Four Ways Out of a Federal Deficit

In this piece, I will outline and elaborate on each of the four options that indebted governments can attempt to exercise to address the problems that are commonly associated with a high debt-to-GDP ratio. Namely, federal governments can default on their outstanding liabilities, enact austerity measures, inflate the debt away, or pursue policies that encourage economic growth.

Please note that the information provided below is for general education and that we are merely scratching the surface of an incredibly complex and dynamic topic. The Red Oak Financial Group Investment Committee typically does not place significant weight on such long-term and secular considerations when debating asset allocation, either on a strategic or tactical basis. Also, given the uncertain nature of such complicated political and economic issues, I refrain from making a detailed prognostication on how the United States’ worsening fiscal situation will be resolved. Nonetheless, there is intrinsic value to knowledge accumulation and the subject of the national debt is one that warrants consideration.

Setting the Stage

The US federal deficit, the cumulative difference between the federal government’s revenues and expenditures, is a perennial topic of discussion and debate among financial market practitioners, policymakers, and the members of the tax paying public. This focus on fiscal policy, the use of government spending and taxation, stems from the fact that it is one of the primary tools used by governments to steer the economy and achieve objectives such as controlling inflation, managing unemployment, and fostering economic growth.

When national debts are constrained to modest levels relative to a country’s economic output (gross domestic product) and when fiscal outlays are allocated to projects with a high expected return, there is likely to be a durable benefit to private sector households and businesses. However, economists have long noted that the marginal benefit of issuing additional debt diminishes as overall indebtedness increases. Said differently, countries with high public sector (federal government) debt-to-GDP ratios (>100%) should not expect new debt issuance to significantly enhance the standard of living of their populace or sustainably boost economic growth. The foremost reasons why the net benefit of new debt issuance tends to be subject to diminishing returns as the value of outstanding liabilities grows are as follows:

· Diminished Return on Investment (ROI): Initially, borrowing is often used to finance activities that are likely to provide a high return on investment, such as infrastructure development, education, and research and development. Funding such projects via debt issuance is the low hanging fruit. With the most impactful and therefore cost-effective projects having been funded, the proceeds from additional debt accumulation will likely be put towards opportunities with lower expected returns.

· Rising Debt Service Costs: Interest expense, which can be thought of as the amount of government resources that must be diverted away from productive investments and essential functions to service the deficit, increases alongside the level of debt.

· Crowding Out: Profligacy, or imprudent amounts of deficit spending, on the part of the fiscal authorities can increase interest rates (the cost of issuing new debt) throughout the economy. In doing so, private sector investment that would have occurred had interest rates remained at a less burdensome level may be “crowded out”. This reduction in private sector investment can offset the positive impact of government spending.

· Reduced Consumer and Business Confidence: Whether warranted or not, debt levels that are thought to be exorbitant can undermine the confidence of investors and consumers and catalyze feelings of economic uncertainty. Reduced private sector confidence often foreshadows a reduction in investment and consumption on the part of households and businesses.

Contextualizing the US Federal Deficit

As of July 2024, the sum total of the national debt was ~$33 trillion. When this figure is put in context by comparing it to US gross domestic product of ~$27 trillion in fiscal year 2023, it yields a debt-to-GDP ratio of 122% (=$33T / $27T). This ratio can be useful in that it allows for a comparison of debt levels over time and between countries of various sizes.

United States Federal Debt-to-GDP. Source: fred.stlouis.org, Federal Reserve Bank of St. Louis

For the sake of establishing a contrast, countries such as Italy (~140% debt-to-GDP), Greece (~170%), and Japan (~270%) have some of the most onerous public debt levels among developed economies, and all three nations have been plagued by anemic annual GDP growth in recent decades. On the contrary, Poland (~50% debt-to-GDP), New Zealand (~60%) and Slovenia (~60%) have achieved higher annualized GDP growth in recent years, while not allowing their respective fiscal deficits to widen to the point where marginal utility (the usefulness of each unit of newly issued debt) declines rapidly. Naturally, innumerable factors have influenced each nation's policies regarding deficit management, and the size of the fiscal deficit is only one of the causal elements affecting an economy's growth rate. Still the inverse correlation between debt-to-GDP and economic growth remains relatively robust, especially among highly indebted nations.

