The Gift That Stopped Giving

The Treasury Departed reported yesterday that the federal budget deficit increased to $319 billion for the first quarter of fiscal 2019 (October through December). The deficit was 42% higher than the first quarter of fiscal 2018. Tax revenue and other receipts were nearly flat at $771 billion, but spending increased nearly 10% to $1.09 trillion. On the revenue side, tax receipts were obviously constrained by the Tax Cuts and Jobs Act, which will reduce taxes by $1.5 trillion over 10 years. However, revenue from higher tariffs and excise taxes, as well as higher employment taxes, were just enough to offset the decrease in individual and corporate income tax receipts. On the spending side, the 10% increase was attributable to higher military and entitlement spending, as well as a sizeable increase in interest expense (up 19% year-over-year to $100 billion!).

We also learned this week that the national debt rose above $22 trillion for the first time. Together, the debt and deficit figures are quite troubling. We are supposedly enjoying a relatively prosperous economy. Unemployment is at 4%, wage growth is picking up, and GDP grew at slightly above 3% in 2018 – the fastest pace since 2005. Typically when the economy is this strong, we tend to see a decrease in budget deficits as robust economic activity yields higher tax revenues and there is less need for government spending (including transfer payments) to support the economy. According to an article in The Wall Street Journal today, “the last time the jobless rate was below 4%, in 2000, the U.S. ran a budget surplus of 2.3% of GDP for the year. Revenue that year rose 11% from a year earlier. And in 1969, when the jobless rate last touched 3.7%, the U.S. ran a budget surplus equal to 0.3% of GDP. Revenue was up 22% that year.”

This go round, by contrast, the Trump administration produced a double-whammy of major tax cuts and big increases in government spending in the waning stages of an economic expansion. The predictable result has been a spike in budget deficits, even though we were told that better economic growth would produce higher tax revenues and offset the spending increases. The chart below shows that deficits typically rise with the unemployment rate, which we use as a proxy for economic vitality. Today, the opposite is happening.

Sources: Congressional Budget Office and Bureau of Labor Statistics

Unfortunately, the outlook going forward only gets worse. While high budget deficits are expected to continue (and in fact increase quite significantly), economic growth is expected to slow from the strong pace of 2018. Both the Fed and the Congressional Budget Office are expecting 2.3% growth in 2019. In 2020, the Fed expects 2.0% growth while the CBO is all the way down at 1.7%. This softening in economic growth reflects a number of factors, including the economic slowdown outside the US; a stronger dollar; plummeting energy prices; the lagged effects of Fed interest-rate hikes; the fading effects of the tax cuts; and uncertainty with regard to trade, monetary and immigration policies.
Budget deficits, on the other hand, are expected to rise to 4.1-4.2% of GDP in 2019 and 2020 and remain at or above that level through 2029. By the year 2022, we will be running trillion-dollar annual deficits. Moreover, we would be remiss not to mention that these forecasts by the CBO do not include a recession, which we haven’t had in 10 years (read: we are overdue). What will happen to the budget deficits (and debt) if the economy falls into recession in the next few years? Will our politicians be less willing to go further into debt to support an economic recovery? Will investors in US Treasuries be as willing to accept such low yields as our debt load approaches $30 trillion? How about $40 trillion?

Sources: Congressional Budget Office and Bureau of Labor Statistics and Federal Reserve. GDP growth rate for 2020 is the average of the CBO projection (1.7%) and the Federal Reserve projection (2.0%)

The federal debt, and the resources needed to service that debt, continue to rise. The chart below shows that interest on the federal debt is expected to rise from $325 billion, or 1.6% of GDP, in 2018 to $928 billion, or 3.0% of GDP, in 2029. This is an enormous burden for an economy to overcome. And again, these projections by the CBO assume no recession, and they also assume only moderate increases in borrowing costs over the next ten years.

Source: Congressional Budget Office’s “Budget and Economic Outlook, 2019-2029,” published in January, 2019.

The fiscal challenges facing the country do not rise to the level of imminent crisis. This problem has been lurking in the background for quite some time, and it largely reflects the unsustainable promises our government has made in the form of entitlements. Having said that, there is also no way to know if or when the investors who buy our debt will begin to balk at our ever-worsening fiscal situation. It won’t become a crisis until suddenly it is. Furthermore, we are clearly going against conventional wisdom by running such large deficits at this stage in an economic cycle. We are becoming increasingly worried about having the resources, both fiscal and monetary, needed to support the economy during the next recession.