By Mike Dolan
LONDON (Reuters) – Big public debts typically stem from big economic and political junctures that require government to spend big – but reining them back risks ‘creative’ solutions markets may struggle to price.
The cumulative cost of post-pandemic public spending amid new geopolitical realities – including anything from green energy investment, chip-making security or Ukraine-related defence bills for example – are now getting plotted into years ahead of outsize government deficits and debt projections.
The uncomfortable question of debt sustainability is top of mind again for many in financial markets.
Although an issue across the Western world, much of the sound and fury about mounting debts centres on the United States – and for good reason.
The Congressional Budget Office projects a 17 percentage point jump in the U.S. public debt-to-GDP ratio over the next 10 years to 116% – twice the average level of the past 20 years – and then rising even further to 166% by 2054.
Describing it as a ‘non-controversial’ statement, Federal Reserve Chair Jerome Powell on Tuesday said U.S. fiscal policy was on an ‘unsustainable path’.
While that may be stating the obvious, it’s a bald statement from the most powerful public servant presiding over the rising cost of that debt pile.
And this is where the whole issue risks looping.
Having hit a record low in April 2021, the average interest cost on the U.S. public debt has more than doubled since then to 3.23% – the highest in 14 years – as the Fed has hiked interest rates to contain the post-pandemic inflation spike.
The persistence of brisk growth and above-target inflation despite that monetary tightening is, for many economists, at least partly down to the demand stimulus created by those unchecked deficits. And it argues, in turn, for tighter Fed policy than many had hoped.
And even though the CBO’s long-term debt projections are explosive, they are based unnervingly on relatively modest expectations for borrowing costs ahead – with the average debt servicing cost only getting back above the 20-year average of 3.7% in 2054.
The problem comes from the debt accumulated in the interim and the fact the CBO can’t see a ‘primary’ budget gap that excludes interest costs returning back below 2.0% of GDP – also the average of the 1994-2023 period – for the next 30 years.
What’s more, total debt servicing costs start to exceed its projected nominal GDP growth projections from 2044 onwards – breaching an oft-cited debt sustainability red line on the need to keep “r minus g”, or the interest rate minus growth, in negative territory.
The CBO is not alone of course. The International Monetary Fund doesn’t see the overall annual U.S. deficit back below 6% of GDP for the next five years at least – even if slightly off this year’s eye-watering 7.1%.
What’s for sure is that no one sees any fiscal retrenchment in this election year. And the level of Fed easing expected has been scaled back sharply as inflation gets stuck above target, adding to renewed bond market angst over the past month.
What happens after the election is another question – but don’t hold your breath.
NEEDS BE…
Justification for the fiscal largesse has started to take on a different tone in the meantime – even in Europe where the deficit and debt trajectories are more contained over the coming five years.
UniCredit’s chief economic advisor Erik Nielsen this week recounted an anecdote from the recent IMF meeting during which an unnamed U.S. Treasury official told him people were looking at ‘debt sustainability’ the wrong way – describing what appeared to be a ‘war economy’ rationale for heavy spending.
Existential threats to U.S. democracy and institutions and the priorities of tense geopolitical rivalry, it was argued, required the outsize public spend to bolster the economy longer-term and to garner internal and external support for American status quo and its position in the world.
Narrow debt sustainability, as a result, was merely a subset of that goal and basically irrelevant if the overarching goals failed.
As to whether the maths eventually add up, there seemed to some hopes the Fed will smooth the path and that growth holds up.
“This may lead to a higher debt burden to GDP for longer – and into the next generations,” Nielsen said, recounting the chat. “But, if managed properly, it’ll be a future generation still living in the world’s leading liberal democracy, as opposed to in a country in chaos … and/or potentially dominated in several key areas by China or other non-democracies.”
French President Emmanuel Macron made a similar point about Europe last month in a speech in which he claimed: “There is a risk our Europe might die.”
Urging the central bank to help ensure that didn’t happen was one of his many solutions and he called for an expansion of the European Central Bank’s mandate to go beyond inflation and target faster growth and address climate too.
Stopping short of endorsing a wider ECB mandate, UniCredit’s Nielsen also reckoned the bank had been too severe in its recent tightening relative to the needs of retooling the euro economy and that the resulting recession had undermined investment.
“After all, if – just if – a central bank’s reaction function causes unnecessary economic pain inside the electoral cycle, then it runs the risk of a political reaction.”
So much for centrist voices.
In conservative quarters, the knives are also out for central bank independence.
The Wall Street Journal reported late last month that allies of Republican U.S. presidential candidate Donald Trump are drafting proposals that would attempt to erode Fed independence if the Republican former president wins – arguing Trump should be consulted on rate decisions and have the authority to remove the Fed Chair before his term ends.
And ruling British conservatives trailing in opinion polls ahead of an imminent general election there are also reported to be keen to lean on the Bank of England too to aid their cause.
If the imperatives of fiscal retrenchment and electoral cycles don’t quite mix, the easier option may well be to ensure monetary policy makers keep the whole show on the road. Stressing a ‘war footing’ may just increase those risks.
The opinions expressed here are those of the author, a columnist for Reuters.
