Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Good news: budget deficit plunges. Bad news: not for long

The Treasury Department recently released the June tally of revenues and outlays of the US Government, and the news is surprisingly good. Federal spending was down by 12% compared with June of last year while revenues were 3% higher, resulting in a shortfall only half as large as a year ago. For the 9 months of the current fiscal year to date, the deficit has plunged by 77% compared with the same period in 2021, the biggest decline ever for the first 9 months of a budget year.

The Congressional Budget Office now predicts that the fiscal 2022 deficit will fall below $1 trillion compared with $2.8 trillion last year and a whopping $3.1 trillion in 2020. Government spending declined sharply with the expiration of various pandemic-related relief programs, while revenues rose from increased tax collections as the economy picked up speed.

Running a budget deficit is sometimes necessary during recessions or extraordinary events like the pandemic or the financial crisis of 2008. But the US Government has run large and increasing deficits for all but 4 years since 1970, leading to a massive and mounting national debt that will inevitably stymie growth and burden future generations.

To fully understand the implications of perpetual annual deficits, it is helpful to recall the distinction between the deficit and the debt. The budget deficit is the excess of spending in a given year over the total revenues received for that year. By analogy, if a family spends more in a year than its income the difference is a deficit that must be covered by borrowing or tapping its savings account. A surplus occurs if spending is less than income, otherwise known as living within one’s means.

The national debt is the net accumulation of deficits minus surpluses over all time. For example, 2021’s $2.8 trillion deficit was added to the total owed by the US Government (or, rather, by its taxpayers) at the end of fiscal year 2020, bringing the total US Federal debt held by the public to nearly $23 trillion. For context, that boils down to about $89,000 per adult.

It is useful to express the debt and deficits as a percent of the size of the economy to make meaningful comparisons over time. The 2021 deficit of $2.8 trillion equates to 12.4% of GDP, down slightly from 15% in 2020, the most in the entire post-WWII period. The much smaller projected 2022 deficit is just 4.1% of GDP, but still adds another trillion dollars to the bill. The total national debt stands near 100% of GDP, by far the highest since WWII.

So what? Compared with a decade ago, there has been relatively little interest in tackling the deficit and debt problem. Once ranked the number one issue by voters in the years following the Great Recession, one can barely get a decent barroom argument started today over the surging obligation. Meanwhile, the national debt has more than doubled in that time. Complacency born of the apparent lack of catastrophic consequences predicted by the deficit hawks has essentially taken the issue off the table. Yet like any impending crisis, it doesn’t really matter until suddenly it does.

For one thing, 10 years of historically low interest rates have hidden the eventual impact of servicing that massive debt pile. This year the reckoning begins as rates continue to climb higher and add substantially to the cost to taxpayers of interest on the Federal debt.

A comprehensive 2021 forecast by the CBO assumes that interest rates remain relatively low through 2031 at an average rate of 1.6% before rising gradually to 4.6% over the ensuing 20 years. Under this exceedingly optimistic scenario, the cost of interest on the national debt would consume nearly half of all federal tax revenue by 2051. Clearly, rates are now rising much faster than CBO assumed, and a more realistic model from the Concord Coalition forecasts that interest alone will eat up 57% of all revenue in 30 years. Given that 2/3 of the budget is already comprised of mandatory spending (other than interest) like Medicare and Social Security, discretionary spending would be effectively choked out.

Additionally, large structural deficits impinge upon household incomes by stifling long-term economic growth. Economists speak of the “crowding out” effect, as government borrowing soaks up an increasing share of available capital and shrinks the slice of the pie for the private sector to fight over. This effect has been absent of late thanks to near zero interest rates but has only been hibernating. Rising rates are likely to reacquaint us with competition for capital that constrains growth and incomes.

This is hardly an exhaustive list of the negative impact of running perpetual deficits. Admittedly, deficit hawks have been treated as Cassandras crying in the wilderness (and mixing their metaphors), and even some mainstream economists have proposed additional borrowing at what had been assumed to be indefinitely low rates. Now, unless Congress and the President move toward taming the beast, all this “cheap” debt must eventually be refinanced at substantially higher cost.

The reduction in this year’s deficit is great news but is very temporary under even the best scenario. The time to tackle the problem is now, understanding that any impactful action will no doubt come with some pain. Adulting is hard.

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