The Independent Market Observer

The Federal Deficit and Debt: A Painful Problem to Solve

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 16, 2023 3:11:54 PM

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debt and deficitToday, I want to discuss a topic that has somewhat fallen off the radar: the federal deficit and debt burden. It has been off the radar screen for a decade, since the last debt panic. The reason for that is that the panic led to real reforms that largely solved the problem. That episode—the fiscal cliff and the sequester—has a lot to tell us about today’s situation. Let's take a closer look.

The Big Picture

My take has historically been that, yes, the deficit and debt were real problems, but they were solvable. In fact, until recently, they were solvable without too much pain, as we saw in 2012 and 2013. Yes, spending would have to be cut, and taxes would have to go up. Not too much pain doesn’t mean no pain, but the problems could be resolved. And that is what happened last time, which is a big reason I felt that way. But as a result of the very large deficits that have accrued over the past several years, that largely hopeful take is becoming less achievable.

The problems are still solvable, mind you, but the pain level needed to do so has increased substantially. There are a couple of reasons for that.

Financial Stability Taking a Hit

First, we have the deficits themselves. The Tax Cuts and Jobs Act of 2017 cut tax rates across the board, dramatically decreasing revenues while spending continued to increase—resulting in much larger deficits. Those larger deficits continue to accrue as debt, which is now up substantially both in absolute terms and as a percentage of the economy. Finally, and most immediately, the rapid increase in interest rates is taking what was still a sustainable debt service burden, albeit on a much larger debt, and increasing it even further over the next several years.

You'll note that I have avoided actual numbers here. That is because, whatever numbers are quoted, there is substantial uncertainty involved. So, the numbers themselves don't matter. What does matter is the amount of the deficit and debt (both very high) and the fact that the interest expense will be ratcheting up. The country's financial stability is getting hit in all three ways at once.

Tax Increases and Spending Cuts

So, what does this mean? First, it is important to understand this is still a solvable problem and the world is not coming to an end. It will be painful, though, requiring both tax increases and spending cuts. Those are likely in both the near and medium terms.

For example, the individual tax cuts from the last administration are due to expire at the end of 2025. There will be an effective tax increase then, which will help on the revenue side. Further tax increases are likely, and probably necessary, to balance the budget. But with current tax levels very low by historical standards, such increases would be possible but painful.

On the spending side, the increasing publicity and urgency around this issue are likely to get spending more under control. And cuts, although difficult, will be increasingly likely. We saw this with the fiscal cliff and sequester a decade ago, where Congress did indeed—albeit very unwillingly—cut spending. It can be done.

So, the problem is solvable, but it will be painful. I don't like it either, but it will happen. The one unavoidable economic truth is that if something can't continue, it will stop. And that is where we will be over the next several years.

An Early Warning

What does that mean for the economy? Higher taxes and lower spending don't necessarily mean lower growth. Taxes, after all, have been higher in the past while growth was still strong. Existing trends, especially the very strong labor market, should help keep growth healthy, and other positive factors specific to the U.S. will continue to apply. We can and will still grow even as we get our fiscal house in order.

The real takeaway here is that, once again, this is still a problem that can and will be solved. It will be harder and more painful than it would have been, but we will get through it and prosper. There will be a lot of bad headlines in the next couple of years, as is usual when a problem emerges, but the headlines are part of the solution. We will have further posts as events warrant but consider this an early warning bulletin.

Keep calm and carry on.


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