Government Finance 101. Fiscal Policy: Welcome to Alice in Wonderland

 

PRELIMINARY SUMMARY OF FISCAL 2024 BUDGET

The deficit in fiscal 2024 will be around $1.9 trillion, about $4.9 trillion in revenue and $6.8 trillion in expenses. Interest on the national debt this year is around $960 billion, over twice the interest on the fiscal 2021 budget. Interest expense this year passed outlays for the military.

Leaving aside Social Security and Medicare, interest expense is about 20% of total budget outlays. Interest expense is about half the budget deficit.  

SOME BASIC DEFINITIONS AND A LITTLE DETAIL

Some basic definitions for people in government suffering from political amnesia:

 

Deficit.   The difference between the federal government’s spending and its revenue in one fiscal year.  The fiscal year starts on October 1.  So fiscal year 2024 started on October 1, 2023. You know right away this is going to be confusing.

Debt.  Short for national debt or federal debt.  The sum total of all past yearly deficits minus yearly surpluses.

Commentators often say we shouldn't worry about the national debt because we owe it to ourselves. Well, sort of. About 20% of the national debt ($7 trillion) is owned by…the U.S. government!  Mostly Social Security and other trust funds and federal employees' retirement funds. Of the other 80%, or about $28 trillion, about $4.6 trillion is held by the Fed; American investors and institutions own less than half, or $14.5 trillion.

Foreign lenders own about $8 trillion, or about 30% of the Treasury securities not held by the U.S. government. Much of this is held by foreign central banks and importers and exporters to finance international trade. China owns less than $1 trillion of this. The number has been going down; don't believe the scare rhetoric that the Chinese government could sell all its U.S. government debt and crash the American economy. Much more is held in "tax haven" (money laundering, money hiding and tax avoidance) countries. It is comforting to know that South American and Mexican drug lords, corrupt government officials everywhere and Russian oligarchs have faith in the U.S government and its dollar.

The Fed is currently selling off part of its large inventory of Treasuries it accumulated to help finance Covid stimulus programs. So it looks like the federal government will have to sell most of its future debt to Americans and other private investors. In the long run, it is likely the government will be able to sell its increasing debt only at higher interest rates.

INTRODUCTION

The projections in this post are from the Congressional Budget Office (CBO). These are from 2024. They are updated every two years. Basically, they are trend projections of existing programs and tax revenues. They assume that events such as recessions, epidemics, wars or new programs to fight the effects of global warming will not happen over the next ten years. Good luck!

I first wrote this post about seven years ago. I update it about every two years. Every time it gets more depressing. When interest rates the government paid on the national debt were very low, no one in the government talked about the rising interest expense and what to do about it. But now with higher interest rates, interest expense has risen and has become a larger part of government budgets. Interest expense in 2024 passed defense expenditures. Even if interest rates stay where they are now (7/24), increased interest expense will eat up most of the projected increased tax revenue over the next ten years. Interest rates on the national debt are likely to rise as the national debt continues to increase more than nominal (taxable) GDP. 

But still, no serious discussion. I understand why. For 20 years until late 2022, the Fed kept interest rates at very low levels. Among other effects, this was a massive subsidy to the federal government. It kept the cost of the increasing national debt low, below the political radar screen. No elected representative or politician wants to talk about it. The choices to minimize the increase in future interest expenses are political dynamite. Better to blame deficits on welfare payments to illegal immigrants.

For a detailed and lucid presentation of the current federal debt and the issues involved, see John Mauldin's essay titled "Debtors and Creditors" at mauldineconomics.com.

 FISCAL ACCOUNTING: PROJECTIONS TO 2034

The national debt will be around $35 trillion by the end of 2024. It is expected by the CBO to be about $20 trillion higher in 2034, to be around $55 trillion. Over $50 trillion will be in non-government hands. At an interest rate of 3.5%, interest on the national debt in 2034 will be about $1.7 trillion. The increase in yearly interest payments from 2024 to 2034 will be about equal to the increase in tax revenue.

