DANIEL VAUGHAN: The National Debt and Deficits Matter Again

October 5, 2023

If you're an average person faced with typical financial pressures, you readily understand that if interest rates go up, that makes debt more expensive. If you take out a new loan at 8% one month versus the 3% you could have had the month prior, it's understood the 8% loan is more expensive. If this seems elementary, that's because you have common sense. If this is confusing, you may be the Federal Government or Wall Street investors relying on the Federal Reserve.

Markets and Wall Street are roiling this week because interest rates are spiking. Put another way, everyone realizes that interest rates are high, and the U.S. Government is still pumping out debt, which gets more expensive by the day. The headline of Greg Ip's column in the WSJ summed it up: "Rising Interest Rates Mean Deficits Finally Matter: Investors ignored deficits when inflation was low. Now they are paying attention and getting worried."

CNBC reports, "Violent moves in the bond market this week have hammered investors and renewed fears of a recession, as well as concerns about housing, banks and even the fiscal sustainability of the U.S. government." The soft landing, which everyone has discussed with considerable belief, is losing momentum as the most likely scenario.

For the last few years, we've talked ad nauseam about Jerome Powell and the Federal Reserve. Flying underneath that is Janet Yellen's Treasury, and now she's front and center. Ip put it this way, "Now, the Treasury itself is a source of risk. No, the U.S. isn't about to default or fail to sell enough bonds at its next auction. But the scale and upward trajectory of U.S. borrowing and absence of any political corrective now threaten markets and the economy in ways they haven't for at least a generation."

Yellen is the problem now. The Federal Reserve still plays a substantial role because inflation is still an issue. But the Treasury becoming part of the growing problem is why Yellen and Powell are singing different tunes. That's why the Fed continues to preach the "higher for longer" mantra to any journalist within earshot.

On the flip side, Yellen is much less confident. At a recent event, she said, "People are trying to figure out exactly what it's going to take to keep inflation moving down ... And the economic resilience that they see maybe suggests higher for longer, but we'll see. I think it's by no means a given."

Deficits matter, which by extension means government spending matters. After decades of cheap credit, the federal government has to answer questions about its debt levels. And what's equally scaring investors is that the current front-runners for the 2024 election, Biden and Trump, don't have any plans to cut that spending. The WSJ notes:

Investors looking for U.S. political will to rein in deficits would take note that both former President Donald Trump and President Biden, their parties' front-runners for the 2024 presidential nomination, have signed deficit-busting legislation and that both of their parties have pledged not to cut the two largest spending programs, Medicare and Social Security, or raise taxes on most households.

Now, former House Speaker Kevin McCarthy was ousted, and one of his negotiated plans in the House included cutting spending. The rebels who kicked him out may talk a big game on cutting spending, but their gambit ensured the spending cuts McCarthy had negotiated are gone. Gaetz and friends have done more work to increase spending than anyone.

In the aftermath of the Great Recession of 2007-2009, it was popular and common to talk about the dangers of high deficit spending and increasing debt. And for a while, people took that seriously. The Tea Party movement was launched, and there were serious attempts to address the U.S. deficit and debt.

But nothing ever came of any of that noise. We never got serious attempts to draw down spending. In fact, the opposite occurred. The only saving grace was that interest rates were low, so it was easy to spend in excess in that environment. Donald Trump played on this as well, pushing more infrastructure spending while interest rates were low and inflation was non-existent. 

All of that is gone now. Interest rates are at multi-decade highs and headed higher. Inflation is clawing at the doors, trying to get back in. And the Federal Reserve has played every card in its hand to try and stop the rolling disaster. To the Fed's credit, inflation has slowed down. The problem is that we're now in the higher for longer portion of the plan, which means U.S. debt is getting expensive very quickly.

And that means the U.S. will start paying more interest on its debt than it will on using that money for anything else. That will cause deficits to increase faster and pile on more to the national debt. The next House Speaker must deal with this problem immediately because it's front and center for Yellen's Treasury and Powell's Fed.

Nothing lasts forever. After two decades of low interest rates and economic growth, we've got high rates, fast growth, and exploding debt. It's easy to ignore debt when it is cheap. But if you have common sense, you know that won't last forever. 

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