Finance

US Gears Up for a Sobering Fiscal Future, As Debt Nears WWII Peaks

(Bloomberg) -- The Congressional Budget Office (CBO) released alarming projections illuminating a stark fiscal reality. Its recent report predicts that the United States' federal government debt is on a troubling trajectory, expected to burgeon from 97% of GDP in the previous year to a staggering 116% by 2034, surpassing levels seen during the Second World War. Yet, experts warn that reality could paint an even more dire picture.

, Source: Congressional Budget Office

Revisiting the CBO’s forecasts reveals fundamental assumptions that may be overly optimistic. The market forecasts for interest rates that are currently in place suggest that the debt-to-GDP ratio could escalate to an unprecedented 123% by 2034. If the tax cuts pioneered by former President Donald Trump persist, the financial burden for the nation could intensify further still.

In an arduous attempt to gauge the weight of this fiscal forecast, Bloomberg Economics undertook a staggering one million simulations to test the resilience of the United States' debt outlook. An overwhelming 88% of these simulations forecast that the debt-to-GDP ratio is on a destructive path, with expectations of an increase over the next decade.

The Biden administration has proposed a plan that includes tax hikes targeting corporations and the affluent to mitigate fiscal woes and manage debt servicing costs. "I do believe we need to reduce deficits and to stay on a fiscally sustainable path," Treasury Secretary Janet Yellen conveyed to lawmakers during a February hearing. She emphasized that the administration's proposals could significantly reduce deficits and maintain interest expenses at comfortable levels, but stressed the import of bipartisan cooperation for these savings to materialize.

However, implementing such policy adjustments entails navigating a Congress severely split along partisan fault lines. While House Republicans push for significant spending cuts but falter in pinpointing specific reductions, Senate Democrats emphasize the lesser role of spending in worsening debt sustainability, spotlighting interest rates and tax revenues as the primary levers. Both sides appear reluctant to tamper with the benefits conferred by key entitlement programs.

Considering the gravity of the situation, it's conceivable that a crisis, such as a chaotic sell-off in the Treasuries market spurred by a downgrade in the US credit rating or apprehensions surrounding the exhaustion of Medicare or Social Security trust funds, could force action. This is analogous to playing with fire.

A brief preview of such a crisis unfolded last summer, when a Fitch Ratings downgrade coincided with an elevation in Treasury debt issuance, orienting investor focus on the associated risks. The events culminated in soaring benchmark 10-year yields which reached a zenith of 5% in October—the highest in over 15 years.

Britain's recent financial turmoil offers a cautionary tale of how rapidly fiscal confidence can erode. The ill-fated tax cuts proposed by former Prime Minister Liz Truss precipitated pandemonium in the gilt market and devastatingly swift yield surges, eventually compelling the Bank of England to intervene and quell the risk of financial catastrophe.

In contrast, the strength of the US dollar as the primary reserve currency and its pivotal role in international finance currently mitigate the likelihood of analogous fiscal disruption. Nevertheless, should investor confidence in US Treasury debt as the definitive safe asset degrade, the repercussions would be epochal, stripping the United States not only of easy access to financing but also diminishing its global clout and prestige.

Behind the Cutscene: How CBO Crafts Fiscal Forecasts

When crafting its debt forecast, the CBO employs assumptions that rest within the realm of possibility: a universal expectation of GDP growth near 2%, a return of inflation to the 2% target, and the anticipation of interest rates descending from recent highs. These postulates mirror those from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, although the CBO’s rate expectations are marginally more conservative.

A closer examination, however, exposes several optimistic underpinnings of the CBO forecast:

1. Legal mandates force the CBO to base calculations on existing statutes, which entails phasing out Trump's tax cuts by 2025. Contrarily, intentions for extension are in the air, with President Biden himself favoring the prolongation of certain measures. The Penn Wharton Budget Model assesses a permanent extension of these revenue provisions to cost roughly 1.2% of GDP annually beginning in the late 2020s.

2. The CBO also assumes that discretionary spending will align with inflation and not keep in stride with GDP, leading to a projected decline in defense spending from about 3% of GDP presently to 2.5% in the mid-2030s. This projection seems ambitious when juxtaposed against the backdrop of ongoing conflicts and emerging geopolitical threats—a more pragmatic forecast would likely inflate the CBO's predictions by at least 1% of GDP.

