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https://www.cato.org/policy-analysis/case-federal-deficit-reduction-spending-cuts-avoid-fiscal-crisis

A Case for Federal Deficit Reduction

Spending Cuts to Avoid a Fiscal Crisis


The United States is heading for a fiscal crisis, sooner or later, if it does not reduce its federal budget deficit to curb the growth of debt. Federal budget deficits are already high and set to rise further. This will add to the federal debt, which within four years will hit its highest‐​ever level relative to GDP. On unchanged policies, age‐​related entitlement spending will then increase debt much further over the next three decades. Meanwhile, higher interest rates after the recent inflation have raised the cost of new government borrowing and of managing existing debt as it matures.

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While there is substantial uncertainty regarding the future path of interest rates and when, precisely, a fiscal crisis might occur, there is a strong case for taking action today to avert the possibility down the road. A deficit reduction program implemented today would not only provide insurance against a fiscal crisis or reduce the prospects of debt weighing on economic growth, but it would also avoid the clear pitfalls of developing policy in the heat of a crisis.

In an ideal world, a deficit reduction package would entail forward‐​looking reforms to age‐​related entitlement programs, elimination of wasteful or economically harmful government programs, and pro‐​growth tax and regulatory reforms to ease the burden of the fiscal adjustment. Unfortunately, such a comprehensive package looks politically unlikely any time soon. At the very least, policymakers should work to identify spending cuts that make economic sense or to develop a fiscal resolution plan (or “living will”) that could form the basis of negotiations for deficit reduction should a crisis occur.

Introduction

We could call it a warning. For years, politicians in Washington, DC, have been running up the federal debt, not least through borrowing vast amounts for bailouts and stimulus packages during crises. Between 2007 and 2022, federal debt held by the public surged from $4.6 trillion to $24.3 trillion. That propelled debt from just 36 percent relative to gross domestic product (GDP) to 96 percent, the highest level since World War II.1

For most of that period, mainstream economists told politicians they could be relatively relaxed about this flow of red ink. The sharp jumps in debt hadn’t produced obvious ill effects for the macroeconomy, nor had they apparently generated angst among the federal government’s lenders. Even by 2018, the debt was an “absolutely trivial” worry, according to Nobel Prize–winning economist Paul Krugman, not least because of low interest rates.2 In a January 2019 Foreign Affairs article, former Treasury secretary Larry Summers and former chair of President Obama’s Council of Economic Advisers Jason Furman wrote that, with extensive global savings and “suppressed investment demand,” interest rates would remain historically low.3 This would reduce the costs of financing a growing government debt, raising the burden of debt the country could bear sustainably.

In his 2019 American Economic Association p**********l address, Olivier Blanchard, former chief economist of the International Monetary Fund, spoke to the growing consensus for less concern about rising debt, saying, “The signal sent by low rates is not only that debt may not have a substantial fiscal cost, but also that it may have limited welfare costs.”4 Debt was near enough a free lunch. Sure, politicians would eventually need to reform unsustainable old‐​age entitlement programs or raise taxes significantly to fund those promises to seniors—but that was a distant problem.

Politicians obliged. Running increasingly large budget deficits became the norm, even in “normal” times. Annual borrowing was running at 4.6 percent of GDP before the p******c—the largest gap between spending and tax revenues since the mid-1980s—despite historically low unemployment. Congressional p******c spending packages and a downturn in revenues added a further $7.5 trillion in debt from 2019 to 2022.

Then inflation hit. As the Federal Reserve tightened monetary policy to choke off rising prices, Treasury yields—the interest rates the federal government pays to those who lend it money—saw their sharpest rise since Paul Volcker’s monetary tightening from 1979 to 1982.5 The yield on a 10‐​year Treasury peaked at 5 percent on October 23, 2023, before receding to just under 4.2 percent by March 2024.6 That’s still 75 percent higher than the average yield seen through the second half of the 2010s.7

A core assumption behind the blasé attitude to debt—that interest rates would remain low—had evaporated. While it’s unclear whether higher yields are a temporary blip or the herald of sustained higher rates, analysts realized that the US debt outlook is highly sensitive to the path of these uncertain borrowing costs. Sustained low rates could no longer be taken for granted. The ratings agency Fitch downgraded US debt. The term premium on debt rose in the fall of 2023. Commentators and economists, including the previously relaxed Blanchard, now openly worry about a full‐​blown US fiscal crisis.8

The jump in yields has already made it more costly for the government to borrow, at a time when Congress plans to borrow an average of $2 trillion per year over the next decade.9 Higher yields are also making the government’s outstanding $27.5 trillion debt pricier to manage, as existing debt must be refinanced at higher rates as securities mature.10 The longer that higher yields endure, the worse the implications for the federal government’s budget deficit and the future path of debt.

For all the focus on bond yields, however, the t***h is that the United States was on an unsustainable fiscal path even before rates spiked and will remain so even if yields fall back again. Some basic fiscal t***hs show that we are headed toward a fiscal crisis, sooner or later, unless significant action is taken to reduce the scale of future deficits and debt. Higher bond yields merely accelerate this timeline. The events of the past 12 months have been a flashing warning signal of the general need to get our fiscal house in order by reducing future budget deficits.

As with everything from the Cato Institute, the article is quite lengthy. Size constraints in OPPs system disallows such a lengthy article. By following the link, those desire to se the remainder can do so.