Bloomberg reported that the US recorded a budget deficit of $146.8bn in May, which is the largest for the month since 2009 when the US government had to bail out several financial institutions including Citi, AIG, and Goldman Sachs. This 66% increase in the gap between government spending and tax revenue since last year has mostly been attributed to tax reforms, which included a cut in the corporate tax rate from 35% to 21%. The full effect of this tax cut has yet to materialise and can only be reliably measured after at least a year of development; it is, however, estimated that the tax would lead to a $1.5trn loss of revenue over ten years, which is particularly alarming for the millennial generation.
It is important to clarify the difference between the budget deficit and national debt of a country. The budget deficit refers to the shortfall of tax revenue collections relative to government expenditures in a given period (e.g. one month or one year). The deficit needs to be continually financed by borrowing money through issuing Treasury Bills, for which the Chinese and Japanese Central Banks are currently the largest investors. However, the national debt is the total principal of all government securities issued till date or in simpler words, the sum of all previous budget deficits. Therefore, even if successive governments can enact policies which cut the budget deficit in the following fiscal year, the national debt will continue to rise until there is a budget surplus. The US national debt now exceeds $21trn.
However, it is the future generation of working people that will be forced to bear the debt-servicing costs, which are expected to rise unless the government finds a way to boost tax revenues. The tax cuts also occur at a time of an aging population in the US, with the ratio of elderly people (above 64) to working-age population rising to 23% in 2018 from 19% in 2010. This points to much higher levels of social security spending such as state pension and Medicare.
A Policy Error?
The Chief Global Strategist for Morgan Stanley, Ruchir Sharma, noted in an interview on CNN’s GPS that the tax cuts have come at a strange time when the economy is in its 9th year of expansion: “(…) if you are not going to run a budget surplus now, when are you going to run a budget surplus?” Keynesian theory has been touted by proponents of persistently high budget deficits; Keynes did propose expansionary fiscal policy during a recession to stimulate the economy and reduce unemployment. He also wrote about surpluses in boom periods to repay the previous debt and prevent excessive inflation.
It is imperative to note that 2018 marks the end of an era of cheap borrowing, with the Federal Reserve raising the Federal Funds rate to the 1.75%-2% target range last week. As credit becomes more expensive, so do the debt repayments. Those will need to be financed with even greater borrowing, cuts to US government spending on health care and education, or higher taxation. This problem is argued by economists to be insignificant for a country like the US, as long as investors are willing to purchase Treasury Bills (and so lend money to the government). Foreign investors held $6trn of US debt, while the Federal Reserve had a balance sheet made up of $4.5trn mostly in government securities before quantitative tapering started in October 2017. Finding buyers does not seem to be a problem for the US government, which could frame Donald Trump‘s fiscal policy as less reckless than it might seem.
The budget deficit is currently 3.5% of GDP relative to 10% of GDP back in 2009. Economic growth arguably has created the necessary fiscal space required to borrow more money. When the Chinese and Japanese Central banks hold $3trn-$4trn of this debt, it seems like global credit markets will not shun US debt, as has happened in Greece, Portugal, and Italy. The US T-Bills are still regarded as ‘riskfree’ due to the AAA rating despite the government debt exceeding 100% of GDP. This implies that the US is still far from reaching a tipping point, where debtholders lose confidence in a government’s ability to repay any money and refuse to lend at all.
As a side note, one other explanation cited is the currency; as a last resort, the Federal Reserve can print more money or utilise gold reserves if a crisis hits the economy. The lack of individual currencies within Eurozone countries meant Greece and other Southern European states could not inflate their way to solvency by printing money. This made the probability of default too high for any creditor to lend money. The result: Greece defaulted in 2015 on maturing debt before being rescued by the EU.
The role of interest should not be forgotten. Even if the US were able to continue raising the necessary funds, taxes would at some point have to rise (unless spending falls) to fund the ever-increasing repayments in a new era of rising interest rates. Any sudden or radical tightening in fiscal policy by future governments could trigger a recession if expectations for business/consumer spending fall as a response. Therefore rising national debt leads to an increased risk of a self-fulfilling economic downturn, given that future governments’ actions are unpredictable. At a debt to GDP ratio of 105%, it is natural for internal and external creditors to expect a higher interest rate to compensate for increased credit risk on interest payments, even if this risk is not substantial.
Facing high national debt means that the government is always at risk of breaching its debt ceiling, similar to a person’s credit card limit. A shutdown occurs when the government is unable to pay off maturing bonds for the month, cannot honour its immediate spending commitments with the money available, while being unauthorised to borrow more. This recently happened in January for three days when spending plans took longer to approve than planned. Congress must agree to extend the debt ceiling in order to enable the government to continue funding its obligations by rolling over previous debt (paying off old debt with a portion of the net proceeds from bonds issued). Negotiations on extending the debt ceiling have been suspended until March 2019, but there is fear that the Trump administration will continue to struggle to secure an extension which will satisfy funding requirements for more than a few months. Future attempts to raise the debt ceiling may be in vain unless strict spending cuts are agreed upon as a condition for showing better day-to-day fiscal management.
For now, there is no funding problem, provided all lenders continue to think the US is safe enough to invest in. There is unlikely to be one in the future unless a financial crisis in the likes of 2008-10 hits again. However, investors and observers should proceed with caution. With the fiscal deficit predicted to reach $804bn in 2018 (21% increase from last year), the rate at which national debt increases points to a future of high taxes and cuts to spending to service repayments in a new era of tightening monetary policy. Credit risk increases as debt grows larger. The government should communicate more clearly how they plan to control the growth in national debt. The same applies to the Federal Reserve to clarify how the pace of monetary policy will be impacted going forward.
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