Why do deficits matter?

Wall Street seemed less than bothered by Moody’s downgrade of its government debt rating; neither stocks nor bonds flinched much. To be fair, will the US government ever default on its obligations? I very much doubt it. That is the whole point of credit ratings: to give investors a sense of how likely a debtor is to default on their debts. A downgrade from the ratings agencies should lead to higher borrowing costs; there was hardly any reaction from the treasury market this week, and many dismissed the news as Moody’s was not leading the way.

Government borrowing spiked due to the financial crisis, but was starting to come down, then came Covid, and governments once again threw money at the problem once again. Why do deficits matter? You had Warren Buffett as the latest to raise the topic at his annual meeting, as he expressed concern at the levels of government borrowing.  He described the current fiscal deficit as “unsustainable” and emphasised the need for government spending cuts. Citing the current fiscal deficit of 7% of GDP, defined as how much more the government spends relative to what it earns, the rest it borrows, as unsustainable.  

So what’s the issue? Just borrow more. Well, that is what they have been doing. The problem is that the more you borrow, the more interest lenders demand. Or rather, if you are expected to need to borrow more, it makes sense for investors to anticipate this, which pushes prices down. The other solution is to cut spending, which harms the economy. Printing money can lead to inflation, which is what many fear, and is exacerbated by the new tariff policies. Increase taxes, which is politically challenging, as Ms Reeves discovers. Cutting spending too aggressively raises the risk of recession, which in turn increases the likelihood of a further rise in the budget deficit, creating a vicious cycle. Alternatively, you could try a little of everything: keep spending but moderate it, introduce a DOGE, increase taxes modestly, and avoid hurting the economy too much. This combination should help improve tax revenue and reduce the budget deficit; it’s a balancing act. Mr Trump’s budget bill is counting on supporting growth through tax cuts, hoping for greater investment, stimulating the economy, and anticipating that tax revenues will rise as a result, with the deficit falling as a proportion of GDP. That was somewhat where Ms Truss aimed to go with her budget, but without the endorsement from the OBR. The one outcome Mr Trump will want to avoid is a recession, that is what the markets are banking on at present.

We also see today the impact of higher taxes on inflation rates. The Consumer Prices Index rose by 4.1% in the 12 months to April 2025, up from 3.4% in the 12 months to March. A rise in prices was expected, but indexed price rises, particularly in energy and water bills, also drove this jump. It will be interesting to see how the bond market reacts today.