Focus
October 11, 2024 | 13:26
Where Have You Gone, Fiscal Discipline?
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Where Have You Gone, Fiscal Discipline?Government finances are in a tough spot, especially in the U.S., and there is little political will to fix them. This risks a market response. |
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As we enter the final month of the U.S. election campaign, there is one economic subject that neither candidate seems willing to address head on—how to deal with the bloated budget deficit. The CBO estimated this week that the deficit for the fiscal year that ended in September widened to $1.83 trillion, or roughly 6.5% of GDP, the third-largest gap on record after the two blowouts in the pandemic years of 2020 and 2021 (Chart 1). Instead, the focus has been on new measures that would, on net, actually raise the deficit—this at a time when the accumulated government debt held by the public is poised to break above 100% of GDP for the first time since 1946. |
The non-partisan Committee for a Responsible Federal Budget (CFRB) this week scored the announced proposals by the two candidates as significantly boosting the baseline deficit over the next ten years from $22 trillion—by $7.5 trillion under Trump, and by $3.5 trillion under Harris. We would emphasize that these estimates have a wide confidence band, and are based on only rough outlines of potential policy changes. But the key point is that neither is considering serious fiscal restraint. This lack of concern about the challenging fiscal landscape risks a market accident at some point—i.e., a bond market revolt, which could drive long-term yields higher. The fundamental issue with federal finances is that revenues have been consistently below non-interest expenses ever since the budget was blown open by the Great Recession in 2008/09 (Chart 2). In the prior thirty years, the operating budget (i.e., ex-interest costs) had been in balance, on average, with the underlying surplus swelling as the economy recovered, and then dropping heavily when the economy fell into recession. But the balance never got back up after 2009. And this has been a bi-partisan issue—in stark terms, Republicans have cut taxes, but done little on spending, Democrats have lifted spending, but done little on taxes. On top of this deterioration in underlying finances, the big back-up in both nominal and real borrowing costs has driven the interest bill dramatically higher. In the latest fiscal year, spending on interest reached almost $900 billion, nearly exactly in line with both outlays on defense and on Medicare (Chart 3). In little more than two years, interest outlays have doubled amid the rise in yields and the underlying jump in the debt during the pandemic. Debt dynamics are not overly friendly, with the real 10-year yield now hovering just below 2%, compared with an average of just 0.4% in the decade prior to the pandemic. In those halcyon days, real borrowing costs were steadily below the U.S. economy’s long-run growth potential, which perhaps inspired the Modern Monetary Theory (MMT). Now we are faced with a much more sober reality of real interest rates at, or even a bit above, the economy’s long-run growth potential, a much more daunting backdrop. Of course, part of the reason why interest charges have spiked higher is not just the rise in market yields, but also the steep run-up in debt in recent years (Chart 4). There was a big step-up in debt/GDP in 2020/21 as the economy temporarily shut down and government spending rushed to fill the void—this was certainly not unique to U.S. finances. But, this followed the big step-up in debt during and after the Great Recession, which had already set finances on a challenging path. And, since then, there has been no net improvement in debt from the dire days of 2020/21. As a result, the debt held by the public has gone from a standing start of 35% of GDP as recently as 2007, to almost 100% now. As mentioned, this is the highest level since the aftermath of World War II—the difference is that the U.S. economy was poised to embark on a massive boom in the post-war years, and no such economic boom lies ahead. Thus, even with no major additional measures, the debt/GDP ratio is headed for a record high in the near future. There is no sugar-coating it—the U.S. faces a fiscal challenge in the years ahead. Between a near-record debt load, less favourable demographics, slower potential growth, and more normal real borrowing costs, there is a clear need for fiscal discipline. Some would assert that “deficits don’t matter”, and perhaps they don’t…until they do. In other words, one only really knows that government finances have weakened to the point where the market will say “enough”, when the market actually says “enough”—and by then, it’s too late. Two years ago, the U.K. mini-budget mini-crisis offered a stark example: 10-year gilt yields flared 250 bps in a matter of 7 weeks, which served as a warning to all others. While the U.S. is a very different credit, and unlikely to face the exact same challenges, it’s clear that the market can react suddenly and violently to unexpected fiscal weakness. No one wants the bond vigilantes to need to ride back into town. |
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And where does Canada stand in the current fiscal environment? On federal finances alone, there really is no comparison. Aside from 2020, Ottawa’s budget deficit/GDP ratio has been consistently smaller than Washington’s gap for the past twenty years (Chart 5). And the cumulative federal debt is considerably lower, albeit there is an ongoing debate over precisely which measure of debt best captures reality (net, gross, general government, including or excluding public pension funds, etc.). On a gross basis, Canada’s government debt is only about 20 ppts less than the U.S. as a share of GDP, but almost 80 ppts lighter on a net basis. (The fundamental difference is the large Canadian public pension assets, versus thinly funded U.S. social security; that undoubtedly leaves Canada in healthier fiscal shape, but the pension assets wouldn’t help much in a crisis—hence the debate.) Even with Canada’s firmer fiscal position, there are at least three issues. First, federal finances appear weaker than initially portrayed in this year’s Budget. While Ottawa set a $40 billion deficit anchor, the monthly figures suggest that finances have drifted well off-course (Chart 6). In the past 12 months, the cumulative shortfall is running at $57 billion (1.9% of GDP). To be sure, these are not the final figures, and there may be some special factors that bring the balance closer to target—but given the steady underlying deterioration in recent results, it appears to be “anchors away”. |
Second, the operating budget is struggling to stay in surplus, and Canada faces the same less-friendly debt dynamics as the U.S. in coming years. While Canada’s demographics are somewhat more helpful, that is offset by much weaker productivity, arguably an even bigger medium-term challenge for government finances. And, finally, Canada’s finances must include the provinces for a more complete comparison. Mileage varies by province, but the pressure on spending from rapid population growth, the rising interest burden, and—yes—a lack of fiscal discipline has driven combined provincial balances from a surplus just two years ago to a deficit of nearly 1% of GDP now. Provincial debt alone is now just over 30% of GDP. Bottom Line: The overriding trend in the past 15 years has seen a significant shift in the debt burden from the household sector to the shoulders of government (Chart 7). Nowhere has this shift been more dramatic than in U.S. federal finances. The problem is that many economies are now testing the limits of sustainability of that public sector debt, at a time when real interest rates have climbed and demographics are turning unfavourable. Reining in public finances will prove challenging when compromise is a dirty word and there is seemingly zero political appetite for restraint. This combination raises the risk of an abrupt financial market adjustment—a back-up in yields—when faced with a further deterioration in the budget deficit. |
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