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Do the Markets Care about the $2.4 Trillion U.S. Deficit?

If the U.S. federal government properly accounted for its explicit and promised liabilities, it would record a national debt of $64 trillion and a national deficit of $2.4 trillion in 2006. Although capital markets seem to care about the officially reported budget deficit—a metric that is backward looking and quite misleading—the markets have done little more than yawn at the federal government’s mammoth, and growing, forward-looking budget imbalance. Are investors uninformed? They should remember that the common belief that capital markets cannot fail is precisely the reason why they can. The opinions and conclusions expressed in this article are solely those of the authors and do not necessarily represent the opinions of the Cato Institute or the Wharton School. Our calculations show that if the U.S. federal government properly accounted for its explicit and promised liabilities, it would record a national debt of $64 trillion and a national deficit of $2.4 trillion in 2006. The major culprits are Social Security and Medicare. Although the capital markets seem to care about the officially reported budget deficit—a metric that is backward looking and quite misleading—the markets have done little more than yawn at the federal government’s mammoth, and growing, forward-looking budget imbalance. Are investors uninformed? We discuss four hypotheses that might explain the market’s indifference to our looming financial crises: First, market participants believe that explicit government debt is “real” whereas unfunded liabilities are not (a belief that is not tolerated if a corporation expresses it). Second, Stein’s Law says, “That which cannot go on forever won’t.” Policy makers and market participants interpret the law to mean someone in the future will somehow figure out how to pay the piper. Third, the future is too uncertain to be predictable, so market participants are taking a wait-and-see attitude just when they should be worried. Finally, the market believes foreigner investors will bail us out—despite the fact that those investors have their own, similar problems. The common belief that capital markets cannot fail is precisely the reason why they can—and why an Argentina-type disaster can happen in the United States. The financial shortfalls that the federal government faces are unprecedented, as investors will eventually figure out. Hopefully, policymakers will have the wits and political will to address these shortfalls soon and avoid a situation in which investors suddenly realize the shortfalls’ implications and attempt to exit the fixed-income market all at once.