US Federal budget deficits have always tended to be cyclical, spiking during recessions and diminishing when the economy is running strongly again.Given that the vast majority of Federal receipts come from individual and corporate income taxes/withholding that makes sense. The data back to 1970s shows the magnitude of deficits through a cycle:
- In 1974, the US budget deficit was 0.4% of GDP. The subsequent oil shock-induced recession took this to 4.0% of GDP by 1976. Then, by 1979 better tax receipts from better economic growth cut that to just 1.6%.
- The next recessionary period (1980 – 1983) saw the Federal deficit rise to 5.7% of GDP, a level not seen since the end of World War II. However, by 1989 this was more than cut in half to 2.7%.
- Another oil shock in 1990 (Iraq invading Kuwait), and the deficit widened once again to 4.5%. But then something really unique happened: the Federal government printed budget surpluses from 1998 to 2001, averaging 1.4% of GDP.
- Those surpluses would not last, however, and by 2003-2004 the Federal budget deficit was back to 3.3% of GDP. Still, a few good economic years cut to just 1.1% by 2007.
That’s the way things used to be. The average annual deficit from 1970 to 2007 was 2.3% of GDP. Shortfalls were bigger at the trough of a cycle than at the top. And if things went really well (like in the late 1990s), a surplus was possible.
Here’s how they are now (or at least very recently):
- The Great Recession took the Federal deficit to 9.8% of GDP. There are only 4 other years back to 1930 with larger readings: 1942 to 1945.
- The average deficit/GDP since 2010 is 4.8%, more than double the 1970 – 2007 average of 2.3%.
- The closest year to the pre-Crisis average was 2015, with a 2.4% deficit/GDP ratio.
- Since 2015, the deficit/GDP ratio has gotten worse and stood at 3.8% in 2018.
Now, one might think that since the US 10-year Treasury yields just 2.08% today none of this really matters. The US is not alone in deficit spending, after all, and at least its size, geopolitical importance, and 100% dollar-denominated debt buffer it from the sort of debt crises that have befallen other countries.
But we can’t help but think the dramatic shift between pre- and post-Financial Crisis in terms of deficit/GDP has long-term ramifications. For example:
- Assuming that the deficit/GDP ratio rises by 3 points in the next recession (typical of past downturns), the US budget shortfall will increase by $600 billion ($20 billion in GDP times 3%). And that’s on top of the $1 trillion/year deficit the US currently carries.
- This will put some real pressure on the Federal Reserve to buy Treasuries in order to offset government issuance and keep long-term rates as low as possible.
- Depending on the depth of the next recession and its timing, the Federal government may need to spend even more than the typical 3% drawdown. This may be necessary, for example, if companies choose the next recession to adopt new labor cost-saving technologies at scale.
- Taken to its extreme, the recent experience of high deficits and low interest rates fosters the notion that the US government can basically borrow whatever amount it wants for whatever purpose it desires. That works until it doesn’t.
Summing up: deficit analysis tends to get lumped in with other economic ghost stories because slow global growth and tame inflation have limited its ability to inform the direction of interest rates. Fair enough, that: only theories that predict future price action merit attention.
But we’ll close this section with a story about Pete Peterson, the co-founder of Blackstone among many other accomplishments, and a well-known deficit hawk late in his life. I attended a talk he gave about a decade ago where someone asked him “Are you changing your personal investments to incorporate your fears about unsustainable government spending?”
His answer was surprising given the passion he had for the topic: “For many years I did not. But I am starting to now, yes…” We feel the same way now.