As deficits spiral out of control, the ability of the US government to function and make decisions is diminishing. The combination of the prolonged debt ceiling discussions that came down to the 12th hour in early June following weeks of wrangling, followed by the last-minute approval by Congress of an interim 2023-24 budget two weeks ago just before the deadline, is not a good reflection on the United States, the world’s largest and arguably most transparent democracy. Both of these two events less than six months apart threatened to shut down the US government, creating un-necessary uncertainty and adding risk to the financial system.
As Moody’s quite rightly debates whether or not to strip the US of its last Aaa rating and investors prepare for another contentious budget discussion prior to the expiry of the interim budget on November 17th, it is bewildering to me why US government leaders cannot work together to find a common agenda for the people.
I would consider all this good entertainment were it not for the fact that bond investors seem to be noticing – real rates have risen to their highest level since the GFC. The US is fortunate in that it has the leading global reserve currency – the almighty US Dollar – and the largest, most liquid and (still) most respected government bond market in the world. Try as it may, even a misbehaving Congress hasn’t undone the status of the Dollar or US Treasuries, perhaps at least partially because there is no viable alternative, at least not yet. Congress should be grateful that the prominence of the US currency and US government bond market largely shield the country from their dysfunctionality, because if not, the price to be paid would be much more dear.
For those of you that have followed global government bond markets for a long time, you know that no country in the world could get by with murder like the US. Even the UK was nearly brought to its knees just over a year ago when a proposed budget increased the deficit too quickly, causing Sterling to get hammered and Gilt yields to rise to levels not seen in years, all in a matter of hours. The budget had to be withdrawn and the BoE had to intervene to stabilise a situation that was quickly spiralling out of control. Look at it this way – the US has a perpetual “get out of jail free” card as far as fiscal ineptitude, a fortunate attribute especially during a time like now when Congress cannot get out of the way of itself.
As dysfunctional as it is at the moment, the fact is that US government leadership has drawn together during crisis periods, saving the country from what would have likely been longer and deeper recessions during both the Great Financial Crisis and the Pandemic. The “secret sauce” was a combination of accommodative fiscal and (unconventional) monetary policies. However, now the price must be paid as both fiscal and monetary policies need to be “normalised”. This article will discuss fiscal policy, an area that the US – if it were a student – would be close to failing.
The vocal right Republicans have a point
The infamous eight ultra-right Republicans that have been a thorn in the side to the mainstreamers in the party have exploited the narrow advantage that Republicans have in the House, essentially high jacking the party on many important issues. Having said this, they are right in wanting to force some sort of fiscal discipline on the government in order to restore the US to a more stable financial footing. Government debt is simply too high and – even more concerning – deficits are increasing to unsustainable levels. Something has to be done.
US national debt
The US has the largest amount of government debt in the world by a landslide, currently $33.5 trillion and counting.[1] The debt of a country naturally increases as its economy grows, so debt needs to be examined in the context of the size of the economy, not on an absolute basis. This is not troubling so long as debt-to-GDP does not drift too far above a level that represents fiscal responsibility. The graph below illustrates how the debt-to-GDP of the US has changed since 1966.
In particular, the debt-to-GDP of the US has been moving in the wrong direction since the GFC, and it has worsened year after year under both Democratic and Republican leadership since then.
The table to the right illustrates the debt-to-GDP and debt ratings of the G7 and Australia for 2022. As the table suggests, the US is fortunate to still have its existing debt ratings, hardly deserved when looking at the ratio of total debt-to-GDP compared to lower rated countries with better debt ratios. Even more troubling is the combination of “direction of travel” of deficits and the current bipolar and dysfunctional state of the US government, which inhibits a pragmatic approach to reducing deficits over time.
US deficits
The US largely ran a balanced budget until the mid-1970s, after which deficits started to occur regularly. The last time the US ran a budget surplus was under the leadership of President Bill Clinton from 1998 to 2001. Since then, both Democratic and Republican parties have dug a deeper and deeper hole, as you can see in the graph below.
