What’s Another Trillion or So?

Wednesday, the Congressional Budget Office (CBO) published its updated federal budget projections for the years 2019 through 2029. The figures were not encouraging. Due largely to the recent budget compromise between Congress and the White House, the CBO increased its budget deficit projections for 2019 and each of the ensuing ten years. The budget shortfall for 2019 is now expected to be $960 billion, up $64 billion from the CBO’s projection in May of this year. Thereafter, the budget deficits are expected to exceed $1 trillion in each of the remaining 10 years of the forecast period. On a cumulative basis, the deficits over the forecast period were increased by $870 billion to nearly $13.2 trillion. These projections, if they indeed materialize, would result in the federal government owing $34.4 trillion – or 112% of GDP – at the end of 2029. It is important to point out, though, that the CBO’s projections do not incorporate the effects of any recessions over the forecast period. If recessions had been included, the deficit and debt projections would likely be much higher.

This is just the latest piece of distressing news about our deteriorating fiscal future. Despite relatively stable economic growth over the 10-year expansion since the end of the Great Recession, deficits have climbed to levels normally associated with economic downturns. During recessions, for example, the federal government would be expected to run above-average deficits due to: 1) lower tax revenue resulting from lower household and business incomes; 2) higher benefits to support the unemployed; 3) stimulative tax cuts; and 4) increases in government spending designed to fill in a deficiency in demand. Once the pump is primed and the economy starts to recover, the deficits should start to fall due to higher tax receipts, lower transfer payments, and less need to fill a deficiency in demand.

The Trump administration justified the large tax cuts and spending increases of 2017 and 2018 by saying that the actions would spark a sustained acceleration in economic growth to 3% or even 4%. The higher rates of economic growth, they said, would produce more tax revenue (and therefore a more balanced budget) than would have been possible under the higher tax rates. This is classic supply-side economics. Unfortunately, the plan hasn’t gone according to script. GDP growth did accelerate a bit in 2018 to 2.9% from the 2.4% reported for 2017. However, the consensus opinion is that growth is set to slow in 2019 and 2020 until we once again reach the 2% rate of growth (or lower) that has been the trend since the recession ended. At the same time, the budget situation has deteriorated meaningfully. The expected growth in tax revenue needed to offset the tax cuts and spending increases has not materialized. In other words, the stimulus measures implemented over the past two years generated very little bang for the buck. The outlook for economic growth appears no better, yet we remain stuck with the hefty tab.

We have argued for quite some time that the administration’s actions were highly unlikely to achieve their goal of sustainably higher rates of economic growth. The tax cuts and spending increases (mostly on defense) did not address the major issues preventing the economy from growing at a faster pace. We said that a far better use of those resources would be investments designed to improve labor productivity and competitiveness in an increasingly global economy. Specifically, we supported investments in education, infrastructure, emerging industries (biotech, green energy, artificial intelligence and machine learning), and efforts to combat the negative effects of climate change and chronic health conditions. Cuts in corporate tax rates, which were arguably justified in the name of competitiveness, should have been conditioned upon investment expenditures rather than simply offering carte blanche. In the absence of firmer demand for their products and services, we said that corporations were much more likely to simply continue buying back their own stock rather than ramping up investment spending. And more than all else, we worried that the tax-cut windfall would accrue to those who have already been doing spectacularly well – the wealthy – while the middle class would continue to struggle. In a nutshell, we said that any near-term, stimulus-induced improvement in economic growth was likely to prove transitory if we continue to ignore the long-term structural impediments to higher growth.

One of the obvious drags on economic growth has been the trade war with China. Some economists believe that the negative effects of that trade war, rather than any longer-term structural economic challenges, are the main force driving slower growth. But while trade is certainly a factor, it is not the only (or even the primary) factor that is holding back the economy. An article in the Wall Street Journal this week read, “The CBO said Wednesday higher tariffs are expected to reduce the level of U.S. GDP by 0.3% by 2020, primarily by raising prices, which reduces consumers’ purchasing power and increases the cost of business investment.” Given that the CBO expects GDP growth to slow from 2.9% in 2018 to 2.1% in 2020, and that expected growth over the next several years is far below the administration’s targets of 3%-4%, I think it’s fair to say that the impact of the trade war only accounts for a small part of the problem.

If you’re an economist, data rarely get any clearer than the chart below. The chart shows that the large stimulus initiatives of 2017 and 2018 were not successful in generating sustainably higher rates of economic growth. In response to this inconvenient truth, it is now being reported that the administration is mulling still more tax cuts in response to slowing growth. In addition, President Trump continues to pound Fed Chair Powell daily about cutting interest rates, perhaps by as much as 1%. These developments beg the question, how much capacity will be left to respond to the next recession? This is not a trivial issue. When the next recession comes (and it will), we may find ourselves without much ammunition.

Everybody loves tax cuts, but lower taxes are not a panacea for all economic ills. Our leaders, from both political parties, have been spending at unsustainable rates for far too long. Low interest rates have been the enabler. In fact, some are beginning to opine that deficits no longer matter in an environment of very low interest rates. We emphatically disagree. Sooner or later, we will all have to pay the tab, whether it be through higher taxes or much higher rates of inflation (loss of purchasing power).

There are a couple of investment implications we can glean from the deteriorating fiscal situation. First, while it seems that interest rates will remain very low far into the future, there will come a point when rates are pushed higher as a result of rising credit risk, a surge in inflation, or both. From this standpoint, buying long-term bonds at current rates seems like a losing proposition. Second, there will come a time when the sheer amount of government debt will crowd out private investment, and this could very well cause additional damage to the economy. By and large, though, this is not a problem that our generation will be forced to solve…or is it? The day of reckoning could be closer than many believe.