America's deficit won't shrink

The Congressional Budget Office's updated baseline puts the federal deficit above $1.5 trillion in 2024, rising toward $2.6 trillion over the coming decade, and that is before Congress passes anything new. Mandatory entitlements and rising interest costs account for all of the increase.

A baseline that flatters

The baseline is, if anything, generous. By law it assumes current policy runs its course, which means the individual tax cuts passed in 2017 run only until the end of 2025 and then lapse. Both presidential candidates want to keep at least part of them: Donald Trump has promised to extend them in full, and Joe Biden has pledged not to raise taxes on anyone earning less than $400,000 a year. Every extension adds to the deficit the CBO has already pencilled in, and debt held by the public, already close to the size of the economy, is on course to pass its post-war record before the decade is out.

Stalemate in Washington

Neither major party has the will to face the arithmetic. Republicans will not consider tax increases, and Democrats reject changes to Social Security and Medicare. With the government now borrowing at interest rates of around five per cent, the cost of servicing the debt compounds year after year. The result is a debt spiral that runs on autopilot, and a supply of Treasuries that never stops growing.

The entitlement clock is running too. The Social Security trustees reported this month that the main retirement trust fund is projected to be exhausted by 2033, at which point current law would force an automatic cut in benefits. Neither party has proposed a way round that, and both have campaigned against the obvious options. The cheapest path politically is to cover the gap with more borrowing when the moment arrives.

How interest compounds

The mechanics of the spiral are simple. Whether the debt ratio rises or falls depends on two things: the primary balance, meaning the deficit before interest, and the gap between the interest rate on the debt and the growth rate of the economy. For most of the 2010s the government borrowed at rates below nominal growth, so the debt ratio could stabilize even with modest primary deficits. As old, cheap debt matures and is refinanced at today's yields, that cushion is disappearing, and a primary deficit of the current size leaves the ratio climbing every year.

The effect shows up in the composition of spending. The CBO projects that net interest will exceed the defence budget this year, and interest is the fastest-growing major line in the federal accounts. Every percentage point on the average cost of borrowing now adds hundreds of billions of dollars a year to outlays once it has worked through the stock of debt, and none of it buys a single service.

Deals used to happen

Divided government has produced fiscal restraint before. The budget agreements of 1990 and 1993, the first of which cost George H.W. Bush his pledge on taxes, combined with the productivity boom of the late 1990s to deliver surpluses from 1998 to 2001. The Budget Control Act of 2011 imposed spending caps after a debt-ceiling standoff that cost the United States its AAA rating from Standard & Poor's. The difference now is that the spending growth sits in programmes both parties have declared untouchable, and in interest payments that no vote can cancel.

Bond markets lose patience

Investors have already given a preview. Fitch downgraded the United States in August 2023, the Treasury raised the size of its bond auctions that same month, and by October the ten-year yield had touched 5 per cent for the first time since 2007. Much of that rise was attributed to the term premium, the extra return investors demand for tying up money for longer. Moody's cut its outlook on American debt to negative in November, citing large deficits and political polarisation.

The buyer base is also changing in ways that raise the price. Foreign central banks, once the dominant holders of Treasuries, own a much smaller share than they did before 2008, and the Federal Reserve is still shrinking its portfolio. The marginal buyer is increasingly price-sensitive: pension funds, insurers, hedge funds and households, all of whom need a higher yield before they take on more duration. A market that once relied on buyers who did not care much about price now depends on buyers who care a great deal.

The losers from a higher term premium are long-duration assets: holders of long bonds, housebuilders and their customers, utilities and other heavy borrowers whose financing costs track long-term yields. Savers in Treasury bills, by contrast, collect high yields without taking much duration risk, and the curve is likely to steepen as supply lands at the long end.

Britain supplied a sharper warning in September 2022. The government of Liz Truss announced large unfunded tax cuts, gilt yields jumped so fast that pension funds using leveraged hedging strategies faced collateral calls, and the Bank of England had to buy long-dated gilts to stop a fire sale. The prime minister was gone within weeks. America's position is far stronger, but the episode showed that bond markets can reprice fiscal risk in days once a government's plans lose credibility.

Where the argument could fail

The counterargument is that America's borrowing capacity is unusually deep. The dollar is the main reserve currency, Treasuries are the world's collateral of choice, and Japan has carried far heavier debts for decades with low yields. Term-premium estimates are model-dependent and fell back after October as inflation cooled. None of that alters the supply schedule, however, and a market asked to absorb ever larger auctions will set the price at which it does so. The next test comes in the Treasury's refunding statement at the end of July and in the reception of the ten- and thirty-year auctions, and the bigger one after November, with the debt-ceiling suspension lasting only until early 2025 and the tax cuts up for renewal.

The deficit is no longer a feature of the business cycle. Washington has built it into the budget, and investors will probably demand a higher term premium on long-dated Treasuries for many years to come, with the first real test arriving when the next Congress takes up the expiring tax cuts.