Budgets & Tax Cuts & Deficits. Oh my!

I smell a fight.

February 22, 2025

As we approach another ‘make or break” moment in the ongoing federal budget showdown, I can’t help but wonder if this time the process might bring about the inevitable reckoning with the chaos that is Washington today. If markets hate uncertainty (and they usually do) and negative surprises (which they almost always do) this summer could be a doozy.

Markets are famously volatile, but they can usually be expected to range within some high and low historical ranges. Pricing within those boundaries is influenced by expectations for the various metrics that influence the world’s economies. What are expectations for interest rates and for corporate earnings and inflation over the next few years? What will be the dollar’s valuation compared to our trading partners? Will consumer spending, the largest US GDP driver, be robust—or will it be decelerating, or contracting? All these assumptions are comparative. How will these metrics compare to their historical norms, and to similar metrics in other markets and in other countries. Importantly, all alternative investment returns are compared to a “risk free” rate – what returns are available to investors taking zero risk when invested in alternatives like short term US Treasuries. To utilize that metric, a predicted interest rate environment is necessary. Everything else is comparative to that guaranteed, risk free, rate of return. When that assumed guarantee is no longer sacrosanct, the entire superstructure of the global capital markets breaks down.

We have actually seen this movie before, during the Financial Crisis of 2008. During that fiasco all assumptions about credit risk and what was truly “guaranteed” were called into question. We went to work at Wachovia every day and wondered if Goldman Sachs and Lehman Brothers and Merrill Lynch and Bear Stearns would be there the next day. (Goldman and Merrill, yes. Lehman and Bear Stearns, no, and you have not heard the name Wachovia in quite a while.) The crisis was exacerbated because many of the “assurances” in the system were implied. Agencies like Freddie Mac and Fannie Mae were not “direct obligations” of the Federal government, but as federal agencies there was an implicit backstop by the Treasury. Some larger companies, like AIG or Citibank, were considered “too big to fail” and that something—a bailout or a backstop or an arranged marriage with a stronger company—would resolve the crisis. At the center of the matrix was a sacrosanct guarantee that the US Government would honor its obligations on a timely basis.

Keeping the markets functioning during that crisis required previously unheard-of injections of capital into the financial system by the US Government, along with promising to backstop instruments that everyone had assumed were as safe as treasuries – things like money market funds and mortgage paper issued by Fannie Mae. To read a synopsis of what happened over the timeline of that crisis is misleading at best, for it minimizes the extraordinary day to day anxiety and the constant deliberations and experimentation with financial solutions that had never been tried before. Former Goldman Sachs CEO and then Treasury Secretary Hank Paulson led the negotiations. Every move by the Fed or the Treasury was analyzed and criticized and deliberated, if necessary, in Congress, as these massive federal infusions of liquidity, amounting to hundreds of billions of dollars, needed Congress to approve the appropriations. Approval did not come easily, as many Congressional members, especially “Deficit Scold” Republicans, were loath to saddle the federal government with hundreds of billions of dollars in new debt. Only when the stock market reacted with trillions (trillions - with a “T”) of dollars in losses brought about by Congressional votes to reject the requested Treasury rescue funding did the recalcitrant members change their votes to approve the bailouts.

Which brings me to the point of the story.

The Financial Crisis of 2008 highlighted the importance of the US capital markets in general, and the sacrosanct guarantee of the US Treasury debt in particular, as the foundation girding the world’s financial systems. The sacrosanct nature of those guarantees underpins everything else. Time seems to have fogged the rear-view mirror, and there are cracks beginning to show in the system. US Treasury debt has already been downgraded by both S&P (in 2011) and Fitch Ratings Services (in 2023), from AAA to AA+. Neither rating service is saying that the US Government cannot afford to pay their bills on time. What they are both saying is that they can no longer assume (as in trust) that we always will, given the dysfunctional nature of our Congress. In Fitch’s words: “…important decisions are likely to be reached on an ad hoc, issue-by-issue basis, underscoring the U.S.’s deterioration in governance on fiscal matters over recent years.”

There are currently eleven countries that enjoy a higher credit rating than the United States. Singapore, Switzerland and Canada all have higher credit ratings than we do. The US dollar remains the world’s reserve currency not because it is the most credit worthy, but because it is the most liquid. There aren’t enough Swiss francs around to fund the global financial system. I suspect that there is also a residual of Winston Churchill sentiment that “Americans can always be trusted to do the right thing – after all other possibilities have been exhausted.”

Republican congressional leadership is now operating as if Trump is in total control, and that he can bend the economy and the markets to his will. Good luck with that. This summer, Congress – and the White House – will need to agree on a spending package and debt limit ceiling to accommodate the budget deal, and also respond to the expiration of the 2017 tax cuts that will expire at the same time. Fitch Rating Service is now projecting that by year end 2025 our outstanding debt will be at 120% of GDP, more than twice the debt level of the average AAA country (48.99%) or AA rated country (50.69%)

In day’s of yore, during the glory days of the Tea Party, Republicans would have gladly shut down the government rather than approve deficits of this magnitude. Ten years ago, in 2015, House Speaker and Deficit Scold in Chief, Paul Ryan warned of an impending collapse of US Treasury financing because our debt level was at an unsustainable 99% of GDP. That number had almost doubled in the prior fifteen years, from 54% in 2000. We are now approaching 120%, and interest rates are considerable higher than they were five years ago, exacerbating the cost of financing all of that new debt. Adding to the reality of the math, we must now add the lack of trust by the credit rating agencies and the global investment community in the US Treasury’s “guarantee”. What makes this monument particularly problematic is the current work in progress to roll over the 2017 Tax Cuts and Jobs Act which expires this year, and add President Trump’s promised additional tax cut to the mix.

President Trump lives on leverage and would gladly finance more tax cuts with borrowed money. At what point does the market, and traditional Congressional Republicans push back? I smell a fight. There is now and probably always will be a debate about the breakpoint at which the level of debt becomes a bridge too far and investors start to question the sacrosanct nature of a US Treasury “guarantee”. Democrats now find themselves in the odd position of aligning with deficit hawks and having to vote against the proposed budget busting legislation, or siding with the President who, no doubt, will again be spouting the supply side fantasy of tax cuts financing themselves though increased economic activity. (Not - but a subject for another day.)

We will start to read stories about these upcoming negotiations next month, as Congress reaches their first funding deadline in mid-March. Then the real fun begins. We should be approaching our national debt ceiling in the second half of this year, and enabling legislation will be necessary to raise it. Then add new tax legislation to the headlines. As these deliberations wind their way through the gauntlet of Congressional negotiations and approval (or not), and the markets react to the inevitable dysfunction and those headlines, I think that we can assume that the average citizen will let their Congressional representatives know exactly how they feel about it. I mentioned earlier that consumer spending is the primary driver of economic growth, representing almost 70% of GDP. That consumer spending is driven by consumer confidence. (Can I afford to buy this car? Can I afford to go on this vacation?) That consumer confidence is driven by that consumer’s most recent 401k statement. (An oversimplification perhaps, but generally true.) When markets start to react to the latest negative headlines from Washington, all bets are off, all party loyalties go out the window, and all efforts will focus on staunching the flow of red ink.

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