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Our Ever-Expanding Fiscal Deficit

Why the U.S. economy is positioned to avoid the severe side effects afflicting many other countries with ballooning deficits

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Robert T. McGee, Head of Macro Strategy, Chief Investment Office, Bank of America Private Bank

Robert T. McGee, Head of Macro
Strategy, Chief Investment Office,
Bank of America

Fears surrounding government deficits and debt have been a central feature of political discourse in America since the days of the Founding Fathers. Indeed, the idea of a central government with perpetual debt was a significant point of contention between Alexander Hamilton, the first Secretary of Treasury, and Thomas Jefferson, the first Secretary of State — a conflict that contributed to the formation of our earliest political parties and the bipartisan nature of the United States political system. Chronicles of the debates in the early days of the republic make it clear that the bitter animosities of today’s political scene are nothing new.

Hamilton, who was heavily influenced by the British system, believed in a large marketable pool of government debt and a private central bank like the Bank of England, which was at that time already a century old and had been established to help finance England’s wars with France. In his quest to build a strong central government, Hamilton recognized the importance of governmental access to finance, but he confronted significant opposition. In fact, the debate over a U.S. central bank continued until 1913 with the creation of the Federal Reserve System.

Prior to the establishment of a central bank, and with a low tax base largely reliant on tariffs, government debt generally mushroomed only during wartime. However, the creation of entitlement programs like Social Security in the 1930s and massive defense expenditures in the 1940s solidified the government’s dependence on income taxes and significant borrowing. Since then, spending on entitlement programs has been growing at a much faster rate than the overall economy, which has led to widespread concern about the debt and deficit. (See “U.S. Debt Nears Highest on Record,” below, to track the fluctuation of the U.S deficit over time.”)

U.S. Debt Nears Highest on Record

Though the U.S. debt and deficits have approached the highs reached during World War II, that doesn’t mean it’s time to panic.

U.S. debt by year as a percentage of GDP

Source: U.S. Treasury/Haver Analytics. Data as of 3/6/2018.

The factors at play

So why hasn’t this spending and the concomitant and ballooning Federal deficit created the much-feared economic instability? Understanding the interactions between a changing supply of government debt, central bank policy and the balance of payments between the U.S. and the rest of the world can help shed light on why we haven’t really seen any symptoms of a serious debt problem since the Revolutionary War, when the institutions to manage it had yet to be created. Here are the key considerations:

The U.S. money supply

Most important, U.S. government debt forms the basis for the U.S. money supply. The Federal Reserve buys Treasury securities when it wants to expand the money supply. Over the past 70 years, aside from the recent period of quantitative easing after the financial crisis of the late 2000s, normal growth in this central bank demand for government debt has hovered around 6%, roughly in line with the growth rate in cash flows through the economy and nominal gross domestic product (GDP). This implies that once the Fed normalizes its balance sheet, likely somewhere in the range of $2 trillion to $3 trillion, natural growth in Treasury debt for money supply purposes will be in the range of $120 billion to $180 billion a year — let’s call it about $150 billion of new debt demand each year. This is “monetized” debt that is never paid off and is essentially interest-free since the Fed refunds the interest payments to the Treasury.

The ratio of debt

The assumption of nominal GDP growth of about 5% to 6% per year along with a fixed ratio of government debt-to-GDP implies a fiscal deficit of 5% or 6% of GDP in addition to the Fed’s monetary requirement. Since the level of nominal GDP is about $20 trillion, 5% of it is about $1 trillion. A deficit of $1 trillion plus the monetary base requirement of about $150 billion implies that a deficit of $1.15 trillion would keep the ratio of outstanding non-Fed-held government debt-to-GDP constant around current levels, which currently show no signs of straining the economy. Furthermore, Congressional Budget Office projections for the fiscal deficit for the next 10 years are below 5% of GDP.

The influence of interest rates

The level of interest rates also influences the sustainability of government debt, as we often see in emerging markets. Rates far higher than GDP growth are usually a sign of serious debt problems. Fortunately, U.S. rates are typically in the same ballpark as nominal GDP growth, and have been even lower in recent decades, allowing for higher levels of sustainable debt.

“Similar to concern about the size of the debt, concern about foreign holdings falls in the class of chronic worries that never turn into real-world problems.”

A question of ownership

Another consideration in gauging the sustainable level of government debt is who owns it — domestic or foreign investors. People often express concern, for example, that large Chinese or Japanese holdings of Treasuries make the U.S. vulnerable to abrupt selling by these foreign holders. Similar to concern about the size of the debt, concern about foreign holdings falls in the class of chronic worries that never turn into real-world problems, and several factors explain why.

First, the flipside of the outflow of dollars fueled by the U.S. trade deficit is foreign use of those dollars to invest in the U.S., and the premier reserve currency status of the U.S. dollar adds to external demand for greenbacks. A substantial share of this foreign investment in the U.S. takes the form of U.S. Treasury holdings as many foreign investors live in less stable environments and seek Treasuries as a lower-risk investment compared to those in their own countries. Furthermore, the U.S. central bank can print as many dollars as it needs to balance economic forces like interest rates and inflation; this capability contrasts with the plight of countries that borrow dollars but don’t enjoy that “exorbitant privilege,” sometimes precipitating financial crises when they can’t repay the dollar debt.

To be sure, too much debt can make investors nervous. In trying to discern the future, however, investors often look to the past for perspective, and as a result of the foregoing dynamics, thus far the U.S. has avoided the negative consequences of excessive government borrowing. The growth of the government debt has largely been within the parameters set by the size and growth rate of the economy that generates the tax revenues to finance the government. In addition, the U.S. enjoys wider latitude to borrow beyond the limits constraining most other countries. And finally, the United States enjoys a more stable monetary history than other major economies as well as the world’s premier reserve currency status. As we see our debt expand along with the economy, it’s fair to trust in a substantial external demand for it, adding to the fiscal capacity of our economy.

Comparing the limits set by these factors with Congressional Budget Office projections for future fiscal deficits, the U.S. government will more than likely be able to finance future borrowing without the severe side effects seen in many other countries with big deficits. It’s a large pool of debt, yes. But it remains in high demand with historically low interest costs. Hamilton would be pleased.

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