Macro Signposts | 27 November 2024

Please note that Macro Signposts will pause next week following the U.S. holiday, resuming the week of December 9.

U.S. Debt Dilemma: Politics and Economics

Throughout the long U.S. election season, we emphasized that regardless of which candidate and which party wins, the U.S. deficit was likely to be the biggest loser. Now, with President-elect Donald Trump entering office in January along with a narrowly unified Republican Congress, the longer-term outlook for the deficit and debt is becoming a bit clearer - or at minimum, we can analyze the probable scenarios. In brief: While the debt trajectory is unquestionably upward, scope for a better-than-feared deficit outlook could help the bond market tolerate, or even welcome, these policy changes.

Demographics drive debt
According to Congressional Budget Office (CBO) forecasts, the ratio of U.S. debt to GDP will likely surpass 200% in the next few decades. The greatest contributor to that rising debt is demographics: the steadily aging population, whose healthcare costs (for one example) are projected to drive accelerating growth in the costs of Medicare and Social Security.

Ahead of the election, we argued that neither party was likely to meaningfully alter this longer-term trajectory, since both political parties pledged not to touch Social Security and Medicare benefits - two categories of mandatory (nondiscretionary) spending that effectively drive all of the projected increase in government spending. The Republican sweep in some ways further solidifies that view, since historically, when serious spending and tax reforms have been undertaken and enacted, it has been under divided government with bipartisan legislation. Neither party wants to take all the blame for tough budget choices that affect their communities.

Republican priorities, and challenges
Having said all of that, President-elect Donald Trump campaigned on reducing deficits - even slashing the current 6.5% deficit all the way down to 3%. At the same time, he campaigned on extending the provisions of the 2017 Tax Cuts and Jobs Act, or TCJA, as well as cutting additional taxes. Reaching a 3% deficit, while also extending costly tax cuts, will be near-impossible. Here is why:

Mathematically, making good on this goal would require the Trump administration and its new Department of Government Efficiency ("DOGE" - an advisory commission) to find around $875 billion in the budget to cut, and getting (likely bipartisan) agreement from Congress to legislate the new lower appropriations. This is going to be a tough sell for a few reasons.

First, the economics: This magnitude of government spending cuts would pose a large headwind to GDP growth. According to the U.S. national income and product accounts (or NIPA, published by the Bureau of Economic Analysis), federal government expenditures were around $1.8 trillion in fiscal year 2024. Reducing government spending by $875 billion in one year would require all non-federal-government expenditures (consumption, investment, net trade, etc.) to grow almost 9% nominally to achieve the Trump administration's real GDP growth target of 3% (equivalent to 5% nominal growth, factoring in 2% inflation). For context, average nominal GDP growth rates, excluding federal spending, in the first decade of the 2000s were around 5.5%; in the decade following the global financial crisis, they averaged 3.5%. The economics works a bit better if you assume the deficit targets are hit over time, rather than all at once: Reducing government expenditures by 10% per year over the next several years would require around a 6% nominal growth rate in all other GDP expenditure categories to hit the 3% real GDP growth target. It still seems like a stretch.

Second, the politics: We suspect it would be very difficult for officials to implement these types of changes. Excluding interest payments, the federal government's discretionary spending budget (including defense and non-defense) was roughly $900 billion in 2024, according to government statistics; lawmakers couldn't cut $875 billion per year in discretionary categories alone without taking them nearly to zero (i.e., literally no spending on defense, teachers, veterans, cancer research, etc.). So they would also need to find room to reduce areas of mandatory spending. Medicaid and Supplemental Nutrition Assistance Program (SNAP) benefits cost the federal government around $740 billion in 2024, so even a dramatic (and politically unrealistic) reduction in these programs likely wouldn't reach the administration's goal.

Feasible scenarios
We doubt that federal government budget reforms will change the longer-term debt trajectory in any meaningful way. However, a combination of incremental spending improvements, tariffs, and budgetary techniques may not increase the deficit as much as feared in the coming years. So what could actually get done?

First, the estimated 10-year cost of the TCJA is around $4.0 trillion, according to the CBO. However, extending the provisions for only four years would drop that estimate to around $1.7 trillion. Repealing some of the Inflation Reduction Act (IRA) credits, coupled with a short-term easing in the state and local income tax break caps and other tax goodies could be included with $100 billion - $200 billion in additional front-loaded costs.

Second, Congress could pair this with some expense-lowering reforms. There are legitimate areas of fraud, waste, and overlap - healthcare and defense the most cited examples - that could at least in theory reduce government costs. The Government Accountability Office (GAO) has released a number of studies on fraud, waste, and redundancies that, if addressed, could theoretically save the federal government around $400 billion - $500 billion per year, by our estimates.

Implementing the reforms to realize cost benefits over time likely requires more staff (not less) today, and will still likely require bipartisan support from Congress, something that has failed to materialize in the past. (For example, during the Obama administration in 2010, the bipartisan Simpson-Bowles Commission formulated a plan to address the fiscal situation, but it never made it to a vote.) However, some incremental savings are likely possible. Just $100 billion per year of efficiency gains would reduce deficits over a 10-year horizon by an estimated $1 trillion.

Third, augmenting the reforms above with somewhat higher tariffs on China and other countries could further offset the estimated costs of a short-term TCJA extension. For example, revoking China's Permanent Normal Trade Relations (PNTR) status, which has afforded them most favored nation treatment since 2000, in favor of a scheme that would raise the effective tariff rates on China by another 10 percentage points (roughly the amount of the increase associated with Trump's Section 301 investigation in 2018) could raise an estimated $400 billion over 10 years.

While these "pay fors" would not be large enough to change the long-term debt trajectory of the U.S., we think they are incrementally better relative to a full, unfunded TCJA extension - which many market participants seemed to expect heading into the election.

Implications for investors
What would all of this mean for the economy? While the longer-term deficit outlook will remain challenging - moving to 3% deficits isn't going to happen anytime soon - some incremental budgetary offsets, using tariff revenues and maybe some efficiency gains, could reduce the additional costs of a short-term extension of the TCJA, without having a large impact on economic growth and inflation.

For markets, this outcome doesn't seem terrible. Although the longer-term fiscal trajectory would remain unsolved, government efforts to pay for further tax cuts without resorting to large tariff hikes or major spending reductions (which could do serious harm to the economy) could be just enough signal that fiscal constraints matter, as does maintaining the robust U.S. economic performance observed since the pandemic - a potentially goldilocks environment for both the bond and the equity markets.

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