Impact of Government Actions on Financial Markets

Victor Levinson Comments

With financial markets showing modest changes in May, even with Inflation fears and improving economic activity continuing to dominate the financial media (see also our April 2021 Comments), we add the impact of government actions to our discussion.

While the market-based private sector dominates U.S. economic activity, there are times when government action plays a crucial role. When the Coronavirus began its spread in the U.S. more than one year ago, and many parts of the economy slowed dramatically or came to a halt, the government began the first of two major economic stimulus programs to help people pay their bills and keep businesses running. While the first program passed easily in the Congress, the second was met with much more resistance, and required a special Congressional procedure for the Biden administration to have it approved. Currently, the administration is trying to gain passage of an additional economic stimulus package aimed at infrastructure upgrades and is again meeting a great deal of resistance. Putting the politics aside, the economic argument against continuing to pass all these spending programs is that the government already has a very large debt (approximately $22 trillion; source: “Peter Peterson Foundation”), and finding the money to pay for these additional programs is likely to require some mixture of adding to the deficit, printing more money to nominally pay down the deficit (that is, adding to inflation), increasing existing taxes, and/or relying on higher future tax revenue from the anticipated increased economic activity .

A governmental budget deficit is measured annually and is not necessarily harmful. When interest rates are very low, as they have been for a number of years now, the government can borrow at low cost to engage in its economic expansion activities. But borrowing without a clear plan for repayment brings up the undesirable prospect of increasing inflation (discussed in our April Comments). This can occur when the government essentially prints new money by buying its own bonds and bonds of other issuers. When the government buys its own bonds, it increases demand for those bonds, which in turn tends to increase bond prices and reduces yields for the buyers of those bonds.

The need to raise taxes to reduce budget deficits is very often quite politically contentious. (For a highly informative and readable book on the subject of taxes, see “Rebellion, Rascals, and Revenue,” by Michael Keen and Joel Slemrod). Taxes are the way governments fund their activities, from providing for the nation’s defense and protection, educating its population, providing a safety net for its less well off, providing health care, maintaining an acceptable infrastructure, and many other functions.  While reasonable people may dispute what to spend on and how much, the basic fact is that taxation takes money from those who earn it and gives it to the government to debate about and ultimately spend. Taxpayers can be individuals or corporations, and each participant in the economy is required to participate. When taxes fall short of spending, that is when the borrowing discussed above comes into play, with the potential for more deficits and inflation.

All of these cross currents are in play every day, and very much a part of current financial media reporting. See NY Times articles headlined “Inflation is Coming, How Much, for How Long” (Jeff Sommer 6/4/21, page B8); “Roaring 20s? The Budget Forecast Has Its Doubts” (Neil Irwin 5/29/21 front page); and “The Economy is Sending Mixed Signals, Confusing Almost Everyone” (Ben Casselman 6/4/21, page B4).

For those in favor of an expansionary government with significant impact on the economy, particularly in troubled times, those advocates should also understand the potential downsides of more government deficits, more undesirable inflation, and additional taxation.  For those who favor more financial restraint from the government, they should be prepared to live in a society that might not see government perform its essential functions, which has many implications beyond the scope of these Comments.

As for the responses from the financial markets, as usual, only the future will tell. Our longstanding advice continues: maintain the asset allocation designed for your long-term goals, and try to ignore the ongoing commentary designed to get you to make portfolio changes in an effort to time the market’s unpredictable moves.