One of the worrying aspects of the current situation is that the economy is near the peak of the cycle. The deficit has tended to follow the business cycle, rising and falling along with the unemployment rate. However, even with the jobless rate currently at historically low levels, the deficit remains very large. This suggests that the budget problem is structural rather than cyclical.
Public debt has increased fourfold since 2005, recently moving above USD 33 trillion. Even taken as a ratio to nominal GDP, the debt has doubled over that time period. A basic tenet of economics is that the government debt-to-GDP cannot rise forever. Strong growth in nominal GDP since the end of COVID-related lockdowns in mid-2020 has helped to contain the debt ratio, but with deficits set to remain large and the economy likely to slow, a resumption of the upward trend appears inevitable. In our view, the debt is not at crisis levels yet. One measure of this is the strength of the US dollar versus other major currencies in foreign exchange markets. However, it does appear that the huge supply of Treasury bond issuance is one of the factors driving up bond yields in recent days.
The combination of rising public debt and higher interest rates is causing the interest expense on the debt to soar. According to the Bureau of Economic Analysis, interest payments ran at an annualized rate of USD 909bn in 2Q23, a record amount and double the level of seven years ago. If the current level of bond yields prevails in the years ahead, interest payments will increase even faster as more of the current debt is rolled over at higher interest rates and debt levels also continue to rise. The projection that the cost of carrying the debt will be ever-increasing as a share of GDP is a clear sign that public finances are not on a sustainable path.
Big changes are required
Under these circumstances, it is hard to imagine that public finances can be put back on a sustainable path without a significant tightening of fiscal policy, including both spending cuts and tax increases. Without a change in policy, the gap between revenues and outlays will continue to widen in the long run. In our view, there isn’t any miracle solution—for example, somehow greatly boosting the economy’s growth potential so that revenue rises—which doesn’t involve some politically unpopular policy decisions. Furthermore, if a recession should hit before something is done to narrow the structural deficit, we could end up in circumstances that force fiscal austerity measures to be implemented during a recession.
Given the current political situation, it is hard to be optimistic that the necessary changes will be implemented anytime soon. Since the beginning of the fiscal year on 1 October, the government has been operating under a short-term continuing resolution (CR) that will expire on 17 November. There has been basically no progress since then as the House of Representatives has been focusing on electing a new speaker. With less than a month left before the current CR expires, another CR will likely be needed to avoid a government shutdown. It is possible that a small amount of short-term spending cuts will eventually be implemented, but we think there is little chance for the kind of “grand bargain” needed to deal with the long-run budget issues. More significant changes will likely have to wait until after the 2024 elections.
One factor that could help to raise some revenue is that the personal income tax cuts included in the 2017 Tax Cut and Jobs Act will expire after 2025. While Congress often reaches last-minute agreements to extend expiring tax and subsidy measures, in an environment where passing legislation is difficult, it is possible that these tax cuts will expire as scheduled, especially for higher-income households.
The clock is also ticking for the trust funds backing Medicare and Social Security, which are currently projected to run out of money in 2031 and 2033, respectively. Unless something is done to shore up the system, payments would have to be cut by around 20% when the trust funds run dry, which politically is difficult to imagine. The closer we get to these dates, the more the political pressure will build, and in our view it is likely that some sort of bipartisan commission will be established within the next five years to work on a solution.
Main contributor: Brian Rose, Senior US Economist