Focus
March 05, 2021 | 14:31
America’s Budget Albatross
America’s Budget Albatross |
The pandemic recession and resulting economic policy responses have left a legacy of high and rising federal debt, giving post-COVID fiscal consolidation greater urgency. The CBO’s long-term budget outlook released this week painted a bleak picture of the consequence of inaction. |
The pandemic-related relief bills passed during 2020 have ballooned the budget deficit. The $3.1 trillion shortfall for the fiscal year ended last September was a record high in dollar terms and a post-WWII high relative to GDP (14.9%). Since then, the Consolidated Appropriations Act was signed into law in December, with pandemic-related provisions worth $774 billion this year alone. The Senate is now considering the $1.9 trillion American Rescue Plan Act passed by the House of Representatives on February 27. Although the Senate version and final bill could trim the price tag, it’s unlikely to be reduced enough to prevent this fiscal year’s deficit from topping last year’s in dollar terms and taking a run at the post-WWII percentage-of-GDP title (note: from here on, all references to years are fiscal years). Probable back-to-back $3 trillion-plus deficits are in sharp contrast to the pair of precisely $1.0 trillion shortfalls forecast for these two years by the Congressional Budget Office (CBO) in its last pre-pandemic budget and economic outlook (January 2020) (Chart 1). According to the CBO’s current projection (February 2021), and before accounting for the House-passed American Rescue Plan Act (ARPA), the deficit profile falls below its pre-pandemic path next year and stays there for the remainder of the decade, albeit still drifting up over time. The CBO’s assessment of the ARPA only covers its direct budget impacts. These lift the deficit by $1.23 trillion this year and $440 billion next year. However, with the Plan weighing in at 5.7% of GDP this year and 8.9% in total, major macroeconomic feedback is looming that should reduce the Plan’s net effect on the deficit. Including the ARPA’s direct impacts, the deficit profile slips and stays below its pre-pandemic path beginning in 2023, despite the combined $5.0 trillion miss during the preceding three years. |
This astonishing result reflects two factors. First, the major fiscal relief measures were, are, or will be, temporary, such as the tax rebates and topped-up unemployment insurance payments. Second, February 2021’s economic outlook is more deficit-friendly over the medium term than January 2020’s. For example, interest rates are meaningfully lower, mostly reflecting the Fed’s very accommodative monetary policy. In 2023, for example, 3-month Treasury bill yields are projected to average 0.2% with 10-year notes at 1.5%. These compare to 2.0% and 2.7%, respectively, in the pre-pandemic projection. This results in a significantly lower profile for net interest outlays (Chart 2), despite a higher-running debt burden that’s destined to head even higher once the ARPA is signed. Indeed, lower net interest expenses can completely explain the lower deficit profile from 2023 onwards, on average. |
However, the ARPA should result in higher longer-term interest rates than in the CBO’s current baseline, given the Plan’s likely consequence of stronger real GDP growth and faster inflation, along with larger Treasury borrowing requirements. Indeed, the bond market has already begun to sell off. But, the ex-post interest rate profile should remain below its pre-pandemic path, if only because of the Fed’s new monetary policy framework. Another example is that inflation is meaningfully lower. During the four years ended 2023, inflation, as measured by the GDP price index, is forecast to run an average of 0.4 percentage points per annum below the pre-pandemic trajectory (Chart 3). Assuming the inflation elasticities of outlays and revenues are similar, and given outlays overwhelm revenues, slower inflation results in smaller deficits (and vice versa). The CBO’s lower inflation profile reflects the lingering economic and labour market slack in the wake of the recession. |
The current inflation projection exceeds the pre-pandemic path during the latter half of the period, by an average of 0.2 percentage points per annum. This reflects the economic policy responses—bigger budget deficits and quantitative easing—along with the Fed’s new monetary policy framework allowing inflation to run a little hotter. Compared to the CBO’s current baseline, we reckon the ARPA’s boost to real GDP growth with its positive budgetary impacts will trump the negative budgetary impacts of faster inflation and higher interest rates, at least for a few years. Despite the improved medium-term outlook for the budget deficit compared to the pre-pandemic perspective, there is growing concern about America’s fiscal situation. This reflects the fact that the improvement itself may prove fleeting, and deficits are still projected to be back on a deteriorating trend before the end of the period. It also reflects the fact that although the deficit is lower in relative terms, it remains high in absolute terms resulting in around $1 trillion being added to the public debt each year. And this is on top of the $3 trillion-plus average added during last year and this year, and with 2023’s pile-on likely being closer to $3 trillion than $1 trillion. The Biden Administration and congressional Democrats are poised to follow the ARPA with another fiscal package, likely containing some of the major (non-pandemic-related) tax and spending items on the policy agenda such as the $2 trillion climate-focussed infrastructure program. |
