How Do Fiscal Deficits Affect Financial Markets?

Fiscal deficits are a significant factor influencing financial markets, as they determine the level of government borrowing and the potential impact on various asset classes.

This article will explore the effects of fiscal deficits on the bond market, stock market, real exchange rate, economic growth, and the various ways to finance a budget deficit.

Key Takeaways – How Do Fiscal Deficits Affect Financial Markets?

• Fiscal deficits significantly impact financial markets, influencing government borrowing and potentially affecting various asset classes.
• Higher government borrowing can lead to increased interest rates, potentially impacting the bond market and reducing corporate profits, which can negatively affect stock prices.
• The impact of a budget deficit on economic growth depends on how the borrowed funds are spent, and there are several ways to finance a budget deficit, including raising taxes, issuing debt, and printing money.

Fiscal Deficit Impact on the Bond Market

The US has a structural fiscal deficit of around 5-6% of GDP.

During quantitative tightening (QT) periods like 2022-24, the Federal Reserve sells around 2-4% of GDP worth of its bond portfolio.

This means that the market must absorb 8-10% of GDP in bonds summing those two totals together.

The primary buyers of these bonds are pensions, life insurers, foreign central banks, commercial banks, and other investors.

Such a high level of bond purchases is rare. Rare examples over the past century have been scenarios like 2005-06 when emerging-market countries like China were significantly adding US dollar debt to their reserves during boom periods.

Based on the organic savings generated by the economy, bond purchases may only reach half of that figure.

Without enough buying, this means higher interest rates, which means less credit, which means less spending, and lower economic growth.

Nevertheless, the bond market will always clear one way or another.

The mechanism by which bonds are sold off and other assets are liquidated to buy bonds at higher rates will depend on various factors.

Fiscal Deficit Impact on the Stock Market

The fiscal deficit can also impact the stock market, as higher government borrowing may lead to increased interest rates.

This, in turn, can raise borrowing costs for businesses and reduce corporate profits, leading to less spending, and potentially causing stock prices to decline.

Additionally, if the government’s increased borrowing leads to inflation, it could erode the real value of equity returns.

During periods of higher inflation, it’s especially important to look at things in real terms and not just nominal terms.

Fiscal Deficit Impact on the Real Exchange Rate

A fiscal deficit can also affect the real exchange rate. If the deficit leads to higher inflation, it can reduce the value of a country’s currency relative to others.

This can lead to a depreciation of the currency, which can have both positive and negative effects on the economy.

On the one hand, a weaker currency may improve the competitiveness of domestic exports, helping to restore any balance of payments issues. On the other hand, it can also raise import prices, leading to higher inflation.

A fiscal deficit that isn’t funded by enough buyers (relative to the supply of what needs to be funded) will lead to higher interest rates, which can protect the currency. (What’s bad for bonds isn’t necessarily bad for the currency.)

However, if the central bank doesn’t want interest rates to rise to avoid the hit to lending, spending, and economic growth, they will buy any excess issuance by creating money.

This is negative for a currency.

Effect of a Budget Deficit on Economic Growth

A budget deficit’s effect on economic growth is nuanced and multi-dimensional.

Depends on ROI

The impact of a budget deficit on economic growth largely depends on how the money is spent and the return on investment (ROI) generated.

If government spending is focused on productive investments, such as infrastructure, education, or research and development that are done well, it can have a positive effect on long-term growth that more than pays for any debt issued.

However, if the deficit is primarily used to finance non-productive spending, the long-term growth potential of the economy may be compromised and the ROI will not pay for the total cost of the debt.

Short-run vs. Long-run

There are also short-run and long-run effects.

Spending on credit provides an initial stimulant. But when it has to be paid back, this involves spending less, so debt acts as a depressant as well.

This basic dynamic is why economies and markets are cyclical.

Financial markets (the market for money, credit, and financial securities) also lead the real economy (the market for goods and services).

Ways to Finance the Budget Deficit

There are several ways to finance a budget deficit, including raising taxes, issuing debt, and printing money.

Each of these methods has its advantages and drawbacks:

• Increasing taxes can help reduce the deficit but may also slow economic growth and there are constraints to this.
• Issuing debt can help finance the deficit but can lead to higher interest rates and debt servicing costs if there’s inadequate demand for it.
• Printing money can also be used to finance the deficit, but it may lead to inflation and currency devaluation and can have negative consequences for the economy.

FAQs – How Do Fiscal Deficits Affect Financial Markets?

How do budget deficits affect financial assets?

