Goldman: What Is Going On In The US Is "Usually Reserved For Times Of War"

Back in February, when the world was starting to become familiar with the trajectory of US debt and deficit spending under Trump's fiscal plan, we showed a chart from Goldman which made a troubling forecast: the US fiscal situation was headed for "banana republic" status, or as Goldman put it more politely, "uncharted territory" as a result of soaring federal debt and interest expense.

Now, in a follow up report, Goldman economist Alec Phillips identifies the key risks that will worsen the "already-grim" US fiscal outlook (which he defines simply as "not good"). As a reminder, just yesterday we reported that the US fiscal deficit has resumed its surge, rising 40% Y/Y to $898BN for the first 11 months of the year, following the biggest monthly outlay by the US government in history.

Goldman - which now projects a $1.05tn deficit (4.9% of GDP) for FY2019 - picks up on this and writes that its expects that figure to rise significantly over time, reaching 5.5% of GDP by 2021 and 7% of GDP by 2028. This, Goldman adds ominously, "puts US fiscal policy in  uncharted territory in two respects." 

First, running such a large primary deficit (federal revenues minus spending, not counting interest expense) in a period of strong growth and low unemployment is quite unusual, and according to Goldman is "generally reserved for times of war" as shown in the chart below.

Second, the high (and rising) federal debt-to-GDP ratio "comes at a time when interest expense looks likely to rise substantially as well." This is a similar argument to what Goldman noted back in February, and it also points out that the US also ran a very high debt-to-GDP ratio during World War II, but at the time borrowing costs were fairly low. While Goldman concedes that federal interest expense has been elevated before as well, most recently during the “bond vigilante” era of  the 1990s, "the level of federal debt was low then and the primary deficit was relatively small. Over the next decade the US is likely to face both extremes at the same time."

The gloom continues from Goldman, which next notes that not all of this is due to policies enacted in this Congress, and is one of the few to remember that US debt actually doubled under the previous administration:

In fact, the relationship between the deficit and unemployment rate began to diverge during the Obama administration, as Congress began to loosen its grip on spending and revenues increased by less than they typically do at this point the economic cycle.

That said, the current admin isn't much better, and Goldman says that "much of the deterioration in the outlook has occurred more recently, however. Congress has eased fiscal policy substantially over the past year, by cutting taxes by 1.5% of GDP in FY2019 and 0.6% over the next ten years, lifting the caps on defense and non-defense discretionary spending (0.7% in FY2019) and approving additional emergency spending (0.4%). This fiscal easing should boost GDP growth by around 1pp in 2018, but we expect the boost to taper after Q4 of this year, as the growth effects of the tax cuts and spending increase fade."

One big near-term catalyst for the US fiscal trajectory is what happens during the midterms: the bank, which previously predicted that Democrats would win control of the House as the GOP retains the Senate, notes that "the midterm election result could influence the outlook somewhat" as divided government (our base case) "would lead to a slightly negative-to-neutral fiscal impulse by 2020."  Even if Republicans maintain majorities in the House and Senate, Goldman would expect a slight additional easing as modest tax cuts could be enacted through the reconciliation process; but even in that case, "the fiscal effects on growth should be only modestly positive under such a scenario, if positive at all."

So what is the worst that could happen?

Phillips explains that Goldman's "base case" is for congress to extend expiring tax cuts and to maintain current levels of discretionary spending in real terms. In this scenario, the deficit will reach 7% of GDP by 2028 and federal debt will reach 104% of GDP. This, however, is a more positive outcome than several potential alternative scenarios Goldman has analyzed which include:

  • 1. Business as usual. Our baseline scenario calls for a small amount of passive fiscal tightening through “real bracket creep” in the tax code, which refers to the tendency for revenues to rise as a share of GDP as real incomes rise; and through roughly flat real discretionary spending growth, which reduces the level as a share of GDP. However, this is more restrictive than the typical action from Congress. If instead we assume a business-as-usual scenario that holds revenues and discretionary spending constant as a share of GDP, federal debt would be 7pp higher as a share of GDP by 2028 than our current baseline.
  • 2. Lower growth and an adverse interest rate-growth differential. If interest rates exceed nominal growth when the level of public debt is high, the debt-to-GDP ratio might rise even with a large positive primary surplus. Lowering the growth of real  and nominal GDP and wages by 0.5pp in each year from 2020 through 2028 but holding all else constant, including interest rates—this is a realistic scenario in the case of low productivity growth—would have this effect. The resulting interest rate-growth differential would be in the same territory as the late 1980s and 1990s, when fiscal pressures led lawmakers to enact substantial deficit reduction legislation.
  • 3. A recession in two years. Although we believe the odds of a recession remain low over the next couple years, a hypothetical recession starting in 2020, in which the output gap widens to 4% of potential GDP, could temporarily widen the budget deficit by 3-4% of GDP as revenues decline and countercyclical fiscal factors phase in. Although this scenario assumes that easier monetary policy would lead to relatively smaller deficits immediately following the post-recession period, federal debt levels would remain considerably above our baseline and rise to 110% of GDP by 2028.
  • 4. A deficit reduction package. Perhaps the most striking scenario in this set is the most optimistic one, in which Congress passes a substantial deficit reduction program. In the early 1990s, deficit reduction packages reduced the primary deficit by about 1.5% of GDP over four years. Should Congress enact a similar program in the medium term, we estimate the federal debt would still amount to about 95% of GDP by the end of the decade.

To this all we could add is that scenario 4 is virtually impossible, and that #1 and #3 are synonymous, with a recession in 2020 (or sooner) now inevitable, the question then being just how and where will the US government find the room to add on the trillions in extra debt needed to bootstrap the economy out of what is likely to be the most severe contraction in decades, likely surpassing even the great financial crisis which saw China putting its own debt issuance apparatus into overdrive, an option which will no longer be available this time.

Goldman agrees:

As the 2020 presidential election approaches, the odds of meaningful reduction policies are likely to decline. We are not particularly optimistic about reform occurring soon after 2020, either, as public opinion polling suggests that the electorate does not currently view the deficit to be a particularly important  issue. Of course, the outlook at that point depends on the result of the next election for the White House and Congress. For the moment, however, there are few reasons to expect a shift in fiscal policy priorities in the near or medium term.

The conclusion is unfortunate: with no chance of the current debt trajectory realistically changing, the only question is just how optimistic will this most recent long-term debt forecast from the CBO end up becoming...

... and of course, if the current or future administration will eventually "grow into" the contextual situation that Goldman laid out as justifying the current fiscal outlier state of the US economy, namely entry into war.