The current size of the national debt is 120% the size of the whole American economy (GDP). 

The CBO forecast is probably optimistic. By law, the forecast cannot include the cost of any new spending programs, a recession or any other unusual adverse event like future viruses. Based on past experience, it is likely that at least one recession will occur in the next eight years.

Yearly deficits before the coronavirus were around $1 trillion per year. This should be viewed as a minimum. The increase will be higher by about $5 trillion if the Trump tax cut is renewed in 2025 and more if some of the new expenditures and tax cuts promised by the presidential candidates are enacted. 

Social Security and Medicare are funded by their own taxes and are working down their trust funds (selling government bonds) that fund part of the benefits. Subtracting Social Security and Medicare taxes from the Federal budget, other revenue covers about 50-60% of all other government spending; the other 40-50% is the deficit and financed by borrowing.

 

SOCIAL SECURITY

Even the most conservative projections are scary as more Americans get older (the number of Americans over 65 years old is expected to double over the next 20 years) and the health care industry is doing a really good job of keeping us baby boomers alive longer (mostly paid for with government funds). In addition, part of Social Security expenses comes from past Social Security taxes that are in the Social Security Trust Fund. This fund is projected to go to zero around 2035. Social Security benefits will fall at least 20% or the deficit will come out of general tax revenue. This will add about $300 billion to general expenditures and the yearly deficit. With the rising number of senior citizens, who like to vote (about 25% of registered voters), guess which alternative is more likely. This could be fixed with some relatively minor changes to Social Security taxes or raising retirement ages but so far Congress has totally ignored this large addition to future yearly deficits and the national debt.

YEARLY DEFICITS AND THE NATIONAL DEBT

Total interest on our national debt was about $450 billion in fiscal 2022. In fiscal 2024, total interest expense will more than double to about $960 billion (preliminary CBO estimate). This is greater than military spending. Around 2034, total interest expense could be around $1.7 trillion, about equal to Medicare expenditures. The government has benefitted from the very low interest rates engineered by the Fed over the last twenty years. But interest rates began to rise as the Fed quickly raised the Fed funds rate to bring down aggregate demand and the inflation rate in 2022. Of course this had no effect on government spending. Every one percent increase in the interest rate on the national debt will add at least $300 billion a year to expenditures and the deficit. Another way to look at it is that the interest expense in this fiscal year (2024) was more than half of the deficit. Interest expense is about equal to the cost of national defense. At current interest rates, total interest expense could be about 60% of the yearly deficit in a few years (as the past lower-cost debt is rolled over) and possibly a higher percent further out. The government is borrowing more money each year to pay interest on past borrowing.

A combination of rising national debt of over $2 trillion a year combined with rising interest rates would push politicians and us voters even further into denial. So far, everyone wins. We get corporate and household tax cuts. We spend more money on defense and national security than the next nine countries combined. We have generous social welfare, health and retirement benefits. After paying for Social Security and Medicare with dedicated taxes, we borrow over one-fifth of the total cost of the rest of the budget every year. Even the most optimistic projection indicates that by 2034 all of the income the Federal government takes in will only cover “mandatory” programs (mostly Social Security, Medicare, and Medicaid) and defense. Maybe a part of national debt interest, depending on future interest rates. All of the rest of the budget, all the subsidies and tax loopholes and worthy programs, are funded through borrowing. Who says there's no such thing as a free lunch program? Party on!

What is the point of this discussion? Fiscal policy - the size and changes in the size of yearly deficits and government debt - has nothing to do with political philosophy or promoting economic growth and stability. It has to do with lowering tax rates and no one paying the full cost of received benefits and services. 

TAX RATES

The size of the deficit can also be affected by changes in the income tax rates but only to a limited extent. About 45% of all households pay no federal income tax. Of all the households that file an income tax, about 80% pay more in “payroll taxes” (Social Security and Medicare taxes) than income taxes. The Federal government collects more revenue from payroll taxes (Social Security and Medicare) than from personal income taxes.

 

A high percent of personal income taxes is paid by high income households; they receive most of any personal income tax cut.

