The Debt Bomb

A couple times each year the Congressional Budget Office, which is a non-partisan government agency, releases its federal government budget projections for the next ten years.  The most recent update we received from the CBO was in August.  In the graph below we show their projections, along with historical data going back 50 years to 1966.  You will see that the budget deficit, which is the difference between budget outlays (blue line) and tax revenue (orange line), has narrowed quite significantly since the end of the Great Recession in June, 2009.  The narrowing in the deficit has been the result of tax revenue growing at a much faster pace than budget outlays (spending) from 2009 to 2015.  This is a very positive development as it relates to our nation’s balance sheet and credit standing (US sovereign debt lost its AAA-rating from S&P in 2011).  However, as we look out over the next 10 years, the CBO believes that the deficit will begin to expand again, mostly reflecting sharp increases in entitlement spending and interest on debt.  In fact, the deficit is expected to more than double to $1.24 trillion by the year 2026, which would equate to 4.6% of GDP compared to an expected deficit of 3.2% in 2016.  Still, the 4.6% is well below the peak of 9.8% reached in 2009.

9-21-1Source: Congressional Budget Office   

The problem is that the CBO’s estimates just aren’t credible.  If we take a look at the CBO’s breakdown in outlays (spending), it becomes clear that the agency is in no way being conservative with their prognostications.  Let’s start with the spending categories that are fairly predictable and that we know cannot be avoided (as long as Congress doesn’t pass legislation resulting in reforms).  As long as we make reasonable estimates for inflation, it should be relatively straightforward for CBO actuaries to predict future entitlement spending.  We know that the working-age population is aging rapidly, and we know that there will be fewer people of working age to support those baby boomers who are retiring.  Therefore, the CBO’s projections for future Social Security, Medicare, and Medicaid spending should be within the realm of reality.

Now let’s get to the numbers.  The aggregate outlays for Social Security, Medicare and Medicaid are expected to rise by 6.0% annually from 2016 to 2026 to more than $3.5 trillion.  At this level of spending, these three programs will represent 56.4% of total budget outlays in 2026 compared to an expected 51.0% in 2016.  Where could the CBO be wrong?   Well, people could live longer, or health care costs could rise more rapidly than expected, or immigration could be restricted.  The point is that these figures, although relatively predictable, are still highly subjective.

Perhaps even less predictable than entitlement spending are the interest payments on our debt.  We know how much debt we currently have, but we don’t know how fast that debt will grow, the trajectory of interest rates, or the funding mix (long-term vs. short-term).  The CBO’s projections assume that the yields on the 3-month Treasury bill and 10-year Treasury bond top out at 2.8% and 3.6%, respectively, by the year 2022.  If their estimates actually come to fruition, then our annual interest expense will ONLY grow 187% to $712 billion over the next 10 years – an annualized growth rate of 11.1%.  Also if the CBO is correct, interest on our debt will account for 11.4% of our total budget outlays in 2026 compared to an expected 6.4% in 2016.  But remember, these figures assume a fairly benign interest-rate backdrop in the future.  Interest rates and debt levels could certainly increase faster than the CBO is projecting.

So given the huge growth in entitlement spending and interest on our debt, who gets the short end of the stick?  Well, for one, the Department of Defense.  The CBO has defense spending growing at a 2.2% annual rate over the next 10 years compared to a 4.7% annual rate over the past 50 years.  They say that defense spending will represent 11.5% of total budget outlays in 2026 compared to an expected 15.0% in 2016 and compared to an average of nearly 25% since 1966.  After listening to all the campaign rhetoric about all the threats we face and the depleted state of our military, does anyone honestly believe that defense spending will grow at just 2.2% per year?

That just leaves all the rest.  After accounting for a surge in spending on entitlements and interest, and for very modest growth in defense spending, the CBO is projecting that spending on all other categories will rise at just 1.9% annually compared to the average annual growth rate of 6.5% since 1966.  Even more surprising, the “All Other” category will account for just 20.6% of total budget outlays in 2026 compared to an expected 27.6% in 2016 and an average of 31.6% over the past 50 years.  Someone’s going to have to figure out how to get blood from a stone.

9-21-2Source: Congressional Budget Office

Below we show the annualized growth rates in the different spending categories.  As you can see, the CBO is projecting just around 2% annual growth in Defense and “All Other”, which seems highly unlikely given the historical growth rates and the dysfunction on Capitol Hill.

9-21-3Source: Congressional Budget Office

We are not passing judgment on either presidential candidate’s policies.  In fact, we believe investments in infrastructure and education are long overdue as they should improve labor productivity, accelerate economic growth (thereby helping to reduce budget deficits), and raise living standards over time.  But we are also hearing about massive additional spending in a number of other areas, including defense, veteran’s benefits, tax cuts, additional entitlements, etc.  The question is how to pay for these things.  Neither candidate is willing to offer a plan to cover the costs of their respective spending plans.  And nobody is willing to acknowledge the elephant in the room that is entitlement spending.  We are concerned that unfettered spending growth will lead to meaningfully higher interest rates, which could crowd out private investment, lower economic growth, exacerbate the debt problem, and potentially lead to another financial crisis.  Something has to give.  We think the CBO continues to do the country a disservice by not telling it to us straight.