Briefing | Budgetary blindness

America’s fiscal outlook is disastrous, but forgotten

On the campaign trail, both main candidates largely ignore the problem

May 2nd 2024|washington, dc

It was not so long ago that the hottest topic in American politics was the ballooning national debt. In 1992 Ross Perot had the best showing for a third-party candidate in a presidential election since 1912 on a platform of fiscal probity. Two years later the Republicans seized control of Congress for the first time in 40 years, with the first item in their “Contract with America” being a pledge to balance the budget. Bill Clinton easily won re-election two years after that, in part by negotiating spending cuts with Republicans that led to America’s first surpluses in a generation.

At the start of this fiscal hullabaloo, in 1992, America’s net debt amounted to 46% of gdp. Today it has reached 96% of gdp. For the past five years, under first Donald Trump and then Joe Biden, the federal deficit has averaged 9% of gdp a year. The International Monetary Fund says that America’s borrowing is so vast it is endangering global financial stability. s&p and Fitch, two credit-rating agencies, have already downgraded America’s debt; a third, Moody’s, is threatening to.

Misgivings mislaid

Yet concern about deficits and debt has all but vanished from American politics. Voters seem relaxed about the subject, which barely registers in pollsters’ tallies of the biggest problems facing the country. Although Messrs Biden and Trump both tut-tut about the dire fiscal outlook from time to time, neither has made improving it a centrepiece of his campaign. On the contrary, both would in all likelihood add to America’s debts, by spending more in Mr Biden’s case and by taxing less in Mr Trump’s. Neither candidate dares breathe a word about trimming spending on health care and pensions for the elderly, which account for the biggest share of the federal budget and are set to grow still bigger as the population ages. Yet a fiscal reckoning is coming, whether the candidates admit it or not—and given the politicians’ denial, it may take an unexpected form.

In theory, the two parties could again co-operate to shrink the deficit, as they did in the 1990s. But in those days public opinion was driving politicians to focus on fiscal matters. The deficit regularly ranked among voters’ biggest concerns in opinion polls—the opposite of today.

What is more, circumstance made fiscal discipline easier in the 1990s. Productivity was rising, thanks to the spread of computers and the advent of the internet. Higher growth, in turn, lifted federal revenues. At the same time the government reaped a peace dividend from the end of the Cold War, allowing it to slash defence spending, a relatively painless form of belt-tightening. Nowadays, in contrast, increasing competition with China and Russia may necessitate higher defence spending, not lower. Cutting greenhouse-gas emissions and catering to an ageing population will also strain the budget.

Perhaps worst of all, both parties have concluded that fiscal rectitude does not pay. Mr Clinton’s predecessor, George H.W. Bush, initiated the deficit-cutting of the 1990s by raising taxes, only to be excoriated by the Republican base and lose his re-election bid. Democrats reluctantly accepted the spending cuts of the 1990s, only to see Mr Clinton’s successor and Mr Bush’s son, George W. Bush, fritter away the resulting surplus with a big tax cut.

Since then both parties have embraced profligacy. The younger Mr Bush’s tax cuts were largely extended by his successor, Barack Obama, and taken further by Mr Trump. At about 33% of gdp, government revenue is much lower in America than in almost every other rich country. At the same time expenditures have soared, owing both to demographic change and to economic disruptions (the federal government spent lavishly to mitigate the effects of the global financial crisis of 2007-09 and the covid-19 pandemic). “We used to have a healthy fear of debt, and we’ve lost that,” says Keith Hall, a former head of the Congressional Budget Office (cbo), a non-partisan fiscal scorekeeper.

As inhibitions have melted away, America’s fiscal laxity has grown ever more extreme. The 9% average deficit of the past five years is four times bigger than the annual average since the second world war (see chart 1). It is also nearly twice the average for other advanced economies. This extravagance has undoubtedly contributed to the economy’s relative strength today. Democrats are unapologetic about this, especially in the wake of the covid downturn. “We learned from previous recessions that there’s a major cost to the American people in going too small. This time we didn’t do that,” says Bobby Kogan, who worked on the budget in the Biden administration.

chart: the economist

The frenetic expansion of America’s debts is now being reinforced by rising interest rates. In the two decades before covid, interest payments accounted for about a third of the federal deficit every year. Over the next two decades, the cbo reckons, interest will make up two-thirds of the deficit every year. “Every bit of higher interest rates matters a lot more when debt is about 100% of gdp. So this is a much larger risk now than it used to be,” says Doug Elmendorf, another former director of the cbo.

Putting all this together, the cbo forecasts that America’s debt-to-gdp ratio will rise from the current 96% to about 166% over the next 30 years (see chart 2). As alarming as that sounds, it is hard to judge when a crisis will strike. Japan’s net debt is about 155% of gdp, yet it has no trouble issuing new bonds. America may have extra latitude given the dollar’s role as the pre-eminent global currency, which ensures a healthy foreign appetite for its debt.

