In rough numbers, in the decade starting in fiscal 2022, if the U.S. was able to achieve about 5% annual nominal GDP growth, if the federal budget deficit was held to no more than $1 trillion per year, and if interest rates on the federal debt stayed at the roughly 2% level that prevailed in 2019, the debt to GDP ratio would fall from 106.5% in fiscal 2021 to 93.3% in fiscal 2031. This improvement, while still not getting us anywhere close to our position of 10 months ago, might be sufficient to sustain the confidence of global investors in both U.S. government debt and the value of the dollar.
However, there are a number of difficult “ifs” in that statement.
First, achieving 5% nominal GDP growth would be no mean feat, once the economy had regained most of the job losses from the pandemic. In practice, it would mean achieving 3% real GDP growth, since it is hardly likely that a 2% interest rate on government debt could be sustained for long in an environment of more than 2% inflation. However, this, in turn, would require much stronger labor force growth than seems likely given the continuing retirement of the baby boom and recent declines in immigration. Comprehensive immigration reform that actually boosted the number of skilled immigrants entering the United States would seem to be a prerequisite for achieving that 3% real GDP target.
Second, holding the budget deficit to $1 trillion a year would also not be easy. Even at a 2% interest rate, interest costs on the national debt would rise from $350 billion last fiscal year to an average of almost $600 billion per year over the next decade, accounting for roughly half the budget deficit, and requiring the Administration and Congress to come very close to achieving balance between revenues and other spending.
Finally, a benign outcome would need the Federal Reserve to maintain very low short-term interest rates throughout the decade. This, in turn, would require a certain amount of luck on inflation and the dollar, as any spike in the former or plunge in the latter would make it very difficult to sustain such a policy.
Unfortunately, it is quite possible to predict a less benign outcome.
If nominal GDP growth was just 4% per year, federal deficits averaged $2 trillion per year and the average interest rate on government debt was 4%, the debt-to-GDP ratio would surge to 133.6% by 2031. Moreover, the annual interest cost on servicing that debt would balloon to $1.7 trillion in 2031, requiring an even tighter fiscal policy at the end of the decade than under the more benign scenario.
These are very serious issues for the Federal Government, the Federal Reserve and for investors.
For the Federal Government, it is imperative that, as the economy recovers from the pandemic, it has the discipline to reduce the federal deficit. This will require both reductions in the growth in spending and increases in taxes and will be necessary, not just to control the growth in debt, but also to make sure that the economy does not overheat as it once again approaches full employment. It will also be essential to adopt measures designed to increase the pace of long-term economic growth, including encouraging private investment and growth in the skilled labor force.
For the Federal Reserve, it will require a reassertion of independence. Jay Powell and his predecessors have normally, and correctly, eschewed providing advice on fiscal matters, leaving the details of taxation and spending to elected officials. However, it is important for the Fed not to be perennially seen as “the lender of first resort” to the Federal Government, a role that it has adopted in this pandemic recession. If politicians see it as so, then they will always assume that the consequences of reckless fiscal policies can be delayed until after the next election, which is a recipe for disaster. While the Fed does not need to push against unrestrained fiscal expansion, it does not need to enable it either.