As of last Thursday, the United States Government reached the limit of its authority to borrow. While some evasive actions are being initiated by the Treasury Department to keep the government open and pay its obligations, these steps are expected to be exhausted sometime this summer and no later than Labor Day.
The United States is the only developed country in the world that puts a limit on its government’s ability to borrow. Other countries rely on the market for debt to dictate what their government can do. The United States Constitution (14th Amendment, Section 4) states the “The public debt of the United States, authorized by law…shall not be questioned”. Thus, Congress must dictate the amount of debt the country can assume. While less than the amount shouldered by other countries relative to the country’s Gross Domestic Product (GDP), the federal debt has been rising. The debt limit was raised three times during the Trump administration to accommodate the tax cuts implemented as well as the expense of taking on covid in a recession. There was no serious discussion as to need or whether to do so. Now that it needs to be raised for the first time in the Biden administration, Republicans who control the House of Representatives have gotten fiscal religion and have decided not to raise the debt limit without expenditure cuts in return.
The problem is that more than half of the Federal Budget consists of Social Security and Medicare payments. Another third or so is military expenditures. Thus, the ability to cut the budget is not there, unless payments to the elderly are reduced.
There is a second way to balance the budget. It would involve raising taxes on the wealthy and corporations. This in fact will automatically happen if the 2017 Trump tax cuts are not made permanent. When they were passed it was argued that the cuts would spur economic growth and the incremental tax income would pay for the cuts. They have been given ten years to bring this about. As this has not “happened”, it is expected that the cuts will sunset over the next four years. This will amount to an automatic tax increase of about $1 trillion per year if all reductions are allowed to expire.
A second way to reduce the deficit would be to fund Internal Revenue Service enforcement of tax laws. Based on the law passed last year, there will be an increase of $40 billion per year in tax receipts based on a formula that every incremental dollar of tax enforcement yields five dollars in revenue. The budget increase is for $8 billion per year over ten years. This differs from the $80 billion increase touted in the media.
Republicans are against this, vowing to repeal the measure that may impact their largest donors. Our tax system is based on voluntary compliance backed by the ability to enforce the tax laws as necessary. If this system is not financially supported, then you have a situation like that of Greece or Brazil, where fewer and fewer people pay more taxes because evasion becomes a sport. Unless compliance is adequately funded, those who can afford to retain tax professionals delay or deny their payment, while those who cannot afford to challenge the government wind up paying their full tax liability. The IRS budget has been reduced systematically for years. This is not an expansion of enforcement so much as a restoration of the same.
The consequence of not funding the government will be dire. If the United States were to not honor its debts, the willingness to hold US Treasury securities will be called into question. As this country does not generate enough savings to fund all the debt required, the loss of foreign bond demand would be severe. It would also be the end of the dollar as the world’s reserve currency. Counties like China and Russia would very much like that. Finally, a default of debt payments would lead to higher interest rates for government paper. This would blow a hole in the budget. The reason interest expense has been stable as more debt was being issued for the past decade is due to the decline in the coupon rate on the debt. Reversing this due to our own conduct would be distressing.
The House of Representatives is known for political theater. It cannot be ascertained how serious the members of the House are in steering the government onto the fiscal rocks just to prove they can do it. The last time this happened in 2011, the United States Government lost its AAA bond rating. (It is now AA+). This time around we stand to lose a lot more.
The Economy
Economic activity, while slowing, has not contracted overall. There had been weakness in the indexes that track goods. Services and housing cost continue to be strong. There is now estimated to be a shortage of commercial airplanes for the next several years due to lost production from Covid. This translates into pricing power for the airlines, which means higher ticket prices.
The talk of layoffs is almost entirely in the technology sector. Such jobs are very well paying but also often locally concentrated. One does not hear of layoffs of plumbers or electricians.
Interest Rates
Forecasts abound of how interest rates will peak and then go down later this year. While this is the consensus, that does not make it right. The game of shutting down the government if a group of congressmen do not get their way has no upside from the standpoint of interest rates. A falling dollar would convince foreign investors that a higher interest rate will be needed to offset the potential for a lower return of principal in the foreign currency. The bottom line is for interest rates to go higher and stay high longer than the market is predicting.
Inflation
Inflation is expected to get a second wind from the falling dollar, which will make imported goods more expensive. More expensive imports give cover to domestic producers to hike prices.Since more people work in services than in the production of goods, higher wages will translate into inflation on this front as well. Rents are stabilizing, but from a high level.
The Stock Market
Stocks are going to be volatile. Some companies are going to see their margins squeezed by higher wages on one hand, and softening demand on the other. In truth, margins pre-covid had never been wider for most firms. With increases in labor and interest expenses increasing faster in some cases than revenues, there is not a lot of companies can do to offset. In general, the larger the labor force a company has relative to revenues the more potential for earnings disruption. With revenues moderating, there are not a lot of places for profits to go to escape being eaten up by expenses.
Warren M. Barnett, CFA
January 23, 2023
Statements made within the Perspective are those of the author and should not be considered as individual investment advice. For personal investment advice, please contact the firm at 423-756-0125 or [email protected] to set up a meeting with one of our investment advisors.
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