The Hardest Thing to Do in the Capital Markets...

Jared Dillian |

You ever notice that none of the presidential candidates—of either party—are campaigning on a platform of deficit reduction?

Don’t you think that’s weird?

I remember when deficit reduction was a big priority. Back in 1991. Everyone freaked out over Reagan’s deficit spending, building up defense, but deficit-to-GDP only got up to about 6%. I remember my teachers showing us these current events slideshows in 4th grade. The deficit, at the time, was about $150 billion.

$150 billion sounds like a huge number when you are a kid. But it was only about 6% of GDP, which is above-trend but still manageable.

George Bush Sr. famously broke his pledge not to raise taxes (under the auspices of deficit reduction). He took the top rate from 28% to 31%.

But 1991 was the crucial year. Bill Clinton tapped into voter anger on debt and deficits and won the election handily, and then took the top rate from 31% to 39.6%. Everyone was pretty much cool with it. It was going toward deficit reduction.

He also froze discretionary spending. I worked in the Clinton government. You had to save your paper clips. The constant mantra coming out of the White House was “do more with less.” Career government employees were pissed. No more boondoggles and expensive toys.

You know what happened: Not only did we balance the budget, we ended up with a surplus, that we all fought about—and squandered.

It has been all downhill ever since.


So for perspective, after the financial crisis, the deficit got to about 12% of GDP, in other words, ridiculous levels. Oh sure, you had to pay for TARP, the stimulus, countercyclical fiscal spending, emergency stuff, but as is usually the case, a lot of that “emergency” spending becomes institutionalized.

The budget deficit is much smaller today, about 3% of GDP (but projected to rise), but we mostly got there through enhanced revenue collection. The government has gotten very good at collecting taxes (as you already know).

But if you look at the forecasts from the Congressional Budget Office (CBO), the budget deficit is projected to rise, and rise, and rise… until, about 10 years from now, it is back out to crisis levels. This happens because interest rates are projected to rise (at least by the CBO) and “mandatory” spending (code for entitlements) is projected to increase. This is the Social Security bomb that everyone likes to talk about. Plus Obamacare, which isn’t exactly free.

This is all before any programs that any future president might dream up, including Bernie Sanders’ Medicare for all (and free college).

Once again, I go back to what I said before:

Not one candidate (Democrat or Republican) is campaigning on a platform of deficit reduction.


So right now, the debt-to-GDP ratio is about 102%. Above 100% is generally considered to be the danger zone. The US can easily manage it without interest rates rising, because we are in possession of the reserve currency.

For now.

One of the things I teach in my class is how a bond auction works because that is pretty powerful knowledge. I am not sure Jack Lew knows how it works. For sure, Bernie Sanders does not know how it works. If you have ever traded a bond auction, for sure you understand how supply and demand for government debt influences interest rates. It is super easy: more bonds issued, more supply, lower prices, higher interest rates.

But bond markets do not always behave that way.

When the Treasury was issuing well over a trillion dollars of debt in the financial crisis, I predicted incorrectly that interest rates would rise. They did not. The demand for bonds was so great that these massive auctions that happened every week were many times oversubscribed. Interest rates stayed low, and went lower.

People buy US government bonds for safety. This is not the case with other countries. Greek interest rates did not go down during their crisis; they went up.

I think the hardest thing to do in the capital markets, hands down, is to forecast the direction of interest rates. The bond market makes fools of people—all the time.

So it would be easy for me to sit here and say that government spending will crowd out private spending and that interest rates will go up, because who knows? The bond vigilantes are nowhere to be found. But with China selling, not buying bonds, and who knows what in our future (free college, etc.), it’s hard not to make the argument that over any length of time, interest rates will rise, not fall.

The Endgame

There is a conclusion to this that I won’t spell out for you. Or I could just refer you to Alan Greenspan’s “Gold and Economic Freedom” essay from 1966, the truest thing I have ever read in finance.

We will probably see it play out in Japan before it plays out here. At some point in Japan (where debt-to-GDP is 220%), supply and demand of Japanese government bonds (JGBs) will matter, and interest rates will rise. They won’t have to rise much for it to be checkmate for Japan. Of course, through quantitative easing, the BOJ has pretty much bought the entire bond market, so there really isn’t a bond market.

But at some point it will matter. That day will come.

From 2009 to 2011 (and beyond), I was one of those wild-eyed gold bugs most people make fun of today. The laws of economics are not like the laws of physics. You can break them from time to time. You can break them for years. But not forever. Eventually, they will snap back into place.

By the way, I will be at the Strategic Investment Conference this May in Dallas if you want to catch my live act. I have been working on my stand-up.

Actually, I am really boring in person. But it would be nice to meet you anyway. More info here.

Jared Dillian
Jared Dillian

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