Under budget reconciliation rules, the Democrats can pass another bill for 2022 (the ARPA was for 2021). In the lead-up to the announcement of the ARPA there was talk of a combined ‘rescue and recovery’ bill that would include some of these agenda items. The idea was eventually scrapped, but this suggests follow-up legislation could arrive soon. And, the fact that the ARPA didn’t address the suspension of the debt ceiling ending on July 21 could be a hint of just how quickly the ‘American Recovery Plan’ might arrive. In the next fiscal package, increased taxes will help cover the cost of increased spending, as President Biden has already indicated. But, the aggregate magnitudes are unlikely to be identical, with spending increases greater than tax increases resulting in a larger cumulative deficit. Individually, this will likely be most noticeable in the 2021-2023 interval, with the deficit after a decade showing no change at all, as per budget reconciliation rules. Meanwhile, the federal debt continues to escalate. In the last pre-pandemic outlook, the debt-to-GDP ratio was projected to rise from 80.8% in 2020 to 98.3% in 2030 (Chart 4), with the CBO cautioning about the negative consequences of high and rising federal debt as it eyed the later years in the decade. Last year, the ratio was already 100.1%, more than a decade ahead of schedule, as the recession and policy responses inflated the numerator and depressed the denominator. In the February 2021 outlook, the debt-to-GDP ratio is projected to rise from 102.3% in 2021 to 107.2% by the end of the decade, topping the WWII-era record high (106.1%). |
Interestingly, the 2021 reading is projected to be the high-water mark for the next eight years, as the debt ratio stabilizes in the 101%-to-102% range give or take a couple tenths. The relative stability reflects the fact that the deficit-to-GDP ratio also stabilizes at, or within a few tenths under, 4% during the 2023-2027 interval (Chart 5). In turn, the relative stability here reflects lower net interest outlays. The debt-deficit-net interest nexus is the root cause of concerns over America’s fiscal future. It’s unclear how the ARPA and next fiscal package will alter these ratios given that they will affect both the numerator and the denominator. But, even if we assume benign influences, these relatively stable debt and deficit ratios give a false sense of fiscal security. As mentioned above, ‘stability’ means adding around $1 trillion to the public debt each year with the interest paid on the incremental debt adding to the budget deficit, assuming interest rates don’t change. The latter point emphasizes that ‘stability’ at high debt levels is more fragile than at lower levels, once interest rates start rising and magnifying net interest expenses. |
The CBO's long-term budget outlook (out 30 years) reiterated the negative consequences of high and rising federal debt. The most damning are rising interest rates, which the CBO models as being partly driven by the stock of government debt in the hands of the public. This ends up crowding out private investment which slows economic growth, a negative development for debt and deficit dynamics. It also increases Treasury’s net interest expenses, which, if not countered by higher taxes or lower spending (both bad for economic growth), results in even bigger budget deficits and, eventually, larger debt. In the 10-year outlook, by 2028, the debt and deficit ratios are already on the rise as 10-year yields drift up to the low-3% range by the end of the decade (not an unreasonable assumption). Over the following 20 years, the debt ratio is projected to double with the net-interest-driven deficit ratio testing the pandemic extreme (Charts 6 and 7), paths that increasingly risk a fiscal crisis along the way. Interest rates might not move up to the high-4% range by 2050 as the CBO projects, but there are other factors contributing to the deterioration including an aging population, slower labour force growth, restrained productivity and climate change. When the pandemic is well behind us, major efforts at fiscal consolidation will be required to skirt this long-term scenario. Spending growth will have to be reined in. But, there are limits to how much austerity can be achieved, be they political (two-year election cycles), social (aging society, income inequality) or environmental (climate change). Revenue growth will have to be spurred, probably by more than a reversal of the 2018 tax cuts, which is also politically problematic. The longer-term trends show a modestly rising GDP share of outlays with a mild falling share of revenues (Chart 8). It’s going to be difficult to flatten the former and lift the latter, which is another reason for the growing concern over America’s fiscal situation. |