In recent months, US bond yields have jumped. As a result, households and businesses are facing steep borrowing costs. Higher bond yields have also stalled this year’s equity market gains. And rising US interest rates are pushing the US dollar up against most foreign currencies, making US exports less competitive.
One factor driving rising yields is surging US government deficit financing. On July 31, the US Treasury surprised markets by announcing that its third quarter borrowing would exceed $1 trillion dollars, a jump of $274bn over its previous estimates. Since then, US ten-year Treasury yields have jumped nearly a full percentage point.
Almost the entire increase in borrowing costs is due to soaring real interest rates. In contrast, ten-year expected inflation measures have only edged up by 7 basis points since the end of July. And with the S&P500 down 10.2% since its end-July close, rising real rates hardly reflect improving growth prospects. Nor is the Fed to blame. Over the past three months, the two-year note yield—a gauge of expected future short-term rates—is up just 11 basis points.
Clearly, higher federal government debt issuance is a major factor driving up US long-term interest rates. For investors, the implication is clear. They must now shift their attention from Fed-watching to the convoluted politics of government spending and taxation.
Given divided and polarized government, and with the political climate likely to only become more divisive as the 2024 elections approach, expectations for fiscal policies to curb deficits via tax increases or spending cuts are understandably low. Meanwhile, higher appropriations for military outlays for Ukraine and Israel, alongside rising interest expense, point to further pressures on the deficit. Those pressures may intensify if the economy slows, producing smaller tax revenues and higher cyclical spending, in 2024.
Ultimately, however, investors must look beyond next year’s elections and assess the prospects for fiscal consolidation over the remainder of this decade. That means assessing the political calculus of deficit reduction. To jump start that approach, we offer some guidelines based on the history of the past six decades.
The revealed preference of deficit reduction
To begin, it is difficult to take politicians at their word, even in the best of times. Slogans rarely translate into policy, particularly when sacrifice and pain are involved. Raising taxes or cutting spending on popular programs is rarely a winning political strategy. Accordingly, pledges to cut deficits are often no more than convenient soundbites, unlikely to be backed up by concrete actions.
Back in 1938 the economist Paul Samuelson, noting the difficulties of measuring consumer satisfaction and hence struggling to explain consumption outcomes, developed the notion of ‘revealed preference’. Simply put, revealed preference measures what people do, not what they say.
That strikes us as a useful way to handicap future outcomes regarding deficit reduction. Politicians in both parties may pledge to cut deficits, but revealed preference indicates which ones are most likely to do so.
Consequently, it is instructive to look at the past 55 years (since 1968) of US economic and financial history to identify which constellations of political power in Washington, DC are most likely to deliver deficit reduction.
In what may be a surprise to many, the data is relatively clear. When Republicans control the White House, deficits rise –without exception. When Democrats control the White House, deficits fall, again without exception.
For example, taking the size of the federal government budget deficit (or surplus) in the first term of a new administration and comparing it to the size of the deficit (or surplus) in the final year of the same administration reveals that the average deterioration of the fiscal balance under Republican administrations (beginning with Nixon and ending with Trump) during their tenure amounts to -3.9% of GDP. For Democrats, the corresponding measure records an average reduction in the federal government deficit as a percentage of GDP of 5.1%.
A similar picture emerges when one considers the size of federal government debt as a percentage of GDP. In 1969, when Nixon was sworn in as president, the stock of net federal government debt equaled 28.4% of GDP. Last year, that figure was 97% of GDP. Of the increase in government indebtedness from 1969-2022, 70.8% of it occurred when Republicans resided in the White House.
Of course, many factors account for government deficits and an associated increase in indebtedness. Wars, pandemics, and financial crises have imposed particularly high costs in recent decades, leading to higher government borrowing and spending. Also, increases or decreases in government borrowing are not merely the responsibility of the president. Congress must enact and authorize legislation on taxation and spending. And in many cases, one or both houses of Congress were held by the opposition party during a given president’s tenure in office.
Indeed, divided government during much of the 1990s and from 2010-2016 coincided with, and was partly responsible for, some of the largest periods of fiscal consolidation in US history.
Still, it is nevertheless factually correct that Republican presidential administrations have been sources of rising, not falling, deficits and levels of indebtedness.
It is also important to consider what typically drives fiscal consolidation. Here, too, there is more clarity than one might expect. Periods of deficit reduction, including from 1977-1981 or from 1992-2001, were largely accomplished by falling government spending as a share of GDP, rather than via rising levels of taxation in the economy. From 2010-2016, the burden of adjustment was relatively equally shared by spending restraint and higher tax revenues. In contrast, episodes of significantly larger deficits were preceded by major tax cuts (1981, 2017), unaccompanied by meaningful spending restraint.
The historic record, in other words, is not kind to the notion that deficit reduction can be achieved in ways politicians believe will make voters happy. Notably, supply-side rhetorical flourishes, extolling the tax revenues resulting from cuts to marginal rates of income taxation, have little basis in the historic record.
Strong growth, on the other hand, makes deficit reduction much easier. This was
clearly demonstrated in the second half of the 1990s when growth boosted tax revenues (also supported by higher marginal rates of taxation). But spending restraint was also important, underscored by a decline in government expenditures as a share of GDP from 21.7% of GDP in 1991 to 17.7% of GDP by 2001.
Perhaps the most important reason why growth matters is that it makes the pain of deficit reduction more palatable. Voters care about deficit reduction, but they care even more about rising living standards. During the period of successful deficit reduction from 1992-2000, falling federal outlays as a percentage of GDP were accompanied by average annual increases in real median family income of 1.6%, a surge in living standards never since attained.
Which brings us back to where we started. How are investors to judge the probabilities of sustained deficit reduction over the remainder of this decade?
The answer partly depends on which parties control the White House and Congress. And the history is clear. Democratic control of the White House is more likely to deliver fiscal consolidation.
But the political calculus must also be aligned with voter interests. The most compelling case for deficit reduction may also be the least likely one, namely that politicians are rewarded for fiscal rectitude because it is accompanied by strong and well-distributed growth. If living standards are not rising at a time when spending restraint and higher taxes are put in place, deficit hawks will probably face the wrath of voters.
Little wonder, then, that the prevailing narrative among investors and economists about the US fiscal outlook is guarded, at best. While history suggests that reining in budget deficits and public debt is possible, much must go right to make it a reality this decade.