The Looming US debt crisis
Last year, Jerome Powell emphasised the need for an "adult conversation" about US debt. Yesterday's Congressional Budget Office (CBO) release highlights why this was so.
The CBO projects federal debt held by the public will hit 100% of GDP in fiscal 2025, escalating to 156% by 2055, surpassing historical peaks. Such debt levels threaten economic growth, increase interest payments to foreign debt holders, and risk fiscal instability, significantly limiting policymakers' options.
Economic growth is expected to slow markedly in the coming decades. Real GDP growth is forecasted to decline from 2.3% in 2024 to 1.8% by 2026, averaging 1.6% annually through 2055. Factors such as an ageing population, declining birth rates, and reduced immigration drive this slowdown. Without immigration, the US population would shrink from 2033, directly impacting labour force growth, economic productivity, and tax revenues, ultimately affecting living standards.
The federal budget deficit remains substantial, with a projected $1.865 trillion shortfall in fiscal 2025, averaging 6.3% of GDP over the next 30 years. Persistent deficits, driven by rising interest payments and primary deficits, amplify the debt crisis, creating a challenging cycle to escape. Federal spending is projected to rise to 26.6% of GDP by 2055, fuelled by interest payments, healthcare costs, and increased Social Security obligations due to demographic pressures.
Federal revenues will temporarily increase due to the expiration of certain 2017 tax act provisions, then gradually rise to 19.3% of GDP by 2055. This growth primarily stems from rising real incomes and "real bracket creep," as taxpayers increasingly move into higher tax brackets.
Policymakers face critical decisions, including entitlement reforms, tax adjustments, and strategic investments to enhance productivity. While the CBO projections assume existing laws remain unchanged, decisive actions could significantly alter this fiscal trajectory, resonating with Powell's call for responsible governance.
The interaction between deficit reduction, economic growth, and interest rates is intricate. Meaningful deficit reduction could temporarily dampen demand, prompting the Federal Reserve to lower interest rates to stimulate growth. However, persistent high debt levels, typically hinder economic growth and reduce private investment.
Research indicates that economies with debt around 100% of GDP may require near-zero interest rates to achieve fiscal sustainability. Attaining this equilibrium involves a combination of fiscal consolidation, structural reforms, and monetary policy adjustments. Addressing the US debt challenge is crucial for long-term economic stability, avoiding future scenarios where debt severely limits economic potential and raises the spectre of possible default.
Nevertheless, economic pressures suggest a likely return to zero interest rates, creating a highly favourable environment for fixed income investments in the coming years.
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