Markets Are Sounding the Alarm on Deficits

National Review Online

Tuesday, October 24, 2023

 

The federal deficit doubled in fiscal year 2023, and the bond market is sounding the alarm about fiscal irresponsibility. But Washington isn’t listening.

 

The deficit for 2023, reported at $1.7 trillion by the Congressional Budget Office, was really about $2 trillion (or more than twice the $1 trillion recorded a year earlier). The reason for the $300 billion discrepancy lies in Washington accounting conventions. The government counted the Biden administration’s illegal and unconstitutional student-loan program as part of last year’s spending, and then counted the Supreme Court’s rescission of that program as though it were savings.

 

During his State of the Union speech, and on many other occasions, President Biden claimed credit for “the largest deficit reduction in American history.” In reality, what had happened was that in 2022, spending retreated from its Covid-era peak, as pandemic-related spending measures expired. But now he can no longer make even that preposterous claim.

 

This year’s economic and political circumstances should not have led to a doubling in the deficit. Economic growth has been slow but positive, the unemployment rate is very low, the pandemic and its extra spending is in the past, no major new domestic programs were created, and U.S. forces aren’t fighting any major wars. Revenue is down from the record high of 2022, but it’s still high compared with the long-run average, as a share of GDP.

 

Given those fundamentals, the bond market is spooked. Fitch downgraded U.S. debt in August, citing long-run fiscal problems and Congress’s unwillingness to deal with them. When it made that announcement, the yield on a ten-year Treasury bond was about 4 percent. Today, it’s closer to 5 percent. The yield on a ten-year Treasury has been rising gradually since mid May, when it was around 3.5 percent.

 

The bond market is speaking with a clarity that has been missing in Washington. Higher bond yields reflect lower confidence that bondholders will be paid back. Treasuries are still safe assets, but they aren’t as safe as they used to be.

 

The flip side is that it increases borrowing costs for the government. And not only does the government have to pay higher interest rates, it also has to borrow more money to cover the widening deficit. Higher deficit spending further weakens bondholder confidence. It also crowds out private borrowing and investment, which hinders GDP growth. That comes out to a debt-to-GDP ratio where the numerator is growing faster and the denominator is growing slower. Already around 100 percent, expect it to continue its upward trend, and fast, if no changes are made.

 

And making no changes is basically the bipartisan consensus in Washington right now. Neither party has the will to address the root cause of the debt: entitlement spending. Given that refusal, borrowing will eventually become the largest line item in the budget.

 

Things will get worse before they get better. The federal government is headed for the mother of all fiscal cliffs in 2025, when about $5 trillion in new debt is expected to hit. That’s when the individual provisions of the Tax Cuts and Jobs Act and the suspension of the income limit for Obamacare subsidies expire, along with hundreds of billions in extra federal funding for state and local governments and contract authority under the bipartisan infrastructure law.

 

Politicians might not care what happens beyond the current election cycle, but the bond market does. It sees a government whose spending is out of control; it’s doubling its deficit during a time of low unemployment, with hardly anyone in leadership positions expressing serious concern or making any significant moves to do anything about it. When a crisis comes — and such crises almost by definition come suddenly and at a time no one predicts — politicians will find that they have to care.