US' exploding budget deficit

The United States has an enormous and rapidly widening budget deficit. Under existing law, the federal government must borrow $800 billion this year, and that amount will double, to $1.6 trillion, in 2028. During this period, the deficit as a share of GDP will increase from 4 per cent to 5.1 per cent. As a result of these annual deficits, the federal government’s debt will rise from $16 trillion now to $28 trillion in 2028.

The federal government’s debt has risen from less than 40 per cent of GDP a decade ago to 78 per cent now, and the Congressional Budget Office (CBO) predicts that the ratio will rise to 96 per cent in 2028. Because foreign investors hold the majority of US government debt, this projection implies that they will absorb more than $6 trillion in US bonds during the next ten years. Long-term interest rates on US debt will have to rise substantially to induce domestic and foreign investors alike to hold this very large increase.

 

Why is this happening? Had last year’s tax legislation not been enacted, the 2028 debt ratio would still reach 93 per cent of GDP, according to the CBO. So the cause of the exploding debt lies elsewhere.

Illustration: Binay Sinha

The primary drivers of the deficit increase over the next decade are the higher cost of benefits for middle-class older individuals. More specifically, spending on Social Security retirement benefits is predicted to rise from 4.9 per cent of GDP to 6 per cent. Government spending on health care for the aged in the Medicare programme — which, like Social Security, is not means tested — will rise from 3.5 per cent of GDP to 5.1 per cent. So these two programmes will raise the annual deficit by 2.7 per cent of GDP.

This officially projected increase in the annual deficit would be even worse but for the fact that the cuts in personal income tax enacted last year will lapse after 2025, reducing the 2028 deficit by 1 per cent of GDP. The official deficit projections also assume that the recently enacted increases in spending on defence and non-defence discretionary programmes will be just a temporary boost. Defence spending is expected to decline from 3.1 per cent of GDP now to 2.6 per cent in 2028, while the GDP share of non-defence discretionary spending will fall from 3.3 per cent to 2.8 per cent. These deficit-shrinking changes are unlikely to happen, causing the 2028 deficit to be 7.1 per cent of GDP – two percentage points higher than the official projection.

If a deficit amounting to 7.1 per cent of GDP were allowed to occur in 2028, and to continue thereafter, the debt-to-GDP ratio would reach more than 150 per cent, putting the US debt burden in the same league as that of Italy, Greece, and Portugal. In that case, US bonds would no longer look like a safe asset, and investors would demand a risk premium. The interest rate on government debt would, therefore, rise substantially, further increasing the annual deficits.

Because financial markets look ahead, they are already raising the real (inflation-adjusted) interest rate on long-term US bonds. The real rate on the 10-year US Treasury bond (based on the Treasury’s inflation-protected bonds) has gone from zero in 2016 to 0.4 per cent a year ago to 0.8 per cent now. With annual inflation running at about 2 per cent, the increase in the real interest rate has pushed the nominal yield on 10-year bonds to 3 per cent. Looking ahead, the combination of the rising debt ratio, higher short-term interest rates, and further increases in inflation will push the nominal yield on 10-year bonds above 4 per cent.

What can be done to reduce the federal government’s deficits and stem the growth of the debt ratio? It is clear from the forces that are widening the deficit that slowing the growth of Social Security and Medicare must be part of the solution. Their combined projected addition of 2.7 per cent of GDP to the annual deficit over the next decade is more than twice the officially projected rise in the ratio of the annual deficit to GDP.

The best way to slow the cost of Social Security is to raise the age threshold for receiving full benefits. Back in 1983, Congress agreed on a bipartisan basis that this threshold should be raised gradually from 65 years to 67, cutting the long-run cost of Social Security by about 1.2 per cent of GDP. Since 1983, the average life expectancy of individuals in their mid-60s has increased by about three years. Raising the future age for full benefits from 67 to 70 would cut the long-run cost of Social Security by about 2 per cent of GDP.

At this time, slowing the growth of Social Security and Medicare is not a politically viable option. But as the deficit increases and interest rates rise, the public and the Congress might return to this well-tried approach.

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Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984

©Project Syndicate, 2018

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