The Deficit Spending Boom Won't Last Forever
After bottoming out at $438 billion and 2.4 percent of gross domestic product in fiscal 2015, the U.S. federal deficit has started growing again. It was $666 billion (3.5 percent of GDP) in the fiscal year that ended in September, and with the big tax cut passed by Congress and signed by the president in December, and the moderately generous spending deal agreed to by congressional leaders from both parties on Monday, it seems destined to break the $1 trillion and 5-percent-of-GDP barriers in the next couple of years. 1
What are we to make of this? There are a thousand different takes about the implications making their way through the ether already, and after reading my Bloomberg View colleague Matt Levine's Wednesday newsletter, I'm mindful of trying to add my little bit of alpha before someone stops by my desk to run a regression analysis of my performance. So here's my contribution: a brief rumination on how this experiment in massive fiscal stimulus during good times might end.
There's only one historical episode even remotely comparable: that couple of years during the mid-1980s when President Ronald Reagan's "Morning in America" had already dawned yet the deficit was still at or close to 5 percent of GDP. But there was still some obvious slack in the economy then -- the unemployment rate averaged 7 percent in 1986, compared with 4.1 percent now -- and the deficit then fell sharply during the late 1980s.
It fell in part because politicians in both parties were so freaked out by it, with Congress voting for multiple tax increases and spending cuts. When the 1990-1991 recession sent the deficit rising again, the political pressure to shrink it grew even stronger. Investors in Treasury bonds, ostensibly worried about the implications of the deficit and resulting increases in the federal debt for inflation and the creditworthiness of the U.S. government, were seen as fearsome enforcers of fiscal discipline. As Democratic political consultant James Carville famously put it in 1993:
I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.
That intimidation led to the surpluses of 1998 through 2001, which brought the gross federal debt 2 back down to 54.6 percent of GDP. Since 2001, though, the debt has almost doubled as a share of GDP, while the yield on 10-year Treasuries has fallen from more than 5 percent to, as of this morning, 2.9 percent. Those scary bond market vigilantes became pushovers.
That 2.9 percent is up from just 2 percent in September, and the interesting financial market events of the past few days are an indication that the bond market may be about to regain some of its old relevance. But I imagine it will take quite some doing this time around to persuade politicians in Washington to act with anything like the urgency that they did in the late 1980s and early 1990s.
Since the 1990 tax increase that helped torpedo George H.W. Bush's chances of a second term as president, Republicans have been for reducing deficits when a Democrat is in the White House and increasing them when their party has the presidency. I don't doubt that the Tea Party House members who grumbled to the Wall Street Journal about the spending deal are legitimately frustrated, but as their electoral appeal seems to have been based more on their obstreperousness than their devotion to small government, 3 I don't think this frustration will have much political impact. The Democrats have followed a more consistent path of at least saying worried-sounding things about the deficit no matter who's president, but the events of the past few months (especially the GOP majority's enactment of large, deficit-increasing corporate tax cuts) appear to have soured them on fiscal responsibility as well.
And really, it's hard to blame the politicians for this. The dire warnings of deficit hawks over the past four decades have generally not come true, voters are losing interest in the topic, and there may even be a reasonable case to be made for experimenting with bigger fiscal stimulus as a way to break the economy out of its slow-growth path and free the Federal Reserve to continue its normalization of monetary policy.
Still, a deficit of 5 percent of GDP during good times implies a deficit of 7 or 8 percent in even a modest recession (the deficit hit 9.8 percent of GDP in 2009, during the worst recession in 75 years, and an all-time high of 29.6 percent of GDP at the height of World War II in 1943). Demographic pressures on Social Security and Medicare will boost it even higher over time, as will likely increases in interest rates. The federal debt was just 31.7 percent of GDP at the beginning of the Reagan deficit experiment in 1981. Now it's already more than 100 percent. This cannot go on forever. And as Republican economist Herbert Stein put it back in the 1980s, in another famous quote:
If something cannot go on forever, it will stop.
How will it stop? Stony Brook University economist Stephanie Kelton and her fellow modern monetary theorists have been arguing for a while now that since the U.S. borrows in its own currency, which it can always create more of, the only risk posed by rising deficits is inflation. There's some truth to this view, but it misses a lot about how financial markets -- and politics -- work. If deficits keep rising and rising, it seems likelier that the end will come not in a slow, steady rise in inflation but in a crisis in which lost market confidence and public confidence force drastic action in Washington. That might turn out to be a good thing: I (and many others) have argued that the U.S. needs to suck it up and impose a national value-added tax like every other wealthy nation has, and a fiscal crisis should certainly increase the chances of that. But it would still be a crisis.
No, economic growth resulting from the tax cuts will not close the budget gap. Every serious analysis of the legislation, including that of the very favorably disposed Tax Foundation, projects that it will reduce government revenue (versus the baseline of no tax changes) even if accelerates growth. People who say otherwise are messing with you. Also, in case you've been wondering, the Congressional Budget Office's annual projections of spending and revenue over the next decade, which usually come out at the end of January, have been delayed because of all the extra work the CBO needs to do to factor in the effects of the tax bill and the possible spending deal.
That's debt held by the public plus obligations to the Social Security Trust Funds.
In the words of Kentucky Republican Thomas Massie: "After some soul searching I realized when they voted for Rand and Ron [Paul] and me in these primaries, they weren't voting for libertarian ideas -- they were voting for the craziest son of a bitch in the race. And Donald Trump won best in class, as we had up until he came along."
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Brooke Sample at email@example.com