividends at a rate that exceeds inflation. Strategies for a rising rate environment can also be beneficial during inflationary periods.

•  Look for yield opportunities. In anticipation of rising deficits, the Treasury Department in January announced $42 billion in new issuance, with the bulk of it in the form of short-term Treasury notes. That, coupled with the Fed’s attempts to unwind its balance sheet, could drive up short-term Treasury yields.

  Even a modest uptick in interest rates can push the US dollar higher by attracting foreign capital to fund the deficit. A strong dollar hurts large US exporters, some of which are already feeling the pinch of higher tariffs. Broad international exposure may help mitigate some of this risk.

Deficits are seldom top of mind during prosperous times, and in Washington, DC, saving for a rainy day is about as rare as a bipartisan handshake. Fortunately, investors have control of their own finances. Ultimately, a well-diversified portfolio may be your best defense against the aftershocks of an exploding deficit.

1.  Congressional Budget Office, “The Budget and Economic Outlook: 2018 to 2028,” April 2018. https://www.cbo.gov/system/files?file=115th-congress-2017-2018/reports/53651-outlook.pdf

2.  Congressional Budget Office, Budget and Economic Data, 2018. https://www.cbo.gov/about/products/budget-economic-data