Between costly tax cuts and last week’s hefty spending bill, Congress is generating deficits that aren’t just large, they’re also unprecedented and potentially ominous. And even with some optimistic assumptions, President Trump’s latest budget proposal wouldn’t eliminate these deficits — in fact, the president is still angling to add a potentially costly infrastructure plan on top of current spending. But when the economy is this strong, deficits are usually small and shrinking, not ballooning back toward $1 trillion.
We are following a path that the country hasn’t traveled since World War II, with green economic pastures alongside rivers of red deficit ink. And that combination carries unique risks — not because the numbers are especially large (during the early years of the Obama administration, the deficit regularly exceeded $1 trillion) but because these deficits provide unneeded stimulus, which can overheat an economy already operating near full capacity. And in the process, they drain away funding that might be better reserved for fighting off the next recession.
Congress’s don’t-tax-but-spend approach is a root cause of the sizable deficit. Less than two months after Republicans passed a tax plan expected to cost the Treasury roughly $1.5 trillion, members of both parties agreed to raise spending by as much as $300 billion over two years, not including the new infrastructure and other spending increases in Trump’s budget proposal. Resistance to these moves has been inconsistent, with just two members of the entire Republican caucus voting against both the tax cuts and the spending bill despite the fact that deficit reduction has been a GOP rallying cry for decades. Even famously deficit-averse House Speaker Paul Ryan signed on.
But in plum times, deficits this big carry real risks. To start with, financing these deficits will require the government to borrow more money via the bond market. And to attract enough investors, they may have to pay higher interest rates, in the form of higher bond yields. But that only makes the budget situation even worse, forcing the government to pay back its debt at higher rates.
Private businesses would feel the squeeze, too. If the government starts paying higher interest on its bonds, companies will have to do the same for corporate bonds. That’ll make it costlier for them to raise money, reducing investment and even dampening overall productivity.
This was less of a problem during the Great Recession and its aftermath because bond yields were held down by the Federal Reserve. Among other things, the Fed engaged in a massive bond-purchasing enterprise called quantitative easing, which created a kind of backstop to ensure that the government could find buyers without having to raise payouts.
But the situation has now reversed. The Fed is raising interest rates, selling off bonds and generally trying to restrain an economy that’s growing at a pace the regulatory body fears may be unsustainable. And that means there is no backstop, just an environment where deficits could make it much more expensive for both government and private companies to borrow money.
And this is just one potential issue. Perhaps the greater risk of rising deficits is that they make it harder for the U.S. to fight off the next recession, whenever it comes. Combating a recession generally requires a twofold approach: Rapid interest-rate cuts at the Federal Reserve to encourage borrowing and stimulus spending from Congress, both of which inject cash into the economy. But the Fed is in a weak position now. It can’t cut rates by 4 or 5 percentage points, as it has in recent recessions, because interest rates aren’t that far above zero right now — and the Fed’s own projections suggest they won’t get much higher, even over the long run.
Congressional action is thus especially important, but here’s where deficits get in the way. When Congress passed stimulative tax cuts during the recession of 2001 and boosted direct spending with the American Recovery and Reinvestment Act in 2009, they were starting from a position of relative comfort, as pre-recession budget deficits were either small or nonexistent. This time around, the U.S. is liable to enter its next recession with a substantial deficit, inflaming concerns that even necessary stimulus would be just too dangerous.
To appreciate just how unusual today’s deficits are, consider that the last time the job market was comparably robust was in the mid-2000s, and at that time the deficit declined from 3.4 percent of the GDP in 2004 to 1.1 percent in 2007. One cycle earlier, when the unemployment rate hit a 30-year low in 2000, the U.S. actually ran a budget surplus.
The charts below plot both annual deficits and what’s called the “output gap,” a measure of how close the U.S. economy is to its full potential. And the story comes together in the bottom panel, where the march of dots leading up and to the right shows that from 1950 until very recently, the U.S. has stuck close to the same general pattern: When the economy approached — or sometimes exceeded — its growth potential, deficits tended to be small, or even to flip into surpluses. But when the economy weakened, as in the early Obama years, budget shortfalls widened, sometimes dramatically.
What really stands out are the current projections, which show the U.S. walking into a deficit no-man’s-land, an otherwise empty area where growth is above expectations and yet deficits remain large. Although, in the years since 1950, we’ve had periods where the economy was stronger than today’s, and others where deficits were larger, we’ve never in that time seen a deficit this large in an economy this strong.
But the current deficits aren’t going to vanish; they’re expected to grow. Recent estimates from the Treasury Department show deficits increasing from $750 billion this year to just over $1 trillion by 2020. And while that does include the impact of tax cuts, a separate estimate from the bipartisan, pro-debt-reform Committee for a Responsible Federal Budget — which also accounts for last week’s expensive budget agreement — puts the likely 2020 gap at $1.24 trillion.
The good news is that fixing the deficit problem is relatively straightforward, a matter of finding the right balance of spending cuts and tax increases. And now would seem a propitious time for either approach approach, given that the economy doesn’t need any stimulus.
But deficit hawks seem to have become an endangered species in Washington, apparently outnumbered by the deficit shruggers, who’ve grown inured to the prophecies of impending budget doom. Democrats warned of deficits during the tax cut debate, and some Republicans found their anti-deficit voices last week in a failed effort to block the spending bill — but these critiques seemed mostly opportunistic, a handy weapon for attacking your opponents’ priorities that’s quickly sheathed when pursuing your own.
For now, neither party seems willing to make deficit reduction a top priority, which worsens the odds of finding a solution — and lets the risk accumulate along with the debt.