Topics: Why financial markets are paying close attention to how Congress addresses the long-term budget outlook
April 27, 2012
GDP growth averaged 4.3% for the entire decade [see table in Appendix], which resulted in debt ratios declining from 80% to46%. However, the unique economic conditions and productivity gains of the 1950’s (e.g., interstate highway, rebuilding of Europe and Japan) may not be repeated. While we are hopeful that the US economy recovers more quickly, if it doesn’t, debtratios might not decline below the mid 80’s, risking another round of rating agency downgrades.
Other areas of potential budget slippage: projections of military spending declines are not the same as structural deficitreduction.
One item in the President’s budget proposal was an assumed $800 billion in savings from troop withdrawals out of Iraq and Afghanistan (so-called “OCO” spending). While progress has been made on this front, uncontrollable geopoliticalevents could require OCO spending to rise again. In addition, as shown above, the Budget Control Act
projects thatnon-OCO military spending as a % of GDP will fall to its lowest level since 1940, barely above the levels now spent by Japanand Germany after decades of demilitarization. As a result, financial markets may not ascribe a high likelihood to deficitreduction achieved through lower estimates of future military spending.
It’s not just rating agencies that are unnerved by polarization of political parties
. Markets are aware of the polarizationin Congress, a trend that can be understood by empirical analysis of Congressional voting patterns. As shown below, thepolarization in the House and the Senate is as high as it has ever been, even higher than after Reconstruction, one of the mostacrimonious periods in the country’s history. A closer look at the Senate in particular (below, right) shows that the number of party non-conformists has plummeted. Without a political middle, there is a greater risk that the ideological divide between theparties cannot be bridged, leading to intermittent government shutdowns (or the threat of them
) and market disruptions.
 Entitlements: where we are now.
Market participants are increasingly focused on entitlements relative to discretionaryspending. First, some history. When Medicare was introduced in 1960’s, it was described as “brazen socialism” in the Senate.When Truman proposed a national healthcare program in the 1940’s, the plan was called a Communist plot by a Housesubcommittee. And when President Roosevelt introduced Social Security in the 1930’s, he was branded as a Communistsympathizer by Republican Senators from Ohio, Pennsylvania and Minnesota, publisher William Randolph Hearst and Alf
Financial markets are aware that last year’s compromise avoiding a shutdown was mostly a reflection of FEMA discovering that itunderestimated the amount of funds that it had on hand. There wasn’t a compromise, since Congress didn’t need to make one.
1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%20122013201420152016201720182019202020212022Source: Congressional Budget Office.
CBO's real GDP growth assumptions
Since June 2009
2%4%6%8%10%12%14%19481955196219691976198319901997200420112018Source: CBO, OMB, J.P. Morgan Private Bank.
US military spending since 1940
Percent of GDP
D i s t a n c e b e t w e e n t h e P a r t i e s
Source: Keith T. Poole, University of California -San Diego, January 2011.
Congressional polarization at an all time high
Degree of partisanship as measured through analysis of allCongressional roll calls, 1879-2010
The Creation of an Endangered Species: Party Nonconformists of the U.S. Senate,
Richard Fleisher and Jon R. Bond, 2005.
Number of party non-conformists in the Senate 1953-2004
Congressional session number