At 122% the US is in the top decile of developed economies when ranked by public debt-to-GDP, which brings us to the subject of this article: default, austerity, inflation, or growth are the only four ways out of a deficit.

Four Ways Out of a Federal Deficit

Starting with the least likely path forward, the US federal government, technically, could default on its debt. Doing so would likely cause severe repercussions across the globe and catastrophic economic consequences domestically. Thankfully, an outright failure to service and repay outstanding obligations is generally not considered to be a realistic possibility for the United States. This is because the US Department of the Treasury has the unique ability to print the currency that its debt is denominated and repayable in (US dollars). In effect, the fiscal authorities can always meet their responsibility to repay in nominal terms by simply creating as much currency as necessary. Whereas many developing countries must issue of debt denominated in foreign currencies, the ability to print dollars provides some semblance of a safety net for the US government and makes an outright default scenario extremely improbable.

Another low probability solution for resolving the deficit is austerity. With respect to fiscal policy, austerity refers to a set of policies aimed at reducing government budget gaps via reductions in federal spending and/or tax hikes. Historically, and as almost certainly would be the case in the modern day, politicians who advocate for reducing expenditures on social programs (such as social security, Medicare, and Medicaid), downsizing the headcount or capping salaries of public employees, or increasing taxes are at risk of alienating voters and creating the conditions necessary for widespread social strife. Greece, in the aftermath of the global financial crisis, can be looked at as a recent example of austerity gone wrong. After the imposition of regulations to reduce government spending and increase taxes, in response to a worsening sovereign debt spiral, measures of civil unrest rose markedly. While such policies are not difficult to conceptualize, austerity measures are often politically untenable and socially treacherous, and therefore are unlikely to play a big part in restoring the US to a more sound fiscal position.

From a consumer perspective, inflation is commonly described as a “hidden tax” because it gradually erodes the purchasing power of the currency over time. Similarly, by promulgating inflationary policies the government can “inflate the debt away”, whereby the value of its Treasury obligations are reduced in real terms. Additionally, a rise in the aggregate price level is likely to lead to higher nominal incomes and real estate values (all else equal), which propels tax revenues higher and deficits lower, without the need to legislatively adjust tax rates upward. While letting inflation run hot can reduce the economic drag of the deficit, such policy comes with risks that are worthy of our attention. Prolonged periods of upwardly biased price instability can erode household savings, reduce consumer purchasing power, impact business spending plans, and create conditions of uncertainty that are not generally conducive to public wellbeing and economic prosperity.

Whereas default, austerity, and inflation all have obvious downsides that make them suboptimal, economic growth is the most optimistic and sustainable way to reduce the burden of a large national debt. An economy whose growth rate exceeds the rate of new debt issuance is on track to reduce its debt-to-GDP ratio over time and thereby improve its fiscal position. Furthermore, a robustly expanding economy increases government revenues via higher tax receipts from income, capital gains, and corporate profits, and may reduce the government’s need to issue new debt. Despite the clear and obvious advantages of growing the economy out of a deficit relative to the alternatives, it should be noted that the natural state of highly indebted nations is one of sluggish economic growth. Therefore, if we are to experience a durable increase in the rate at which the economy expands, significant shifts in demographic trends, technology advancements that markedly raise labor force productivity, and/or changes to government policy will likely be required.

Conclusions

To date, US fiscal deficits in the 2020’s have been historically large and the blame cannot be laid solely at the feet of either major political party. Both Republican (under President Trump) and Democrat (under President Biden) administrations have authored and voted affirmatively for increases in government outlays without reciprocal tax hikes. Although the initial upward shift in government spending was in response to the extraordinary circumstances brought about by the COVID-19 pandemic, a continued lack of fiscal restraint is set to provoke questions surrounding the long-term sustainability of deficit spending and the impact of a growing national debt on borrowing costs and financial markets both domestic and foreign.

At present, I am operating under the weakly held assumption that some combination of economic growth (possibly enabled by productivity improvements resulting from future developments in the field of Artificial Intelligence, which the US has an appreciable lead in) and modestly higher inflation will be the primary means of shrinking the deficit and improving the economic prospects for the country and its citizens.

Aaron