The Economy
Unsustainable Fiscal Path Isn’t A Problem. Until It Is . . .
July 2024
The fiscal path of the federal government has become a topic of increasing conversation, not to mention concern, not only amongst the general public but also amongst market participants. The Congressional Budget Office’s (CBO) mid-June release of their updated projections for the federal government budget – the paths of revenue, spending, deficits, and outstanding debt – through 2034 probably wasn’t all that soothing to anyone already concerned with this issue and has, apparently, caught the attention of many for whom this topic wasn’t previously top of mind.
The CBO’s updated projections peg the fiscal year 2024 budget deficit at $1.9 trillion, up from their February 2024 estimate of $1.5 trillion. Moreover, deficits are expected to hover around this higher level over the next few years before becoming larger, both absolutely and as a percentage of GDP, over the later years of the forecast horizon. The CBO now projects that federal government outlays as a percentage of GDP will increase from 24.2 percent in 2024 to 24.9 percent in 2034, while federal government revenues as a percentage of GDP will increase from 17.2 percent in 2024 to 18.0 percent in 2034 (all years referenced herein are fiscal years, not calendar years). By way of reference, over the 1974 through 2019 period, outlays averaged 21.0 percent of GDP and revenues averaged 17.3 percent of GDP, though these shares have swung sharply over recent years, reflecting the impacts of the 2017 tax cuts and the policy response to the pandemic.
Sure, it’s easy to dismiss these long-term forecasts on the grounds that a lot can, and almost surely will, change over the next decade, to the point that any forecast made at present will quickly be proven wrong. What is different in this case, and not at all in a comforting way, is that the path of a considerable portion of federal government spending is pre-determined under current law. To that point, “mandatory” expenditures, which include Social Security and Medicare, will grow sharply over the coming decade. At the same time, the federal government’s net interest expense has risen sharply over the past two years and the CBO anticipates this will remain the case over the coming decade, reflecting both the growing level of federal debt and higher interest rates. Between the growth in mandatory outlays and in net interest expense, there will be increasingly less room in the federal government’s budget for discretionary spending over the coming decade.
Whether or not the fiscal path anticipated by the CBO is sustainable is one question, and perhaps the question most people are focused on, judging from the questions we field from clients. Another question, in our minds equally as important, is whether there are economic implications of such a fiscal path. We’ve already touched on one, i.e., the increasingly narrow scope for discretionary government spending. A much more relevant implication is the potential impact on private domestic investment. One way to think about this is to go back to one of the most basic points in any first semester macroeconomics course, which is that in any economy the aggregate level of investment equals the aggregate level of saving. Which matters because investment is the main fuel of any economy’s growth over time.
Domestic saving consists of combined saving amongst the household, corporate, and government sectors. Any single sector of the economy can engage in dissaving (i.e., run a negative saving rate), as has long been the case in the public sector of the U.S. economy. In a closed economy, dissaving in one or more sectors must be offset by saving in the remaining sector(s), while in an open economy foreign saving can compensate for a lack of or a low level of domestic saving. By definition, however, for any economy the flip side of lower levels of net saving is lower levels of total investment which, over time, is associated with lower rates of sustainable economic growth.
As of Q1 2024, net domestic saving was negative, equivalent to 0.44 percent of GDP. This is the fifth consecutive quarter in which net domestic saving was slightly negative, which reflects a falling household saving rate at a time when federal government budget deficits have been growing larger. But, that this is the starting point from which we embark on the fiscal path anticipated by the CBO makes the prospect of that fiscal path more unsettling as it leaves us with a set of less than desirable outcomes. Either we see lower and lower levels of investment, we become increasingly reliant on foreign saving to finance a given path of investment, or we end up with some combination of the two. Again, anything that puts longer-term growth in investment on either a lower or an unstable/unsustainable path will ultimately translate into a lower sustainable rate of economic growth.
This, at least to us, is the most important context into which any discussion of federal government finances can be put. Net domestic saving will almost surely become increasingly negative on the fiscal path anticipated by the CBO, meaning that we will become increasingly reliant on foreign saving in order to sustain a given path of investment. The cost of doing so, however, will only increase as domestic dissaving becomes increasingly pronounced, i.e., it will take higher U.S. interest rates to attract foreign savings. One advantage the U.S. continues to enjoy is the U.S. dollar’s status as the de facto global reserve currency, which has helped make it possible, and less costly, for the U.S to attract foreign saving to finance both current consumption and future growth. While there are at present no viable threats to that status, that doesn’t mean that no such threats will emerge. Indeed, mounting geopolitical tensions and the prospects of intensifying trade wars are two such potential threats.
One thing that makes this a difficult topic to discuss is that there is no clear line in the sand which, if crossed, would trigger an outflow of foreign saving which would in turn result in a sharp and sudden rise in U.S. interest rates. “It isn’t a problem, until it is” may be the right answer, but that just isn’t an answer that many people find all that comforting, or all that useful. Moreover, many are quick to assume that because that line has yet to be crossed means that there is no such line. We have no doubts that such a line exists, but it could be that before that line is crossed the “bond vigilantes” will saddle up and ride again, pushing interest rates up to a degree sufficient to more or less force fiscal policy makers to act to curb growth of federal government debt.
Recall that the bond vigilantes last rode to the scene in the early-1990s. At the time, federal government budget deficits were growing, to the point that government dissaving was equivalent to more than six percent of GDP, as has been the case over the past five quarters. Increasingly concerned over the prospect of even further increases in the size of the deficit, the bond vigilantes rode roughshod over the bond market, pushing yields on longer-term U.S. Treasury securities up sharply. That was seen as a major catalyst for a bipartisan agreement to rein in growth in government spending, to the point that by the end of the 1990s the federal government was running a budget surplus.
Whether the bond market vigilantes would have enough clout this time around to restore some semblance of order over fiscal policy remains to be seen. It is worth noting that the FOMC tapering the rate at which the Fed balance sheet is winding down and ultimately ending that tapering will blunt upward pressure on U.S. Treasury yields. We’d argue, however, that any such relief will ultimately be offset by the widening deficits envisioned by CBO. As such, though it may not be apparent as soon as it otherwise might be, the current fiscal path clearly seems unsustainable, the questions at this point being how long it can be sustained and what will be the catalyst for a change of course. It would, of course, be less painful to act out of choice rather than out of necessity but, at some point, the choice may no longer be ours.
Sources: Congressional Budget Office
As of July 10, 2024
