Are Ballooning Deficits a Problem for the Economy and Markets?
Rising deficits have been a major story in the headlines recently, and for good reason. According to the Congressional Budget Office, the gap between spending and revenue was $1.7 trillion in fiscal year 2023, which means the deficit grew by $300 billion year-over-year—even as the economy was expanding.1
Federal budget deficits keep growing
The on-again off-again student debt cancellation program resulted in some distortions to deficit calculations. In 2022, student debt cancellations resulted in a $300+ billion addition to the deficit, but following the Supreme Court decision that ruled the program unconstitutional, Treasury accounted for those dollars as a spending cut in 2023. Even still, accounting for these quirks, the federal deficit was more than 7% of GDP in fiscal 2023. Rarely do we see deficits this large during an economic expansion.
Without legislation to curb spending or raise revenues, some estimates show U.S. debt rising from 96% to 123% of GDP over the next 10 years. Nearly all of the increase would be driven by the primary deficit.
Last week, I argued that stronger-than-expected economic growth was putting upward pressure on interest rates, but I also cited growing deficits as a factor to monitor. The U.S. Treasury Department announced over the summer that it would gradually increase the size of its debt auctions to account for the increased spending, which led to some jitters over whether the market could absorb all of the new debt without demanding higher interest rates.
As I wrote last week, the latest Treasury bond auctions show that the market is indeed absorbing new issuance with little issue, and foreign holdings of U.S. debt are up over $500 billion since October 2022 and approaching an all-time high. It may not be a major issue now, but if deficits only continue to rise from here, debt issuance will need to go up too—and the market’s appetite for U.S. Treasury bonds isn’t infinite. Rates would need to go up, too.
For now, it’s important to scale the deficit issue and think about it in relative terms when considering the economic and market impact. To do that, the key data point to hone in on is how much the U.S. government is paying for its debt, i.e., interest costs as a percent of GDP. Interest payments – looked at in a vacuum – point to ballooning costs, with Treasury spending $711 billion in interest payments in 2023 compared to $177 billion in 2022. Higher rates are playing a central role, and the issue could get costlier going forward as more than half of government debt matures in less than three years. If rates stay elevated, this debt will become significantly more expensive.
If we look at interest payments as a percent of GDP, however, the situation looks a bit less alarming. As seen in the chart below, high rates in the late 1970s and early 1980s pushed interest costs as a percent of GDP to levels much higher than we’re seeing today, and the U.S. economy managed to work its way through it—though not without some turbulence along the way.
Federal debt interest payments as a percent of GDP
Bottom Line for Investors
The upshot looking forward is that higher interest costs on U.S. debt could result in a greater appetite for fiscal tightening. Ongoing congressional gridlock and an upcoming presidential election may not make deficit reduction legislation likely in the coming year, but history suggests Congress may soon view it as an economic imperative. The elevated interest expenses cited above in the chart led to several rounds of deficit reduction legislation in the mid-1980s and in the years following, which ultimately resulted in a budget surplus in the mid-1990s. A key motivation for deficit reduction during that period was that ballooning interest payments were “crowding out” other more productive—or at least more popular—areas of spending. We could see this scenario play out again soon.
No administration wants to accept the reality that spending needs to go down and taxes need to go up, or at least economic growth needs to accelerate swiftly (which would result in higher tax revenues) without additional deficit spending. However, recent history suggests the market will respond accordingly if fiscal policy heads in the wrong direction. Last fall, a new government in the U.K. proposed a tax cut amid rising spending and inflation, and British bond yields surged immediately. The proposal was scrapped within a few days.
Disclosure
2 Fred Economic Data. September 13, 2023. https://fred.stlouisfed.org/series/MTSDS133FMS#
3 Fred Economic Data. September 28, 2023. https://fred.stlouisfed.org/series/A091RC1Q027SBEA#
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