The US deficit for the first 11 months of 2022-2023 (Oct 1 to Aug 31) was $1.5 trillion (5.7% of GDP), up from $600 billion in the first 11 months of 2021-22 (3.8% of GDP)[2]. The US will probably never pay down its debt because the economic cost would be too severe. However, the US is certainly capable of getting its house in order by reducing its annual deficits.
Should deficits occur at all?
Countries should run balanced fiscal budgets over a business cycle. It is normal for deficits to occur during economic downturns and for surpluses to occur during economic booms, both acting as automatic stabilisers. However, this is rarely the way it works in practice. In the US, Congress now spends money like a drunken sailor, whether in good times or bad, and regardless of which party is in power. The issue with many Democrats is that they want to continue spending on a variety of social programmes, and the issue with many Republicans is they want to reduce taxes (but keep spending on defence). These are not compatible with deficit reduction, and the leadership has shown no willingness to search for a compromise.
Recommendations
I will put forth several recommendations:
Balance the budget: This probably goes without saying but, practically speaking, has proven elusive. The budget should be balanced by choosing a reasonable timeframe over which to achieve this, and to do it through a combination of higher taxes and lower expenditures. To be fair, I believe that every expenditure item should be on the table. Entitlement programmes like Social Security should not escape given the dramatic change in demographics the country has and will continue to experience. Taxes need to be increased, although I shudder writing this. Personally, I would prefer the libertarian approach of a smaller government altogether, but this is not an objective that can be readily achieved anytime soon. The deficit gap must be acknowledged and closed over a reasonable period of time. To achieve this, US leadership must be pragmatic and make difficult choices if it wishes to right its sinking financial ship. Perhaps a small but representative committee of Democrats and Republicans from both houses should be set up to work on this together under the leadership of the President.
Reform Congress: Impose term limits on members of Congress. Professional politicians never seem to get it entirely right. The longer elected officials are in power, the more their own personal well-being moves to the forefront at the expense of their constituents. According to the Pew Institute (here), the median age of members of the House is 57.9 years, and the median age of Senators is 65.3 years. Our current President is 80 years old and is planning to run for a second term, which would – if elected – make him 86 years old in 2028 when his second term would finish. The average age of the US population is 38.9 years old according to the most recent data from the Census Bureau. There is a serious disconnect. We need younger and less narrow minded people running the country, not ones so entrenched in their own world and focused so intently on their party’s self-interest that they cannot see the forest for the trees. One way to improve this and keep the thinking “fresh” would be to impose term limits on elected officials in both the House and Senate.
Shorten the campaign cycle: Elections in the US are tiring, in that (partially related to there being no term limits), elected officials always have one eye on re-election from the moment that are elected. And the money that goes into campaigns that can drag on for months, or even years (Presidential), could be better spent elsewhere.
Introduce a viable third party: This speaks for itself and is simple. Neither Republicans nor Democrats are covering themselves in glory at the moment, but both share a common interest in ensuring a viable third party never emerges to threaten their duopoly. You can’t get by with this in the business world, so why are US politicians allowed to get by with it? It’s simple – Dems and Reps have all the money and can garner the resources to make sure a viable third party never emerges. Rarely does even in independent candidate get elected, as smart as it would seem to have gobs of independent (or third-party) representatives in Congress to provide a more centrist and balanced approach in both Congressional houses, hopefully offsetting the ineptitude of extremists in both parties.
Conclusion
I hope Congress can get its act together before it’s too late, because otherwise the US might pay a severe price. This would happen so quickly that investors would find it difficult to find cover from UST yields spiking and the Dollar losing its relevancy as a global reserve currency. A bipartisan plan must be developed to reduce deficits, and concurrently, Congress and certain aspects of the US political system should be reformed.
[1] Source is usdebtclock.org. [2] Source is Brookings Institute here.