We recently published a Market Minute that made the case that the low-rate free lunch on deficit and debt dynamics had come to an end. It’s one reason why long-term interest rates are rising as investors question the sustainability of the American fiscal path.
With global bond investors now focused on inflation, deficits and debt, it is an appropriate time to think about how to get yields down, and the budget on a more sustainable path.
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Given the political dynamics in the United States, there is no castor oil constituency around which fiscal consolidation can be organized.
Commitments to social obligations like Social Security and Medicare, rising defense expenditures, and economic populism favored by both parties all make a return to the type of balanced budgets last experienced in the late 1990’s unrealistic.
Any effort to create a sustainable debt path must seriously consider moving the primary budget—the budget excluding interest on past debt—back into balance.
So where does the primary budget stand?
Through the end of last year, the U.S. government ran a primary budget deficit of 2.61% of gross domestic product. The Congressional Budget Office forecasts that figure will be 2.6% over the next decade.
In our estimation, this appears to be overly optimistic. The deficit in our view will be closer to 3% to 3.5% of GDP given the spending commitments that both political parties have made.
That last time the primary budget was in balance or ran a small surplus was during the final quarter of 2007, just as the financial crisis was taking hold. But now, total government debt has surpassed $40 trillion, with interest payments on that debt making up an increasing share of federal spending.
To put the primary budget on a path to balance, Congress and the executive branch would need to cut non-interest rate spending and raise tax revenues somewhere between 2% and 3% of GDP annually for years and hold to that commitment.
Without such measures, the budget won’t balance itself.
One theory that has been offered is that the U.S. can grow its way out of the deficit. But absent a productivity miracle from AI, and that scenario is highly unlikely.
The economy could grow near 3.5% to 4% for a decade, which is double the current growth trend, all while inflation remained elevated, and the numbers still don’t add up.
Is there a solution?
Any solution involves hard choices. Consider Italy, and what global bond investors demanded for Italy to move its primary budget into greater surplus during the 2011 European debt crisis:
- Tax increases: Increased property taxes and the value added tax, and imposed progressive surtaxes on high earners.
- Pension reform: Raised the retirement age and more sustainable levels of contribution.
- Spending cuts: Froze wages for public sector workers and imposed deep cuts to regional and local transfers from the central government.
To see through these significant reforms, a technocratic government was put in place led by the economist Mario Monti, and a nonpartisan cabinet implemented publicly unpopular policies to reassure international investors.
Such a solution in the United States would mean higher tax revenues, new tax revenue sources like the VAT, Tobin taxes, token taxes or robot taxes—in addition to serious and sober Social Security and Medicare reform in addition to hard choices on defense expenditures.
If all that sounds improbable and implausible, that’s because it is.
But the term to remember is crisis.
Now, we are on record that there is no impending fiscal, banking or currency crisis that will force the hands of American legislators, which makes improbable any move to put the primary budget on a path to balance.
But there will be moments when the issue will come to a head. For example, the Social Security Trust Fund reserves are projected to run out by late 2032, and the U.S. flirts with debt ceiling crises on a regular basis.
It would be wise to act now when the economy is growing, and we are at or near full employment, to put the primary budget on a path to balance while cutting a deal on sustaining Social Security.
If not, then it will likely require a fiscal crisis to turn that trick.
