America is borrowing like it's in a recession. It isn't

The federal deficit is approaching six per cent of GDP while unemployment sits near a historic low of 3.5 per cent. Keynesian doctrine says governments should run big deficits in bad recessions, when tax receipts fall and automatic stabilisers kick in. Borrowing on this scale with the economy at full employment has no peacetime precedent, and it looks reckless.

How the gap opened

The deficit is the sum of decisions taken over several years. The pandemic relief packages of 2020 and 2021 have run off, but they were followed by the infrastructure law of 2021 and, in 2022, by the CHIPS Act and the Inflation Reduction Act, whose clean-energy tax credits have no fixed cap and are proving popular. The 2017 tax cuts still reduce revenue each year. None of these measures was paired with offsetting tax rises large enough to pay for it.

Interest is the newer problem. With the Federal Reserve's policy rate at 5.25 to 5.5 per cent, the cost of rolling over maturing bills and issuing new debt has jumped, and interest payments are among the fastest-growing items in the budget. That spending buys nothing and cannot be cut by Congress, yet it compounds: every dollar borrowed to pay interest raises the next year's interest bill.

Borrowing at full employment

The deficit pumps demand into an economy already running close to capacity, working against the Federal Reserve's rate rises. Absorbing this much new debt without the central bank buying it will require bond markets to demand a sizeable term premium. Investors will not accept thin yields from a government that borrows like a wartime debtor in a time of peace and full employment.

The macroeconomic conflict is direct. The Fed raises rates to cool spending, while fiscal policy adds spending back through transfers, subsidies and tax credits. The result is that monetary policy has to work harder, keeping rates higher for longer than it otherwise would, to achieve the same slowdown in demand. Households with savings earn more on cash, companies with floating-rate debt pay more, and the government pays the most of all.

The nearest comparisons

The closest historical echo is the late 1960s, when spending on the Vietnam war and the Great Society programmes ran alongside unemployment below four per cent. That combination is widely seen as one of the roots of the inflation that followed in the 1970s, and it was, at least, wartime borrowing. Even in 2019, when unemployment also touched 3.5 per cent and critics already called fiscal policy loose, the deficit was below five per cent of GDP.

The mid-1980s offer a different lesson. Deficits under Ronald Reagan were large, though unemployment was far higher than today, and real long-term interest rates stayed unusually high for years as the Treasury competed for savings. Bond investors then demanded compensation for fiscal risk as well as for inflation, and got it. The parallel suggests the term premium can stay elevated for a long time once the market decides supply is structural rather than cyclical.

Where the market is pushing back

There are signs the repricing has started. The Treasury said on 2 August that it would increase the size of its quarterly coupon auctions, the first rise since 2021, and warned that further increases would probably follow. Fitch cut America's credit rating a day earlier, citing fiscal deterioration and repeated standoffs over the debt ceiling. Long-dated yields have climbed even as markets increasingly expect the Fed to be near the end of its hiking cycle, which is what a rising term premium looks like.

The buyers who held the premium down in the 2010s have stepped back. The Fed is shrinking its balance sheet rather than adding to it. Foreign official holders have not been expanding their Treasury portfolios, and domestic banks are nursing losses on the bonds they already own. What remains is a more price-sensitive investor base of pension funds, insurers, asset managers and households, all of whom will buy duration only at a yield they consider fair for the risk.

The case for patience

The strongest counterargument is that part of this year's deficit is temporary. Capital-gains tax receipts fell after the market slump of 2022, and the Internal Revenue Service gave taxpayers in disaster-hit parts of California until October to file, which pushed revenue out of the usual months. Strip out such distortions and the underlying deficit looks somewhat smaller. Nominal GDP growth, meanwhile, has been strong enough to hold the ratio of debt to GDP in check over the past two years.

That argument has merit, but it concerns timing rather than direction. Delayed tax payments arrive eventually, and a recovery in capital-gains receipts depends on asset prices that higher yields themselves threaten. Nominal growth erodes debt only while inflation stays elevated, and the Fed is trying to bring inflation down. Once it succeeds, the debt ratio will depend on primary deficits that show no sign of closing, and on interest costs set by a market that now prices the risk.

What would change the call

A credible fiscal package, combining spending restraint with revenue measures, would narrow the term premium quickly, but nothing of the sort is on the congressional agenda before next year's elections. A recession would shift the debate, because deficits would then widen for the right reasons, though from a starting point that leaves little room. The indicators to watch in the meantime are the size and reception of Treasury auctions, the next refunding announcement in early November, and whether Congress funds the government by the 30 September deadline without a shutdown.

Borrowing six per cent of GDP at full employment will push long-term yields higher, and when the next real downturn arrives Washington will have little fiscal room left to fight it. The first cost falls on anyone who borrows at rates set off the long end of the Treasury curve over the next year, from homebuyers to corporate issuers; the second falls on the unemployed of the next recession, whose support will have to be financed at the higher yields that today's borrowing is creating.