Stocks fell yesterday reversing Monday’s gains. There were two primary news events that weighed on markets. First was the sharp drop in reported exports from China. The Chinese economy may still be growing but it is decelerating rapidly as population starts to decline. Deflation threatens. Separately, Moody’s downgraded the credit ratings of 10 regional banks. While survival isn’t in question, their abilities to service debt under stressful situations comes into question.
Perhaps the biggest economic news this week was a report on Federal spending. So far this fiscal year, through 10 months, the U.S. has managed an operating deficit of over $1.6 trillion versus $762 billion last year. Revenues fell by 10%, led by a 20% decline in individual tax payments, probably related to lower capital gains payments. Social Security outlays rose by $111 billion thanks to a huge COLA adjustment related to high inflation. Medicare payments also rose by over $100 billion as the elderly and others began to catch up on deferred procedures.
Maybe the most alarming number is the rise in debt service. For the 10 months, it reached $572 billion, an increase of 34%. To put that number in perspective, corporate tax revenue for the same period was $319 billion. I don’t have to tell you that interest rates today are substantially higher than they were a year ago. Treasury plans to raise $1 trillion in new money this quarter alone. Meanwhile, the Fed continues to reduce its balance sheet at a $1 trillion annualized pace putting yet more debt into public hands. When Treasury pays the Fed, the money is returned to the Treasury. When the Fed pays the public, that’s an incremental outlay. The $572 billion in debt service cost is going to continue to skyrocket.
It’s easy to blame the Biden administration for reckless spending but every dime spent has been approved by Congress. In the most recent set of budget bills passed by each chamber of Congress, earmarks from Republican legislators are more than double those from Democrats. Next year is an election year. Don’t expect any spending restraint even as we listen to a lot of rhetoric from incumbents claiming fiscal responsibility. No wonder Fitch downgraded U.S. credit ratings last week!
While we all know Treasury owns printing presses and can fund any deficit, as the numbers above show, it will have to find more buyers for its borrowings and will likely have to pay more to entice them to keep buying. I don’t expect in the remotest sense an inflation spiral that we see in third world countries. But I do believe the massive buildup of debt will be costly. An 11% increase in outlays is inflationary as well. Major outlays for infrastructure spending already approved, to support the CHIPS Act, and to fund social programs already in the hopper, suggest outlays will continue to grow. On the revenue side, a strong stock market might elevate individual receipts next year. But lower corporate profits will reduce business related income. While the COLA adjustment to Social Security will be lower when set this fall, it will still be significant. Both Social Security and Medicare payments next fiscal year will rise faster than inflation.
The Fed is in a battle to reduce inflation. The surge in Federal spending, now and over the next several years, makes that battle harder. That means rates have to stay higher for longer. Progressive economists suggest that owning the printing press allows for wider deficits. That may be true to a point. But inflation data over the past year, even taking supply chain disruptions out of the picture, suggest that simply isn’t true in the long run. Ultimately, increasing reliance on deficits leads to a rapid escalation in debt service costs that ultimately chokes the capacity to fund programs. If debt service costs rise at anywhere near the current pace, within five years, our government will spend more to service its outstanding debt than for Defense or Medicare. Of all the outlay categories, only Social Security payments will be larger than debt service.
One last number. The $534 billion in debt service for the first 10 months of this year was higher than total U.S. government outlays for any year prior to 1980.
Higher debt service costs are inflationary. They are a cost of doing business. Any business, public or private has to pay its debts to continue operating. Higher debt service requires either greater efficiency or higher prices to compensate. There is no free ride.
The Fed will win this battle. It always does. Higher and higher short-term rates will eventually choke the economy, reduce demand, and curtail inflation. Markets believe short rates are already high enough to get the job done. But then what? If the Fed releases its pressure as Federal outlays continue to soar, won’t inflation climb back? High rates were supposed to lead to a decline in home and auto prices. What they did was lower demand and supply simultaneously. The net was fewer transactions without any significant change in prices. When the Fed starts to let rates fall, will supply increases match the obvious future increase in demand? The battle may be won but the war isn’t over.
I don’t want to be an economic ogre. Federal spending is just one ingredient in the economic mix. But it is the one ingredient that is out of control. When you have two large forces pulling in opposite directions, unwanted consequences occur. Look at energy. The Biden administration wants to accelerate the move away from fossil fuels. In the short-run, that raises prices. It sells oil from the Strategic Petroleum Reserve to offset rising prices. That helps until it can’t release anymore. Now as that process ends, prices start to rise again. Now what? If left to natural forces, prices will rise further. But 2024 is an election year. Will higher prices be tolerated? Stay tuned.
What should be done is obvious. Deficits are fine to an extent. They aren’t fine at the pace they are building. There isn’t a whole lot Congress can do to raise revenues. There certainly isn’t going to be a tax increase in an election year and it is dubious how much money tax increases actually raise. A good stock market and large capital gains receipts are a greater source of income than higher tax rates. What can be controlled are outlays. Use any inflation estimate you want, an 11% increase in outlays is unsustainable. If the Fed target for inflation is 2%, anything above that is inflationary. The rating agencies and the bond market are sending messages. President Biden can’t understand why polls say he isn’t doing a great job on the economy. Yes, GDP is growing but are we collectively doing better in real terms? Only recently have wage gains caught up with inflation. Wages are rising as inflation is receding. That’s great. But is that a short or long term trend? 2024 is going to see slower growth, maybe even a recession. Government outlays for infrastructure and entitlements will keep rising. Debt service is likely to keep soaring. The question isn’t will there be a cost to this fiscal management, it’s when will it have to be paid.
It’s a sports day for birthdays. Deion Sanders turns 56. Rod Laver is 85. Former Boston Celtic great Bob Cousy turns 95.
James M. Meyer, CFA 610-260-2220