Biden steps aside: what it means for the deficit

Joe Biden withdrew from the presidential race on 21 July and endorsed Kamala Harris, adding fresh uncertainty to America's fiscal outlook. The switch changed the shape of the election. Fiscal analysts are now asking what the new ticket means for a federal debt already measured in the trillions.

The starting point is grim whoever takes office. In June the Congressional Budget Office raised its estimate of this fiscal year's deficit to about $1.9 trillion, at a time of low unemployment and no war or recession to blame. Net interest on the debt now costs the government more than it spends on defence, and that bill is set to keep climbing as older, cheaper bonds mature and are refinanced at today's yields.

Same deficit, new ticket

Whichever party holds the White House in 2025, neither has a credible plan to shrink the structural deficit. A Harris administration would try to extend tax cuts for lower earners and expand social subsidies. A Trump administration would push for permanent corporate tax relief and deregulation. Either way, annual deficits would run into the trillions and keep adding to the supply of Treasuries.

A deadline both sides face

The next president inherits a built-in fiscal cliff. Most of the individual tax cuts passed in 2017 expire at the end of 2025, and letting them all lapse would amount to a large tax rise on most households. Neither candidate proposes that. Mr Trump wants the cuts made permanent and has added ideas such as exempting tips from income tax. Mr Biden promised not to raise taxes on anyone earning under $400,000 a year, and Ms Harris is expected to keep that pledge, which rules out most of the revenue a full expiry would bring in.

Democrats would offset part of the cost by raising taxes on companies and the wealthiest earners, but only with control of Congress, which is far from assured. Republicans would lean on growth and spending cuts that have seldom materialised on the scale promised. In both cases the gap between what is promised and what is paid for would be financed by borrowing.

The debt ceiling adds another hazard. The deal struck in June last year suspended the limit only until the start of 2025, so the new administration will face a standoff early in its term. Such fights rarely reduce borrowing much, but they unsettle markets, and Fitch cited repeated brinkmanship last August when it stripped America of its top credit rating.

Ms Harris has not yet set out a fiscal programme of her own, and her record offers only partial guidance. As a senator she co-sponsored Bernie Sanders's Medicare for All bill, and as vice-president she has defended the administration's spending on industrial policy and clean energy. Markets will learn more when she chooses a running mate and at the Democratic convention in Chicago next month, but nothing in her record suggests that deficit reduction would rank high among her priorities.

How the bill reaches the bond market

The mechanism is straightforward. The Treasury funds deficits by selling bills, notes and bonds, and when deficits widen it has to sell more of all three. Buyers have to be found for that supply, and when the Federal Reserve is shrinking its own holdings rather than buying, private investors must absorb more. They do so only at a price, which shows up as a higher term premium, the extra yield investors demand for holding long-dated debt.

Last autumn gave a preview. After the Treasury raised the size of its auctions, the ten-year yield touched 5 per cent in October, its highest in sixteen years, before falling back as the Treasury shifted more issuance towards short-term bills. That shift eased pressure on long bonds, but it cannot continue indefinitely without leaving the government more exposed to short-term rates.

The case for optimism

Deficit hawks can point to one hopeful precedent. The budget deals of 1990 and 1993, struck under presidents of different parties, combined tax rises with spending restraint and, helped by strong growth, turned deficits into surpluses by the end of the decade. Divided government sometimes forces compromise. A new administration facing a debt-ceiling fight and an expiring tax law might find itself negotiating something similar.

That scenario deserves a hearing, but nothing in either campaign points to it. The 1990s deals were driven by leaders who treated the deficit as a first-order problem, and neither party's platform does so today. Health and pension spending on an ageing population will also grow regardless of who wins, adding pressure that did not exist on the same scale thirty years ago.

Who gains, who pays

Savers and buyers of new Treasuries gain from higher yields, at least until inflation erodes them. Borrowers pay, because the Treasury market sets the benchmark for mortgages, corporate bonds and car loans. Future taxpayers pay most, since interest on the debt crowds out other spending in every future budget. The long end of the yield curve is where the strain is most likely to show.

The indicators to watch are the Treasury's quarterly refunding announcements, which set the size of auctions, the CBO's next budget update and, after November, the make-up of Congress. A clean sweep by either party would make large, unfunded tax changes easier to pass.

Changing the Democratic candidate does not change the arithmetic. Whoever wins, the Treasury will keep borrowing heavily, and bond investors should expect supply to keep rising through the next administration. The likeliest result is deficits of around $2 trillion a year for the rest of the decade and steadily larger auctions, with holders of long-dated Treasuries demanding, and probably getting, a higher premium for the risk.