The non-partisan Congressional Budget Office (CBO) released its updated federal budget projections last week, and the figures were not far off from the CBO’s prior projections in September. The biggest discrepancy between the two sets of projections is that the new 2021 deficit, at an estimated $2.26 trillion, is about $450 billion higher than the previous estimate. It’s important to note, though, that this increase does not reflect the up to $1.9 trillion in additional spending that is expected to pass Congress in the not-too-distant future. The CBO will incorporate that additional spending, if it indeed passes, in its next round of estimates. But what’s another couple of trillion?
There has been a lot of media attention devoted to the massive increase in budget deficits associated with the COVID response. If the CBO’s figures are correct, the US government will spend nearly $6.5 trillion more than it takes in over the three years ending in 2022. Another $1.9 trillion will obviously lead to a higher figure. Anxieties are running high that the debt will become so burdensome as to cripple the economy going forward. Another concern is that the massive increase in deficit spending, coupled with the Fed’s continued liquidity injections and interest-rate suppression, will lead to a big spike in inflation. Both are valid concerns. In fact, even some prominent voices on the ideological left, like Larry Summers, are warning that these risks could outweigh the benefits of the massive COVID response.
The most powerful argument in support of an aggressive COVID response is the fact that interest rates are very low, making the federal government’s debt load much more manageable. A quick look at the chart below shows that the cost of servicing the massive increase in federal debt is not expected to be overly onerous by historical comparison. For instance, the CBO projects that federal interest costs of $303 billion in 2021 will represent just 1.4% of GDP compared to the long-term average (since 1962) of about 1.9%. The reason? The CBO expects the average interest rate on the government’s debt to fall to 1.5% in 2021 from about 2.0% in 2020. And the average interest rate is expected to keep falling to a low of 1.3% during 2023-2025 before rising to 2.4% by the year 2031. Based on those projections, interest costs as a percentage of GDP will increase to about 2.4% by 2031 – still just moderately above that long-term average of 1.9%. Doesn’t seem like a complete disaster.
But this narrative assumes the CBO’s projections are credible. We can say with some confidence that they are not. The factors that would most affect the CBO’s analysis are 1) its deficit projections; and 2) its interest rate projections. With regard to deficits, we’ve already noted that an expected $1.9 trillion in additional COVID-response spending is not even included in the analysis. The analysis also assumes no economic recessions over the next ten years, which is highly unlikely and would almost certainly cause higher budget deficits. Additional factors that could meaningfully affect budget projections might be higher-than-expected rates of health-care cost inflation, continued gains in life expectancies, and lower-than-expected tax revenues (driven by tax cuts, for instance). Suffice it to say that the CBO’s projections are hardly conservative.
But personally, my bigger concern is the interest rate projections. Specifically, I believe that the low interest rate argument (in favor of higher stimulus spending) loses some of its power given that the Fed has been artificially suppressing interest rates for many years now. In fact, interest rates have been held significantly below rates of inflation, which effectively means that you lose purchasing power if you loan the government money. Is it likely that investors in US Treasury bonds will continue to accept negative inflation-adjusted coupons as gross federal debt outstanding rises from the current $28 trillion to $40 trillion or more over the next 10 years? Maybe. The experience of Japan would say it is certainly possible to run up massive debt without sparking higher inflation and interest rates. But I wouldn’t want to bank on the hope that the US dollar will remain the reserve currency for the world forever no matter how much debt we run up. The willingness to finance profligate spending could continue for another 20 years, or some key investors (read: China) could recoil this year at the sheer size of our deficits. Nobody really knows.
And then there’s the possibility of a stimulus-induced surge in inflation, which we’ve discussed ad nauseam in previous Market Commentaries. This is Larry Summers’ big fear. He believes the combination of pent-up demand from COVID, loose monetary policy, high asset prices, the weak dollar, and another massive fiscal bill will be too much for the economy to withstand without overheating and causing inflationary pressures. Those inflationary pressures might then force the Fed to raise interest rates, causing a correction in asset prices and inducing a recession. Not an ideal scenario, for sure. According to Summers, “Stimulus measures of the magnitude contemplated are steps into the unknown. For credibility, they need to be accompanied by clear statements that the consequences will be monitored closely and, if necessary, there will be the capacity and will to adjust policy quickly.” To translate, Summers doesn’t believe that Congress or the Fed can be trusted to take the punch bowl away quickly enough, if need be, by raising interest rates, raising taxes or cutting spending. But, importantly, he also doesn’t want to leave ourselves without the resources to invest in education, infrastructure and green energy, among other areas, which have been neglected and are so important to maintaining our global competitiveness and reducing the economic inequality that has hamstrung the economy for so long now.
This type of economic policy is extremely hard to get right. Yet the capital markets continue to assume a highly favorable, if not Goldilocks, outcome. The high level of investor complacency raises the stakes for policymakers. It’s not a time to go out of the thin branches of risk.