As we approach the $20 trillion federal debt milestone amid a change of administrations it seems like a good time for sober reflection about the federal deficit. We have reached a point where the reported deficit is consistently $500-600 billion per year even in reasonably good economic times—recessions will only make it go higher. In the meantime, the federal debt outstanding grows faster than the reported deficit and has averaged just under $1 trillion annually over the last five years. (Last year’s disparity between the OMB’s reported deficit and the increase in debt was larger than normal due to the debt ceiling shenanigans in the fall of 2015). This fiscal mismatch is driven largely by demographics and as such has resisted the tendency of economic growth to pull the country towards budget parity or even surpluses as in the late 1990’s. The combination of tax increases and/or spending cuts which would be required to slow or reverse the trend is politically unpalatable and most likely counterproductive.
Readers will note that in past commentaries I have downplayed the significance of the deficit and offered reassurance regarding the ability of the federal government to continue to function in the face of these enormous and growing deficits. This is primarily due to the Federal Reserve Bank’s willingness to neuter Treasury debt through its quantitative easing (QE) programs, in which it exchanges newly created bank reserves for government debt—a process often misleadingly termed “money printing”. In essence, a government/central bank duopoly which can issue and purchase debt in its own currency is not subject to the normal operational constraints of debt management. However, there is an important caveat to that observation: the arrangement requires a shared agenda and the cooperation of both entities. If the central bank is unwilling to make large-scale purchases of Treasuries by expanding its balance sheet then the whole arrangement breaks down.
Thus far, Quantitative Easing programs in the US, Europe, and Japan have been conducted in the context of aiding economic recovery, not with the express purpose of suppressing interest rates during fiscal stimulus. Perhaps this is necessary to keep up the appearance of monetary prudence; otherwise, the specter of debt monetization comes too clearly into focus and the whole game starts to unravel. We have never seen an explicit combination of QE and meaningful fiscal stimulus in the developed economies. The Federal Reserve may be extremely reluctant to accommodate a larger deficit under these circumstances as it would likely be interpreted as undermining its independence. To put it simply, the decision-makers in Washington and New York still view QE as a tool to be employed in bad times, not in good ones.
This reluctance could be problematic. The new administration has tossed around stimulus proposals in the neighborhood of $500 billion, which sounds like a lot of money but in the context of the government’s budget really isn’t—especially since stimulus packages in Washington tend to be overstated. Still, adding another $500 billion to an expected $1 trillion of debt issued annually means the Treasury needs to sell an awful lot of bonds. It’s one thing for investors to absorb the new paper when prices are going up (yields are falling), but another one altogether when prices are falling and new supply is promised well into the future. We may yet see the return of the bond vigilantes—those semi-mythical creatures who enforce fiscal discipline by the raising interest rates of profligate countries.
As a bonus, the suspension of the debt ceiling expires in March 2017. It is a trite observation that politics makes strange bedfellows, but the sides in the battle to deal with an extension of the limit in either time or amount are apt to be truly bizarre. The Congressmen and pundits who for the last eight years have been decrying government debt and the deficit now find themselves with an administration of their own party which has advanced policies—tax cuts and stimulus—which will increase the deficit. We wait in bemused anticipation for the rhetorical contortions.
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