 

Studies by the IRS show that small businesses and high-income households substantially underreport their income. Large corporations pay substantially less than the statutory rates; some large companies, including GE in the past, paid nothing at all. Large social media companies have moved much of their intellectual property to Ireland, which has one of the lowest corporate tax rates in the world. Warren Buffett's company pays a lower tax rate than almost everyone reading this post. Many industries have special tax reduction rules, including "depletion allowances" for oil and natural gas drillers. Property developers and commercial property owners are notorious for not paying income taxes. 

 

ECONOMIC EFFECTS OF CONTINUOUS FISCAL DEFICITS

A fiscal deficit of $2 trillion means the federal government is spending on transfer programs and purchases of goods and services (income to households and businesses) $2 trillion more than it is collecting in revenue (taken from households and businesses). $2 trillion is 6-7% of total GDP or approximately 10% of consumer spending. Adding the $1 trillion trade deficit which is 3-4% of GDP, then $3 trillion, or 10% of GDP spending, is being financed by these two deficits. Party on!

How is the fiscal deficit financed? Where does the money come from? The sale of new government bonds. At 4%, the interest rate on new bonds in 2024 is $80 billion. Even the interest expense is financed by debt. By 2034, the interest expense at 4% on 10 years of new bonds of $20 trillion will be $800 billion.

Even as the nominal GDP, and thus the tax base, increases, the yearly deficit exists year after year. The old bonds do not disappear by increased tax revenue paying them off. As the bonds come due (mature), they are retired (paid off or rolled over) with new bonds. Combined with new deficits and debt, the national debt get larger. And larger.

Who buys the bonds, and why? American bonds are attractive mostly because they are viewed as the safest bonds in the world. That is, the U.S. government is never expected to declare bankruptcy. Many governments since WWII have partially or totally defaulted on their debt. New governments often default on debt created by prior governments. And not just poor countries. In the 20th century, Russia, Germany, Japan and Italy have defaulted on their debt. Lost wars and revolutions do that. 

It is ironic that bond buyers around the world buy U.S. bonds because they believe they will be paid when their bonds come due. But this belief hasn't really been tested. As long as bond buyers believe in the solvency and safety of U.S. bonds, they will continue to replace them (roll them over) and buy new ones. Keep the faith.

If bond buyers perceived that U.S. bonds were becoming riskier, the first reaction would probably be to demand higher interest rates to compensate them for the increased risk. But, by itself, this increase in yearly deficits and the national debt (and interest on the national debt) would just increase future deficits and the national debt faster. The Red Queen Effect.

But why does the yearly deficit occur year after year (after year)? Or, as an economist might say, why is it structural and not cyclical as Keynes hoped? After all, total tax revenue goes up most years. If spending stayed the same, each yearly deficit would go down. One day in the Star Trek future, there would be no yearly deficit. Easy answer: spending goes up and tax revenue doesn't go up as much as expected because of the political popularity of tax cuts.

COMMENTS ON FISCAL POLICY

 

The federal budget and its deficits do not exist in a vacuum. They are part of the overall economy. Budget deficits are not inherently good or bad. When they occur over the growth cycle is important.  

Government spending is all lumped together in macroeconomics. Yet what governments spend their money on is important. A lot of it is "income transfers," taking tax money from one group and distributing it to others. Much of it goes to people who are old or sick or poor but also some goes to less deserving folks. Some of the spending should be considered consumption. Another part is public investment. This part is vital to economic growth and the development of new technology. Government pays for basic research, public health, infrastructure, education and training, financing and subsidizing private investment, and paying for some of the social costs (such as cleaning up toxic waste dumps) of past private investment and production. This does not include the future costs of fighting the effects of global warming; preliminary estimates are very scary.

The increase in the future cost of the national debt will be about equal to the increase in tax revenue. All new or expanded programs – national defense, fighting carbon emissions and the past costs of pollution, infrastructure, and others - will all be paid for by more borrowing and increasing debt.