Yet Japan has only stayed on top of its obligations thanks to extremely low interest rates. As a share of gdp America’s public interest costs are already roughly double Japan’s. By the end of the decade the only European country with a higher debt-to-gdp ratio is likely to be Italy. And America’s public finances are fraying quickly: to stabilise its debt-to-gdp ratio by 2029, the imf reckons that it needs to trim its primary deficit (ie, before interest payments) by about 4% of gdp—more than any other big wealthy economy. Bond markets have started to get skittish. Yields surged last autumn when the Treasury announced bigger-than-expected borrowing plans, an event that may become more frequent given rising deficit projections.

Mark Dowding of BlueBay, an asset manager, describes it as a faultline under the American economy. The risks are evident but it is impossible to predict when the problem will strike. “Sooner or later, a big earthquake is going to become overdue,” he says. Mr Hall recalls the difficulty of conveying this point to congressional leaders when he led the cbo. “They would ask, ‘Well, if it is unsustainable, when will it blow up?’ And of course the answer is, we don’t know,” he says. “But we are counting on investors being willing to continually buy government debt. We’re just waiting until the crisis comes.”

$3trn question

The campaigning may hinge on Mr Trump’s character and Mr Biden’s stamina, but the presidential election will also mark a fiscal watershed. At the end of 2025 many of the personal income-tax cuts that Mr Trump initiated in 2017 are set to expire. Leaving them all in place would cost about $3trn over the next decade. Even by the spendthrift standards of Washington, that is a huge amount—about double federal spending on transport.

In contrast, simply letting the tax cuts expire would shave about a percentage point off the annual deficit, a big improvement to America’s fiscal trajectory. But a sudden increase in taxes would be wildly unpopular and would presumably cause the economy to slow. No president would want to preside over such a shock, for fear of a popular backlash. So the question is not so much whether the next administration will extend the tax cuts but rather, will it preserve them in their entirety and what else will it do on the fiscal front?

Mr Trump, unsurprisingly, has vowed to make all of his tax cuts permanent. He would also like to go further: he is reportedly weighing more cuts to corporate taxes. Mr Biden has described Mr Trump’s original tax cuts as reckless but his plan would nonetheless maintain them for people making less than $400,000 a year, at two-thirds of the original cost.

Both candidates pay lip-service to fiscal rectitude. Mr Trump talks of paying down the debt by bringing in more revenue from oil drilling—a preposterous idea, given that the federal government only derives a minuscule portion of its revenue from oil. He also wants to raise one sort of tax: tariffs on trade. Mr Trump’s proposal of a 10% universal tariff would bring in about $300bn a year, or 1% of gdp (largely paid for by American consumers, who would see the price of imported goods rise). But these receipts would be eaten up by the extension of the 2017 tax cuts, plus any new cuts. The net effect would be a slightly higher deficit, according to Goldman Sachs, a bank.

Mr Biden’s fiscal ideas are more credible. As well as lowering drug costs and giving the Internal Revenue Service more funding to chase tax cheats, he has proposed a bevy of taxes on the rich and powerful, including higher corporate taxes. But even if Democrats managed an improbable sweep of Congress and so could impose new taxes, it is unlikely that Mr Biden would use all the resulting income to trim the deficit. “There will be lots of pressure on him to use new revenues for new spending programmes,” says Maya MacGuineas of the Committee for a Responsible Federal Budget, a non-profit group. Mr Biden has promised, among other things, to restore a generous tax credit for families with young children, to fund child care and to forgive student debt.

In all likelihood America will end up with divided government. At one time that might have been a recipe for fiscal restraint, with Democrats’ spending plans scaled back and Republicans’ tax cuts thwarted. But restraint is relative these days: after all, the past two years of divided government have brought gaping deficits. Neither party is willing to cut Social Security (the state pension) and Medicare (government-funded health care for the elderly), which together will hoover up some 60% of all federal spending excluding interest payments by the end of the decade. “Politicians have pledged not to touch them because that’s good politics in an election year. And it will still be good politics in 2025 and 2026,” says Mr Elmendorf.

The biggest unknown is Mr Trump. It is his broader agenda, rather than his fiscal policies, that is most concerning. If his tariffs drive up the cost of imports, they will fuel inflation. A crackdown on immigration would impede the growth in the labour force that has been boosting the economy of late. “If you went into a lab and wanted to construct a policy backdrop to increase the probability of higher structural inflation, it would be exactly what Trump is proposing,” says Michael Medeiros of Wellington, an asset manager.

Then there are the ideas bandied about by Mr Trump’s advisers. Robert Lighthizer, seen as a candidate for a big economic post in a Trump administration, has flirted with devaluing the dollar as a lever for reducing America’s trade deficits. Mr Trump’s allies have also drawn up proposals—reported by the Wall Street Journal—to curtail the Federal Reserve’s independence, perhaps requiring the central bank to consult with the president before making decisions about interest rates.

Whether Mr Trump supports these ideas is unknown; he may not have made up his mind. Any efforts to engineer a weak dollar or to check the Fed’s hard-earned independence would raise alarm bells in global markets, making America look like a banana republic. That could set off a vicious cycle: investors may start to demand higher returns on American bonds, which would drive up the government’s interest bill and, in turn, aggravate its debt woes.

