Some in markets are perplexed that the US economy is holding up well, despite a dramatic tightening of monetary conditions. They see that higher interest rates and less available credit are having the predictable effect in hitting the housebuilding market, yet the consumer market more generally has stayed strong – and employment has remained at high levels.
There are two main reasons. Many people had extra savings from lockdown which they could draw on to sustain spending, whilst employment remained high. The US government has continued with an expansive fiscal policy, offsetting some of the monetary severity. We now know that in the year just ended to September 30, 2023 – using the Congressional Budget Office adjustments for student loan accounting – the federal deficit escalated to $2 trillion, around double the previous year’s adjusted number.
Only the Covid years of 2020 and 2021 saw higher figures, as revenues fell away from lockdowns and special payments were offered to cushion the blow. The year to the end of September 2023 saw the deficit surge $320bn, or 23%, year-on-year to $1.7 trillion, before making the accounting adjustments over student loans.
Social security spending rose by 11%, thanks to an 8.7% cost-of-living increase and more recipients. Medicare rose by 18%. Debt interest charges soared by 33% and will carry on rising as the stock of US debt falls to be refinanced at new higher interest rates and as more is borrowed. At the same time tax receipts fell. Capital gains were well down thanks to falls in equity markets and housing. Some revenues were delayed by natural disasters in California, Alabama and Georgia where the Revenue Service gave more time for filings. There were higher claims for the Covid-related employment retention tax credit, where there were also allegations of too many fraudulent claims.
An ideological divide
The markets often criticise the Freedom Caucus of Republicans for blocking compromises on the Speakership. Underlying their disagreements with moderate Republicans and the Democrats are big arguments over how much the US government should spend, tax and borrow. The Freedom Caucus thinks it needs to make a stand against the remorseless rise in spending and borrowing, whilst others looking on would like a compromise that allows more of both.
Democrats are confident markets would finance a still larger deficit, and a larger deficit would provide more offset to Fed tightening. President Joe Biden wants an early $105bn increase to cover Ukraine and Israel costs. Whilst many of the pressures on bonds have resulted from the Fed action to drive up short-term interest rates, there is also concern about the large amounts of extra debt the administration will have to raise to fulfil its spending plans. Many investors think there is little need to panic about buying more Treasuries all the time you know there will be so many more of them on offer as the government spends and borrows its way to the future. The supply/demand balance in the market is further tipped by Fed sales of bonds it bought as part of quantitative easing.
The Republican/Democrat divide will include exchanges on taxation.
Treasury Secretary Janet Yellen was keen to stress that the main reasons for the larger deficit were a shortfall in tax revenues and a big increase in debt interest. She stressed that the president wants corporations and rich people to pay a fair share and pointed to actions already taken to get a guaranteed minimum tax take from companies and to close more loopholes for the rich. Nonetheless, the substantial rises in Medicare and Social Security are also part of the budget problem, alongside the need to spend more on defence in an uncertain world. She asserts an extra $100bn on defence for Ukraine and Israel is affordable without offering new tax proposals to pay for it.
The independent Congressional Budget Office (CBO) has, for some time, been flagging the likely upwards trend of spending and the deficit in the years ahead. Its summer forecasts for the long-term suggested US state debt could reach 180% of GDP by 2053 and the deficit could reach 10% of GDP compared to the 6% level of today. It has been trying to engage the politicians in an informed debate about how much is affordable in the longer term. It foresees deficits running at or above 5% stretching well into the future, with slower economic growth available to generate more tax revenue needed to afford the spending. The White House put out more modest increases in the deficit in its ten-year numbers. The deficit is already coming in well ahead of the figures it laid out.
The Republican/Democrat divide will include exchanges on taxation. Many Republicans want to defend the Trump tax cuts for individuals which expire in 2025. Most will oppose any further moves by the Biden Administration to invent new taxes on the rich and on profitable companies. Now we have a new Speaker in the post there will be battles in Congress over the supplementary defence package and how much goes to Ukraine and about the size of the annual budget for this year which is still to be agreed. Meanwhile, fiscal stimulus will continue to help output and offset some of the monetary severity.
In CBO’s projections, the deficit equals 5.8% of gross domestic product (GDP) in 2023, declines to 5.0% by 2027, and then grows in every year, reaching 10.0% of GDP in 2053. Over the past century, that level has been exceeded only during World War II and the coronavirus pandemic. The increase in the total deficit results from faster growth in spending than in revenues. The primary deficit, which excludes interest costs, equals 3.3% of GDP in both 2023 and 2053, but the total deficit is boosted by rising interest costs.
By the end of 2023, federal debt held by the public will equal 98% of GDP. Debt then rises in relation to GDP, surpassing its historical high in 2029, when it reaches 107% of GDP, and climbs to 181% of GDP by 2053. Such high – and rising – debt would slow economic growth, push up interest payments to foreign holders of US debt, and pose significant risks to the fiscal and economic outlook. It could also cause lawmakers to feel more constrained in their policy choices.
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