3. Moreover, market sentiment does not resonate with the CBO’s benign outlook on rates, with the anticipation of borrowing costs significantly exceeding the CBO’s estimates.

Bloomberg Economics’ unique model incorporates market data to project future interest rates and analyzes the maturity profiles of bonds to present a revised debt forecast. Adhering to the CBO’s projections while substituting market-based interest rates culminates in the debt-level swelling to 123% of GDP by 2034. Under these conditions, debt servicing costs could spike to approximately 5.4% of GDP—valued at over one and a half times the federal defense spend in 2023 and on par with the budget for Social Security.

For a complete analysis of these projections, you can view the full report on the Bloomberg Terminal.

In a rare consensus across the political spectrum, influential figures have raised red flags about the long-term financial outlook. Federal Reserve Chairman Jerome Powell, former Treasury Secretary Robert Rubin, investment heavyweights like Citadel's Ken Griffin, BlackRock CEO Larry Fink, and past IMF chief economist Kenneth Rogoff all concur about the disconcerting trajectory of national debt and the urgency for political intervention.

To illustrate the uncertainty clouding financial forecasts, Bloomberg Economics deployed a stochastic debt sustainability analysis, repeatedly simulating the debt-to-GDP ratio with a diverse mixture of GDP growth, inflation, budget deficits, and interest rates. In the grimmest 5% of simulations, the debt-to-GDP ratio surged beyond 139% by 2034, an echelon surpassing even that of Italy's crisis-stricken economy last year.

Secretary Yellen offers a different perspective focused on inflation-adjusted interest expenses, preferring them below the 2% of GDP benchmark. While this more optimistic angle shows better prospects, with only 30% of scenarios violating her yardstick over the next ten years, even she admits that, in an extreme case, borrowing could reach levels that would deter buyers.

Partisan Gridlock and the Path to Sustainability

Realizing a sustainable financial pathway calls for decisive action from Congress, an institution plagued by an unpromising record of fraught negotiations. Last summer, differences over government spending nearly precipitated a default, only averted by an eleventh-hour agreement that deferred debt ceiling concerns until after the upcoming presidential election.

Envisioning a US debt crisis can be arduous, owing to the dollar's reinforcement as the global tender reserve. Yet, the persistent government shutdown spectacles seldom disturb the Treasury market, indicating a robust demand for US securities. This demand, primarily buoyed by expectations of interest rate reductions, may not persist indefinitely, and fluctuations could test the market's penchant for accruing federal debt.

Herbert Stein, once at the helm of the Council of Economic Advisers, famously remarked on the inevitability of discontinuation for perpetually unsustainable practices. If the US fails to rectify its fiscal course, a future leader will face the unenviable task of confronting this harsh reality head-on, and if the dollar's supremacy wanes, the consequences will be far-reaching.

Methodological Insights into Bloomberg's Analyses

Bloomberg Economics begins its meticulous analysis using the CBO's baseline fiscal and economic outlook, including forecasts for the effective interest rate, GDP growth rate, and inflation. They then refine these projections by integrating both the rates from forward markets and a thorough, bond-specific analysis.

To further shape the fiscal outlook, Bloomberg Economics executes a statistical technique known as stochastic debt-sustainability analysis:

• Using a VAR model and historic data, they simulate a million scenarios, each varying in interest rates, GDP growth, budget deficits, and inflation.

• They employ bond maturity information to estimate the effective interest rates on US debt in response to short- and long-term rate fluctuations.

• Finally, they evaluate debt sustainability, both by observing whether the debt-to-GDP ratio increases over the next ten years and by verifying if average inflation-adjusted interest expenses surpass the 2% threshold of GDP over the same period.

The intricate analysis remains a collaborative effort, with professionals like Jamie Rush, Phil Kuntz, and Viktoria Dendrinou contributing to the depth and rigor of the forecasting.

For more information on these sophisticated forecasting techniques and the complete methodology, please refer to Bloomberg Economics' detailed breakdown on the Bloomberg Terminal.

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