US Budget Deficits Are Exploding Like Never Before
Story by Liz Capo McCormick, Erik Wasson, Christopher Condon and Alexandre Tanzi , 8/25/23
(Bloomberg Businessweek) — American politicians are keener than ever to juice the economy with government cash, a shift that’s already helping to drive up borrowing costs and looks likely to keep them high long after the inflation emergency is over.
The outlook for the federal budget right now is essentially unprecedented—crisis-size deficits as far as the eye can see, even though the economy appears to be in good health. That prospect is making investors uneasy, as demonstrated by yields on benchmark 10-year Treasuries climbing above 4.3% this week, their highest levels since 2007. Other borrowing costs are rising in tandem: The average rate on a 30-year fixed mortgage has surged above 7% for the first time in more than two decades.
Investors worry that sustained fiscal shortfalls on the scale projected by the Congressional Budget Office could push rates higher still—which only puts more pressure on public finances by adding to the government’s ballooning interest bills. Concerns intensified this month after a one-two punch: The US Treasury ramped up debt issuance, heralding a supply deluge that’s likely to last several quarters, and Fitch Ratings unexpectedly downgraded America’s sovereign credit rating.
“How much debt is too much” is an old debate, and Wall Street has been grousing about Washington’s spending habits forever. But there’s a new twist underlying the bond market angst. This year’s surge in the deficit—which more than doubled, to $1.6 trillion, in the 10 months through July—looks like what happens when the government goes into recession-fighting mode. Except right now the economy is growing at a decent clip, so far confounding the many pundits who’d predicted a downturn this year.
Governments in other countries have been borrowing and spending more too—but the US cash infusion is extra-large, and it’s not a one-time aberration. From Donald Trump’s tax cuts to President Joe Biden’s industrial subsidies, not to mention the multitrillion-dollar pandemic rescue, both Democrats and Republicans are increasingly ready to use the public purse to rev up growth rather than entrusting the job mainly to the Federal Reserve. So the prospects for a big, bipartisan, deficit-reducing deal anytime soon appear slim.
In a strong economy with low unemployment, American politicians “really have no impetus to think they need to change anything,” says Oksana Aronov, head of market strategy for alternative fixed income at J.P. Morgan Asset Management. “You have a tremendous amount of fiscal spending—an unprecedented amount in non-war times. There are a lot of factors coming together to push long-end rates higher.”
The consequences stretch beyond the $25 trillion Treasury market. American housing is now less affordable than at any time since the 1980s, and it will become even less so if rising yields on US government debt pull mortgage rates north of 8%. Stocks may also suffer, since higher financing costs for corporations eat into profits. “History tells us that no asset class is really going to escape this entirely,” Aronov says.
The main reason everyone’s paying more to borrow now is that the Fed has been ratcheting up interest rates for a year and a half to quell inflation. The conventional wisdom is that the most rapid cycle of monetary tightening in four decades is near an end, although Fed Chair Jerome Powell could upend that assumption when he addresses fellow central bankers at the annual Jackson Hole conference in Wyoming on Friday.
Some economists and investors warn that the Biden administration’s fiscal spending—it’s pouring hundreds of billions of dollars into programs to bolster domestic manufacturing of electric cars and semiconductors, and to repair roads and bridges—could rekindle inflation and make it hard for the Fed to dial back its rate hikes.
In Washington, lawmakers fresh from this spring’s debt ceiling showdown are headed for another spending battle, this time over budget plans for the coming fiscal year. Biden and Congress are girding for a government shutdown in September before a deal gets done.
Yet the amount under dispute is just $100 billion, chump change compared with the trillions in spending cuts and tax increases that analysts say would be needed to stabilize the national debt. While noisy battles get fought over the relatively small part of the budget that funds domestic agencies, lawmakers from both parties are loath to pare back Social Security payments or health benefits for retirees. Nor do they want to pay the political price of raising the tax burden on households and businesses.
In fact, the Senate is already looking at emergency spending for the Ukraine war and disaster relief, which would be exempt from caps agreed in the May debt ceiling deal. Republicans, who are in control of the House, have discussed passing more tax cuts.
