Senator Tom Coburn of Oklahoma told the FT that new tax cuts, an extension of Bush programs, will send the capital markets a simple message: America does not care about its deficit. Americans only care about a lower tax base which will keep more money in their pockets and less in the IRS’s hands.

Coburn told the FT that the new tax compromise “fails to send a `signal of austerity” from the US about its ability to reduce its mounting debt burden.'” The senator may be right. Capital markets investors have been selling Treasuries and the rates for US sovereign debt have risen lately. US Treasuries recently had their largest sell-off in two years, as a matter of fact

A vocal and growing minority of economists believe that Americans still do not take the budget deficit seriously. Nouriel Roubini, notorious for drawing attention to himself with bold predictions, said US paper would soon be seen as more risky than debt issued by many nations in Europe. He noted that “Obama-GOP tax deal costs $900 billion over two years. U.S. kicking the can further down the road. Are bond vigilantes starting to wake up?”

US Treasuries are still considered a safe haven investment and that is likely to continue for several years, unless the American economy relapses into recession at the same time that the federal government is bringing in fewer receipts and spending money at near-record levels. The theory behind the new tax cuts is that they substantially lower the odds that GDP growth will slow. More money in the bank accounts of the rich and middle class and companies will  cause a growth in consumer and business spending.

The potential flaw in the argument that low taxes will help spending is that low interest rates have not accomplished a similar goal. The Fed has done what it can to push down interest rates based on the theory that banks will lend more and that consumers will borrow more. Low rates, in theory, drop the risk of default.

The falling cost of money has not had the intended consequences. Large companies have borrowed money at historically low rates. Many of these have simply added to their cash balances, as a sort of “rainy day fund.” Others have used the money to pay down higher coupon debt. Very few huge corporations have substantially increased capital spending or added to work forces. They have instead relied on rising productivity to accomplish what additions to employee bases have done in the past.

Consumer behavior has not been much different. Americans have used whatever additional money they have been able to scrape together to pay down high interest debt or to increase their savings. Sources of capital which they once had, particularly home equity, are gone. A recent Wells Fargo survey showed that many middle class people have saved so little for retirement that they will have to live on $190 a month when they stop working. These people are very likely to pocket any money they save on taxes. They have almost no other choice.

Tax benefits which do not cause accelerated spending almost certainly raise the deficit. More active consumer and business spending probable decrease it. The tax program which the Republicans won is supposed to cost the government $900 billion. The gamble that the money can be recouped through spending is a long one if unemployment remains high, consumers remain concerned, and businesses refuse to increase their investment activity because of a fear that the economic recovery is a mirage.

The world’s investors may indeed look at the US and its debt and begin to consider these a real credit risk.

Douglas A. McIntyre

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