The fiscal deficit has received a lot of attention lately, as it usually does whenever a large spending bill is working its way through Congress. This has been true when either party has introduced a piece of budget-related legislation in the past. Spending/tax bills inherently result in one of two outcomes: a surplus or a deficit, which then adds to or subtracts from the existing surplus or deficit, a deficit being what the U.S. has had since 2001.
Debt is not inherently bad. In fact, debt in the service of innovation and growth can be a good thing. Many companies have grown and flourished after initially being financed by debt.
Neither is a specific amount of debt bad. When it comes to the markets, however, what matters instead is sentiment, a fancy word for human feelings. And maybe the question, "Who is afraid of the big, bad debt?" is better phrased as, "How many of us are afraid of the big, bad debt?" because trouble comes when collective fear becomes momentum.
The 1946 Christmas movie classic It's a Wonderful Life is a timeless example of why this mentality matters. It shouldn't surprise you, but I was not alive in 1946. Nevertheless, I've seen the film—both because I heard it had a meaningful message and because it kept coming up in my business classes.
The film is a lovely commentary on what it looks like to live a wonderful life – how community is essential to our thriving and how our local contributions matter. A scene in the movie also illustrates what can happen when a collective community ceases to trust an institution—a bank run.
In the film, after hearing rumors that the bank may no longer be solvent, community members begin to panic that their money is no longer safe and rush to withdraw their funds. This, of course, fuels more panic until everyone is asking to pull their money from the bank, and the ecosystem of lending breaks down (until, of course, George Bailey steps in with an impassioned speech and saves the Building & Loan. All the feels.)
The risk of expanding the U.S. deficit is that it reaches a tipping point where enough people panic that the system won't hold and start withdrawing their funds. This panic begets momentum, which can lead to a cascading effect.
What is difficult about this situation is that there is no hard and fast rule, no specific number that the deficit could hit where investors say, "That's too much." There's just sentiment, and right now, the sentiment is not panicked, but it might be appropriate to call it anxious.
A quick history lesson also helps illuminate the situation.
A few years before It's a Wonderful Life was released, a group of leaders gathered in Bretton Woods, New Hampshire, to establish rules for a new monetary system. The system aimed to promote stability and economic growth by requiring other participants to peg their currencies to the U.S. dollar, which promised stability by being backed by gold.
As a result, the U.S. dollar became the global reserve currency. As you probably know, the gold standard was abandoned in the 1970s (right before another classic movie, The Godfather, came out – if we're tracking by cultural references). But by then, the dollar had gained significant status as a safe-haven asset because so many countries kept it in reserve, meaning there was and remains considerable demand for the U.S. dollar.
The problem with an increasing deficit is that there hypothetically comes a point where investors and the rest of the world cease to believe that the U.S. can be trusted to pay its debts.
The debt is, of course, serviced by interest, and that interest rate can keep rising – both as a result of external factors and investors becoming more fearful about getting their money back and demanding a higher return.
In recent weeks, the 30-year treasury rate – which reflects what investors require to lend to the U.S. for 30 years – crossed 5%.
Suppose the rates continue to rise, even without an increasing deficit. In that case, it makes servicing the deficit that much more expensive, and as that debt looks riskier, it becomes more likely that the demand for it decreases, resulting in even higher rates being demanded and creating a potential situation where the cost of servicing that debt becomes untenable.
The U.S. has never defaulted before, and the current deficit situation doesn't necessarily mean it will.
Japan currently has a debt-to-GDP ratio of 266% (more than double the U.S.'s projected 122%) that they are still managing to service. However, they have successfully done so by holding down interest rates and are now facing increasing unrest as their policymakers consider some of these same dilemmas.
Still, current deficit conditions, along with higher interest rates, are begging a lot of speculation, which is influencing markets. There's been a lot of talk about whether or not treasuries should still be considered a safe haven asset, and the CFA recently released a research paper suggesting that the U.S. dollar could cease to be the global reserve currency in the next 5–15 years, which would have significant investing implications.
But it's important to remember that this is all conjecture. Sentiment looks for hints as to which direction things could go, and it's looking now.
I write all of this not to incite panic but always to inform. I think it's helpful to know why some of the headlines are what they are, even if the rest of the news itself is less clear.
This isn't a call for a broad investment change but, as always, just another chance for us to be introspective and thoughtful about how we're positioned and our expectations for our plans going forward.
As for our role in stewarding your assets, Matt and I continue to closely monitor the news and the sentiment coming out of the news.
The deficit matters because it has implications for both interest rates on government-issued debt and the economy as a whole. We want to pay attention to it, but it is also just one more thread in a tapestry of variables that influence financial markets.
We're also paying attention to the implications of the rest of the bill regarding our financial plans, particularly from a tax perspective, as well as how other policies are and could influence our investment outcomes.
We remain convicted of a diversified foundation and the meaningful integration of planning and investing to create a stable path forward.
As always, if you have any questions or want to dive in further, please don't hesitate to give us a call.
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