 

A second consideration is what the spending financed by debt is used for. A major use in the past has been to finance tax cuts. Almost all of the stimulus money went to all American families in the form of higher income. The idea was that a big rise in total income would lead to a big increase in total spending. Not as much as expected. There was a big increase in total household saving; many American families didn’t need the extra income. This contributed to later inflation and higher interest rates. This is one reason the prices of stocks and houses are now going up.

 

What the stimulus money was not used for was investment to increase future economic growth. Some of the money in the bills passed by the Biden administration starts to address increased infrastructure needs and the cost of combating the effects of global warming. President Trump, like earlier presidents, wanted Congress to cut back on some of the government's basic research. It is almost impossible to think of any new technology developed after WWII that the federal government did not help finance and develop, including computers, microchips, jet aircraft, the internet, GPS, digital photography, biotechnology, and autonomous driving. Especially in the early stages of basic research and applied research and development. Developing new technology is the main source of economic growth and thus increases in tax revenue. 

The idea that there is some economically rational fiscal policy is a fiction. But presidents who propose yearly budgets and congress members who vote on them are rational. The want to get reelected and expand favorite programs. They ignore the present and future cost of the yearly deficits they create. Somebody else's problem.

Some commentators believe the "debt overhang" of high and rising national debt and its interest expense will be the cause of our next economic crisis.

----------------------------------------------------------------------------------

See the companion post Government Finance 102:  Monetary Policy: The Red Queen's Race for how the Fed has facilitated the creation of our large federal deficit.

For a list of all the posts on this blog, see List of Posts by Topic with links to all other posts.

SOME HISTORY ON HOW WE GOT TO THIS POINT

A little history. If you don’t care how we got so deeply in debt, even before Covid, skip this. Just blame whoever is currently in office you don't like and forget about who you voted for in the past.

American politicians reacted to the end of the Cold War with the Soviet Union not with a “peace dividend” but with profligate spending and yearly deficits. In 1990, just before the Cold War ended, the U.S. national debt was $3.2 trillion. On the eve of the 2008 financial crisis, it had risen to $9 trillion. By the end of 2019, it was approximately $22.5 trillion, seven times what it was just 30 years earlier. This large increase in debt was created by both Republican and Democratic administrations during a period of economic growth.  

Why is the national debt so large?  When Ronald Reagan became president in 1981, the national debt was about $1 trillion.  Most of the increase occurred when conservative Republicans were president! Tax cuts by Presidents Ronald Reagan ("Deficits don't matter."), George W. Bush (reversing the tax increases on the rich by his father), Bill Clinton and Donald Trump, combined with big increases in defense spending and national security, are two of the major reasons. In the last two years of Clinton's administration, the government actually ran a small surplus and the national debt went down. 

The Bush tax cuts have added about $4 trillion to the national debt. The wars in Iraq and Afghanistan have added at least $1 trillion ($4 trillion in the long run). The housing bubble recession of 2007-2009 added another $3 trillion through reduced tax revenues and increased safety net expenditures such as unemployment benefits (not including the $700 billion stimulus program).  These large deficits run under Obama were caused by the financial consequences of the disastrous deregulation and absence of oversight of the financial and housing markets advocated by Ronald Reagan, George W. Bush and Alan Greenspan. The recent tax cuts and increased defense spending of President Trump will add an additional $1.5-$2.0 trillion to the national debt over the next ten years. President Biden's recent programs to improve infrastructure and encourage innovation at least are not the usual income transfers. They might actually help increase future economic growth although I think it could have been done more efficiently at a lower cost (typical complaint of an economist). But I admire the way pro-business liberal Democrats got "fiscally conservative" Republicans to support the bills by making them look like typical pork-barrel programs.

To make you feel better, you should know that the national debt to nominal GDP ratio has been rising in almost all industrialized and modernizing economies. The champion here is Japan; their national debt is more than twice the size of their national economy. They can do this because they pay virtually zero interest on the debt - so the total doesn't matter - and almost all of it is owed to Japanese. Over half of the national debt is owned by the Japanese central bank. No worry about attracting pesky foreign investors.