By Ned Montag, CEO
In his 1996 State of the Union Address, President Bill Clinton declared that “the era of big government is over.” This drew loud applause. Clinton reached this policy shift after the Democrats suffered a massive mid-term election loss in 1994, giving control of both houses of Congress to fiscally conservative Republicans. President Clinton made good on his words in his second term, maintaining spending that was more in line with tax receipts. The result? Federal spending as a percentage of economic activity (GDP) fell during all four years of his second term, and the federal government sustained budget surpluses from 1998 through 2000, the first surpluses in almost 30 years. The economy was humming.
Unfortunately, the budget discipline did not last. Under the weight of the Technology Bubble collapse in 2000, 9/11-related wars in Iraq and Afghanistan, a near collapse of the global financial system in 2008, and a worldwide pandemic that began in 2020, governments worldwide eagerly increased spending, without bothering to raise taxes to pay for it. Consequently, the federal government has run deficits every year in the new millennium, and federal debt has ballooned from $5.7 trillion when Clinton left office to a staggering $33 trillion at the end of 2023, an increase of 480%! The last two presidencies have been particularly undisciplined fiscally, although both Trump and Biden can legitimately blame outlays in response to COVID for much of the massive deficits incurred in recent years.
Generally speaking, governments can usually accumulate debt without serious consequences if the rate of debt accumulation is equal to or less than the sustainable rate of growth in the economy, and therefore the sustainable rate of growth of tax receipts. However, this equilibrium has not been met over the past 23 years. Since 2000, federal spending has grown at an average annual rate of 5.5%, but tax receipts have not kept up, growing only 3.5% per annum. With interest rates on Treasury debt historically low for much of this period, there was little consequence for the lack of budget balance. However, since 2022, interest rates have been rising, and the cost of interest on the federal debt has risen from $535 billion in 2022 to $711 billion in 2023. It is projected to hit $870 billion this year. Political leaders are beginning to recognize that the interest cost of federal debt is becoming a real hindrance to funding other spending priorities. The debt bill appears to be coming due at last.
But the reckless level of deficit spending does not appear to worry the stock market, which continues to hit new highs. To understand why, we turn to a rather ingenious formula first conceived by economist Jerome Levy in 1909 and then refined by economist Michal Kalecki three decades later. The Kalecki Profit Equation was developed to show how the business sector’s total profits are affected by the changing behaviors of businesses, governments, households and offshore trade. Without getting deep into the weeds, according to the Kalecki equation, government budget deficits, along with business investment and dividends paid to shareholders all act to increase business profits. Conversely, profits are reduced by behaviors such as saving money, and the purchase of foreign-sourced goods and services. It is through changes in these factors that aggregate business profits grow or shrink from year to year. While the logic of this equation is not intuitive to most observers, it is quite valid and an excellent way to monitor the broad trends that affect profitability.
According to the U.S. Bureau of Economic Analysis, since the year 2000, total U.S. corporate profits after tax have grown at an average annual rate of 8.4%. This number is interesting since it is close to the growth rate of federal debt of over the past 23 years, 7.9%.
It is also interesting that the Bureau of Economic Analysis estimates last year’s aggregate profits at $3.1 trillion. In comparison, the budget deficit last year was a whopping $1.7 trillion, equal to 55% of total business profits.
Remember that as recently as the last Clinton term, federal government budget management created a net drag on corporate profits! We are absolutely NOT saying that the federal budget deficit increased business profits by $1.7 trillion last year, since some of that deficit spending undoubtedly went into “profit reducing behaviors” like saving or spending on foreign goods and services (Asian cars, trips to Europe, etc.). But we are quite confident that deficit spending has been inflating business profits, and probably stock prices, very significantly over the past several years.
We are now near the start of a new White House administration that has the opportunity to either restore more conservative budget practices or merely decide to let our outsized deficits ride. Greater fiscal conservation in our government would help manage our debt service issues but likely hurt business profits in the process. Deciding to “party on” will keep the economy humming for now, but greatly increase the likelihood of a fiscal crisis down the road. A wise and responsible leader will help us face these important matters and so let us seek the emergence of thoughtful leadership on this and many other topics. As I conclude, I am reminded of my father, who, when faced with such matters often would say: “Well, either you can deal with it, or it will deal with you.”
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The information provided is for illustration purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action to be taken. These analyses have been produced using data provided by third parties and/or public sources. While the information is believed to be reliable, its accuracy cannot be guaranteed. MONTAG employees do not provide legal or tax advice. For specific legal or tax matters, you should consult with your own legal and/or tax advisors. There are risks associated with investing in securities. Investing in stocks, bonds, exchange traded funds, mutual funds, and money market funds involve risk of loss. Loss of principal is possible.