The upshot is that the nonpartisan Congressional Budget Office expects the deficit to expand to roughly 6% of gross domestic product this year—and to stay in that ballpark for the next 10 years. For context, in the six decades or so between the aftermath of World War II and the 2008 crash, the shortfall never reached that level.
What’s changed is that fiscal policy is being used as a tool to prolong expansions and keep the economy humming, according to Doug Holtz-Eakin, a former CBO director who now heads the American Action Forum, a Republican-leaning think tank. “During the 1980s and 1990s there was more of a focus on the long-term picture and making sure our fiscal house is in order,” he says. “And they let the Fed take responsibility for the business cycle.”
One consequence of the slow and grinding recovery that followed the 2008 financial crisis is that US politicians learned there’s a political cost to delegating economic management to the central bank. Trump boasted that his tax cuts accelerated growth, while Biden is trumpeting America’s high-speed rebound from the Covid-19 slump, now getting a second wind thanks to incentives in the Inflation Reduction Act and the CHIPs legislation. Both presidents ducked complaints that such policies would pave the way for bigger deficits or feed into inflation.
A generation of traders has gotten used to bond yields that declined regardless of what happened to government budgets. Expect the historic correlation between those two variables to reassert itself, says Wall Street veteran John Ryding, chief economic adviser at Brean Capital. His back-of-the-envelope prediction is that for a given Fed interest rate, each percentage-point increase in the federal budget balance as a share of gross domestic product will cause a 40 basis-point increase in 10-year Treasury yields.
Monetary and fiscal policies are intertwined in another important way, too: The government’s debt service costs are soaring as a result of the Fed’s rate hikes. Net interest payments on federal debt have surged above $600 billion a year, from around $380 billion when the pandemic hit. They now gobble up about 14% of tax revenue, a level that in the past spurred investors and Congress itself to demand more fiscal discipline, says Brian Rehling, head of global fixed income strategy at Wells Fargo Investment Institute.
“Having more and more of your revenue consumed simply to pay your debt servicing costs to bondholders is not a very productive use of capital,” he says. “Investors should take it seriously.”
Maturities on Treasuries have gotten shorter in recent years, so that almost one-third of the whole national debt needs to be rolled over within the next 12 months—likely at the new higher rates. And that doesn’t take into account additional issuance to finance larger deficits. In the current quarter, net borrowing is coming in at $1 trillion.
After adding up the debt arithmetic and political deadlock, Fitch knocked the grade on US sovereign debt down one level from AAA to AA+ on Aug. 1, predicting the country’s finances will likely deteriorate over the next three years and citing an “erosion of governance.”
Mind you, these dynamics are not uniquely American. In a report this month, Ariane Curtis at Capital Economics found that most large advanced economies will also have higher debt ratios in five years’ time than they did in 2019. “Policy looks set to remain more supportive of demand than it had been,” she wrote. “If deficits remain permanently larger, then long-term interest rates may need to remain higher as well.”
There’s no shortage of spending pressures. On top of aging populations, which need more health care and other social services, governments want to devote more resources to fighting climate change. And in the US, both parties are invested in what’s shaping up to be an expensive great-power contest with China.
Of course, money well spent— if it’s channeled into areas that boost the economy’s productive capacity, such as infrastructure, education and scientific research—could end up reducing the debt burden.
But economists also have plenty of arguments for why a growing debt could be bad for the US. Many invoke the concept of “crowding out”: A surge in public borrowing increases the competition for funds, making it more expensive for businesses and households to borrow, thereby crimping private investment and consumption.
For all the fretting, it’s hard to map out a path that leads to a full-blown bond meltdown in the US, like the ones that threatened European economies last decade and are commonplace in emerging markets such as Argentina.
Not only does the US borrow in its own currency, giving it the ability to print more money in a pinch, but Treasuries—despite what ratings firms say—still represent the strongest of global safe haven assets, which ensures that demand for them will remain robust until an attractive alternative materializes. Also, economists have been raising the alarm over the level of US debt for decades, arguably undermining their case with vague and premature warnings of doom.
“It’s not clear at all that we can identify in advance a particular level of federal debt that would trigger a crisis,” says Karen Dynan, an economics professor at Harvard. “There’s no consensus among experts.”