Budget deficits affect financial assets in several ways.

Higher government borrowing can lead to increased interest rates, which can impact the bond market and raise borrowing costs for businesses, potentially causing stock prices to decline.

Additionally, if the government’s increased borrowing leads to inflation, it could erode the real value of financial asset returns.

Too-high inflation has a negative impact on productivity.

For this reason, a central bank’s most fundamental mandate is price stability.

How do Treasury bonds affect the stock market?

Treasury bonds and the stock market are interconnected in several ways.

When interest rates on Treasury bonds increase, it can make bonds more attractive to investors, leading to a shift in investment from stocks to bonds.

This can result in a decline in stock prices. Furthermore, higher interest rates on Treasury bonds can lead to increased borrowing costs for businesses, which can reduce corporate profits and negatively impact stock prices.

Do higher government deficits increase the supply of bonds?

Yes, higher government deficits typically lead to an increase in the supply of bonds.

To finance a budget deficit, the government can issue debt in the form of Treasury bonds.

This increases the supply of bonds in the market, which can put upward pressure on interest rates.

As a result, this can affect the bond market, the stock market, and other financial assets as investors adjust their portfolios in response to changing interest rates and market conditions.

How does the fiscal deficit impact interest rates?

A fiscal deficit can impact interest rates through increased government borrowing.

When the government borrows more to finance its deficit, it competes with the private sector for funds available to buy its debt.

This competition can lead to higher interest rates.

How does a fiscal deficit affect inflation?

A fiscal deficit can lead to inflation if the government finances its deficit by printing money.

This increases the money supply in the economy, which can result in higher prices for goods and services.

Additionally, if the deficit leads to higher interest rates, it can cause a depreciation of the currency, which may increase import prices and contribute to inflation.

How do fiscal deficits impact long-term economic growth?

The impact of fiscal deficits on long-term economic growth depends on how the government spends the borrowed funds and the return on investment (ROI) generated.

If the deficit is used to finance productive investments, such as infrastructure, education, or research and development, it can have a positive effect on long-term growth.

However, if the deficit is primarily used to finance non-productive spending or consumption, the long-term growth potential of the economy may be compromised.

How do fiscal deficits affect foreign exchange rates?

Fiscal deficits can affect foreign exchange rates in several ways.

If a deficit leads to higher inflation, it can cause a depreciation of the domestic currency relative to other currencies.

Moreover, if a deficit is perceived as unsustainable or if it raises concerns about a country’s creditworthiness, it can lead to a decline in demand for the domestic currency, further depreciating its value.

Can a fiscal deficit be beneficial for the economy?

A fiscal deficit can be beneficial for the economy under certain conditions, such as during an economic downturn or a period of weak private sector demand.

The public sector essentially fills in the hole.

A government can create it owns money, so it’s not squeezed for money like the private sector and doesn’t have to worry about market losses causing it financial trouble.

In these situations, increased government spending can help stimulate economic activity and support growth.

However, the benefits of running a fiscal deficit depend on how the borrowed funds are used and the overall sustainability of the government’s debt.

Another very important factor is whether the debt is denominated in the country’s own currency. That determines how much control it has over it.

When a country has debt denominated in its own currency, it controls:

• whether it can be restructured (liabilities spread out over time)
• whether they can change the rates on it, and
• whose balance sheet it’s on

How do fiscal deficits influence investment decisions?

Fiscal deficits can influence investment decisions by affecting interest rates, inflation, and overall economic growth.

Higher interest rates resulting from increased government borrowing can impact both bond and stock markets, potentially causing investors to adjust their portfolios.

Additionally, the effects of fiscal deficits on inflation and economic growth can influence investor behavior and expectations, shaping their investment strategies.

How can a government reduce its fiscal deficit?

A government can reduce its fiscal deficit by either increasing revenue, reducing expenditures, or a combination of both.

Revenue can be increased through tax hikes, improved tax collection, or by generating non-tax revenue (e.g., selling resources or assets).

Expenditures can be reduced by cutting spending on programs, streamlining government operations, or implementing cost-saving measures.

The choice of strategies will depend on a country’s unique economic situation and policy priorities.

Conclusion

Fiscal deficits can have a substantial impact on financial markets, affecting the bond market, stock market, real exchange rate, and economic growth.

The consequences of a fiscal deficit largely depend on how the money is spent and the methods used to finance the deficit.

Policymakers must carefully consider these factors when determining the most appropriate fiscal strategies to support long-term economic growth and stability.