America’s long-term fiscal sustainability challenge

As the political circus associated with the latest debt ceiling debate kicks into high gear, issues associated with U.S. fiscal sustainability have garnered attention from the media and Wall Street. The massive surge in government spending in recent years and growing concerns regarding the viability of critical transfer programs have made it necessary to undertake a careful consideration of long-term fiscal sustainability.

It is now hard to imagine that a key point of contention in the 2000 election involved the question of how to deal with projected budget surpluses. In fact, in 2001 Federal Reserve Chairman Alan Greenspan noted: “While the magnitudes of future federal unified budget surpluses are uncertain, they are highly likely to remain sizable for some time.”

Reality certainly has a way of making long-term economic projections appear ridiculous. In fact, since 2002 the U.S. has continually run a budget deficit, and, during the last three fiscal years, they have reached historically unprecedented levels ($3.13 trillion deficit in fiscal year 2020, $2.78 trillion in fiscal year 2021 and $1.38 trillion in fiscal year 2022). Meanwhile, the gross federal debt rose from 55 percent of GDP at the end of 2001 to 123 percent at the end of 2022.

All governments face an overall budget constraint: If total taxes and seigniorage revenue are not sufficient to cover total government outlays (government purchases, interest payments on existing debt and transfer payments) during a given period, then the resultant budget deficit will necessitate fresh borrowing. The primary balance, meanwhile, ignores net interest payments on public debt and considers if the government is spending more on public goods and services than it is collecting in taxes.

While the budget constraint considers the flow dynamic, the fiscal sustainability condition describes the stock dynamic. U.S. Treasury’s annual financial report notes: “A sustainable fiscal policy is defined as one where the ratio of debt held by the public to GDP (the debt-to-GDP ratio) is stable or declining over the long term.”

The Treasury openly acknowledges that the U.S. is on a fiscally unsustainable path, a view that is widely shared. To attain fiscal sustainability and ultimately reduce the debt burden, the U.S. must engage in fiscal consolidation that reduces primary deficits in the near term and generates primary surpluses in the future.

Unsurprisingly, the Congressional Budget Office (CBO) does not foresee the government achieving primary surplus anytime soon. In fact, given the projected increases in non-discretionary expenditures (associated with net interest payments, Medicare, Medicaid and Social Security), the primary deficits will widen substantially if nothing is changed.

The U.S. also needs to ensure that the interest rate-growth differential remains favorable. For decades, the average real interest rate cost of servicing the debt was below the real GDP growth rate. Going forward, this dynamic cannot be taken for granted. The CBO projects a potential real GDP growth rate of only around 1.8 percent over the next decade.

Implementing significant structural reforms and improving the institutional framework may help boost long-term growth. But achieving and sustaining higher levels of labor and total factor productivity growth have proven to be a challenge so far this century.

On the interest rate front, there is considerable uncertainty associated with the future path of real rates. The U.S. is, however, exposed to significant interest rate risk as it failed to appropriately structure the maturity duration of Treasury securities during the low interest rate era.

Intriguingly, the U.S. debt-to-GDP ratio declined slightly in 2021 and 2022 after peaking in 2020. The improvement owes a great deal to sharply higher inflation rates (which caused the denominator, the nominal GDP, to rise quicker than the numerator, nominal debt) observed in the 2021-22 period. While unexpected inflation does have the potential to ease the debt burden in the short-run, the impact may wane if inflation becomes more persistent and is better anticipated by market participants.

After World War II, the U.S. was able to gradually reduce its debt burden through a combination of rapid growth, high inflation and financial repression. A post-war baby boom, the entry of women into the labor force, the rapid pace of technological breakthroughs and strong labor productivity growth provided the conditions for rapid economic growth between 1947 and 1973. Strict financial regulations, fixed exchange rates and restricted capital mobility during the Bretton Woods era (1945-1971) allowed for widespread financial repression. It is hard to foresee a repeat of such unique or favorable circumstances in the years ahead.

In fact, factors such as de-dollarization and costly environmental shocks may actually add to ongoing challenges. The risk of fiscal dominance of monetary policy poses an additional long-term threat.

Looking ahead, can we restore fiscal sustainability without undergoing a debt crisis? In the absence of an early and genuine bipartisan effort to deal with the mounting challenges, we may be headed for a future that involves painful fiscal consolidation. To quote Herb Stein, ‘if something cannot go on forever, it will stop.”

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.