How America's deficit spending boom might end

After bottoming out at US$438 billion (S$578 billion) and 2.4 per cent of gross domestic product in fiscal year 2015, the United States federal deficit has started growing again.

It was US$666 billion (3.5 per cent of GDP) in the fiscal year that ended last September, and with the big tax cut passed by Congress and signed by the President last December, and the spending deal agreed to by congressional leaders from both parties last week, it seems destined to break the US$1 trillion and 5 per cent-of-GDP barriers in the next couple of years.

What are we to make of this? There are a thousand different takes about the implications making their way through the ether already, so here is my contribution: A brief rumination on how this experiment in massive fiscal stimulus during good times might end.

There is only one historical episode even remotely comparable: That couple of years during the mid-1980s when then President Ronald Reagan's "Morning in America" had already dawned, yet the deficit was still at or close to 5 per cent of GDP.

But there was still some obvious slack in the economy then - the unemployment rate averaged 7 per cent in 1986, compared with 4.1 per cent now - and the deficit then fell sharply during the late 1980s.

It fell in part because politicians in both parties were so freaked out by it, with Congress voting for multiple tax increases and spending cuts.

When the 1990-1991 recession sent the deficit rising again, the political pressure to shrink it grew even stronger. Investors in Treasury bonds, ostensibly worried about the implications of the deficit and resulting increases in the federal debt for inflation and the creditworthiness of the US government, were seen as fearsome enforcers of fiscal discipline.

As Democratic political consultant James Carville famously put it in 1993: "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody."

That intimidation led to the surpluses of 1998 to 2001, which brought the gross federal debt back down to 54.6 per cent of GDP. Since 2001, though, the debt has almost doubled as a share of GDP, while the yield on 10-year Treasuries has fallen from more than 5 per cent to 2.9 per cent last week. Those scary bond market vigilantes became pushovers. That 2.9 per cent is up from just 2 per cent last September, and the interesting financial market events of the past few days are an indication that the bond market may be about to regain some of its old relevance.

But I imagine it will take quite some doing this time around to persuade politicians in Washington to act with anything like the urgency that they did in the late 1980s and early 1990s.

Since the 1990 tax increase that helped torpedo president George H.W. Bush's chances of a second term, Republicans have been for reducing deficits when a Democrat is in the White House and increasing them when their party has the presidency.

I don't doubt that the Tea Party House members who grumbled to the Wall Street Journal about the spending deal are legitimately frustrated, but as their electoral appeal seems to have been based more on their obstreperousness than their devotion to small government, I don't think this frustration will have much political impact.

The Democrats have followed a more consistent path of at least saying worried-sounding things about the deficit no matter who is president, but the events of the past few months (especially the GOP majority's enactment of large, deficit-increasing corporate tax cuts) appear to have soured them on fiscal responsibility as well. And really, it is hard to blame the politicians for this.

The dire warnings of deficit hawks over the past four decades have generally not come true, voters are losing interest in the topic, and there may even be a reasonable case to be made for experimenting with bigger fiscal stimulus as a way to break the economy out of its slow-growth path and free the Federal Reserve to continue its normalisation of monetary policy.

Still, a deficit of 5 per cent of GDP during good times implies a deficit of 7 per cent or 8 per cent in even a modest recession (the deficit hit 9.8 per cent of GDP in 2009, during the worst recession in 75 years, and an all-time high of 29.6 per cent of GDP at the height of World War II in 1943).

Demographic pressures on Social Security and Medicare will boost it even higher over time, as will likely increases in interest rates.

The federal debt was just 31.7 per cent of GDP at the beginning of the Reagan deficit experiment in 1981. Now it is already more than 100 per cent. This cannot go on forever. And as Republican economist Herbert Stein put it back in the 1980s, in another famous quote: "If something cannot go on forever, it will stop." How will it stop?

Stony Brook University economist Stephanie Kelton and her fellow modern monetary theorists have been arguing for a while now that since the US borrows in its own currency, which it can always create more of, the only risk posed by rising deficits is inflation. There is some truth to this view, but it misses a lot about how financial markets - and politics - work. If deficits keep rising and rising, it seems likelier that the end will come not in a slow, steady rise in inflation but in a crisis in which lost market confidence and public confidence force drastic action in Washington.

That might turn out to be a good thing: I (and many others) have argued that the US needs to suck it up and impose a national value-added tax like every other wealthy nation has, and a fiscal crisis should certainly increase the chances of that. But it would still be a crisis.

BLOOMBERG VIEW

• The writer was editorial director of the Harvard Business Review and is the author of The Myth Of The Rational Market.

A version of this article appeared in the print edition of The Straits Times on February 16, 2018, with the headline 'How America's deficit spending boom might end'. Print Edition | Subscribe