Falling dominos made with US flag looking credit cards

illustration: carl godfrey

Even without such spurs, America may have already embarked on a milder version of this cycle. The imf reckons that loose fiscal policy has become a bigger contributor to its stubbornly high inflation than other factors affecting demand and supply. And inflation is, of course, the reason why the Fed has maintained elevated interest rates, thereby raising the government’s financing costs. Back in January markets expected about 1.5 percentage points in rate cuts this year. If those were to materialise, the Treasury would end up paying about $1.2trn in interest during 2024, according to analysts at the Bank of America. If, however, the Fed holds rates at their current level, as many investors now anticipate, the Treasury’s interest payments will instead reach $1.6trn. The difference—$400bn—adds more than a percentage point to the federal deficit.

Continuing down this path would land America in an uncomfortable new environment. With real interest rates settling at a higher level than in the pre-covid decade, companies and individuals would face higher financing costs, dragging down investment and, eventually, productivity. The government would devote most of its budget to paying interest and supporting retirees, squeezing the funds available for roads, schools, scientific research and more. Amid disappointing growth, the country’s debt dynamics would worsen. This would not be an imminent crisis, but it would chip away at the economy’s momentum. Having outpaced all other big wealthy countries for decades, America might instead lag.

How might it all end? A sovereign default is impossible because all America’s debts are denominated in dollars, and the government can always create money to pay them off. Still, there are other extreme scenarios. One is “fiscal dominance”, when a central bank is forced to print money to finance a deficit, driving inflation so high it erodes the value of ordinary people’s savings. This would be a disguised form of taxation, in effect. Mercifully, it remains an unlikely prospect in America. After all, the Fed has jacked up rates, despite the grim fiscal picture.

Another possibility is “financial repression”, when people are forced to lend to the government to hold down its borrowing costs. Again, that sounds far-fetched in a country like America. But Sonal Desai of Franklin Templeton, an asset manager, reckons that some current arrangements are a step in this direction. Notably, to meet liquidity rules, banks must hold lots of Treasuries. The intention is to safeguard banks against runs, but a side-effect is to create a large, captive pool of buyers for American government debt. “The bottom line is that there is an element of financial repression,” she says.

A more optimistic scenario is that America reins in its debt before it is too late. Perhaps, as in the 1990s, it may benefit from higher growth brought on by rising productivity, this time owing to the spread of artificial intelligence. Regrettably, it seems more likely that a crisis will be needed to bring the country to its fiscal senses. This could come in many forms. One is the ticking clock of Social Security and Medicare. The trust funds that provide a big chunk of their funding will run out of cash in the early 2030s. This, in theory, would force the government to slash benefits to retirees, an outcome so terrifying to politicians that they may at last try to find better ways to make the two schemes affordable.

Rolling, rolling, rolling

Another crunch could stem from America’s gargantuan borrowing needs. In 2024 alone it must roll over about a third of its existing debt and also finance its growing deficit. To do so, the government needs to find buyers for about $10trn of bonds this year, according to Torsten Slok of Apollo, a fund manager. The scale of borrowing will increase with each passing year.

As the scale of Treasury auctions grows ever more daunting, the chance of turbulence rises. As happened last autumn, demand may fall short unless the government offers higher yields. That would send tremors through markets. Paul Winfree, a budget adviser in Mr Trump’s White House, thinks it might take such a disturbance to shake Washington out of its slumber. “The Treasury would come to Congress and say, ‘You need to send out a credible signal to markets that you are committed to doing something on the deficit,’” says Mr Winfree. “And then they would act.”

Matt Eagan of Loomis Sayles, an investment manager, thinks of it as the return of what political types used to call “bond vigilantes”: twitchy markets that force fiscal prudence on politicians. “Five years ago, I would have said there is a low probability. Today, you have to say that there is a possibility,” he says. If the vigilantes do strike, the damage will depend on the economic context. The government has put America in a dangerous spot by running such a high deficit over the past couple of years, even though employment has been strong. Were a bond auction to stumble as the economy is slowing, it might have to do the reverse: impose austerity even though the job market is weakening. “Where you would normally use easier fiscal policy, you may actually be forced in the other direction,” says Mr Dowding.

There is no way of knowing if or when any of this will come to pass. But the likelihood of such harrowing scenarios is growing. For the past decade America’s politicians have got away with ignoring budgetary constraints and would like to continue. But fiscal arithmetic and jittery investors will eventually put a halt to the party. ■

(http://www.autoadmit.com/thread.php?thread_id=5525226&forum_id=2#47636207)

In 2024 alone it must roll over about a third of its existing debt and also finance its growing deficit. To do so, the government needs to find buyers for about $10trn of bonds this year, according to Torsten Slok of Apollo, a fund manager. The scale of borrowing will increase with each passing year.

(http://www.autoadmit.com/thread.php?thread_id=5525226&forum_id=2#47636254)

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