Government Debt Ceiling - CWG Speakers

No more cheap money

Unkind motivations are attributed to the Matt Gaetz-led Republican opposition to former speaker Kevin McCarthy. Gaetz rejects these accusations of grandstanding and argues he is simply trying to prevent runaway federal spending. Traditionally Congress approves the discretionary federal budget through twelve bills to be approved by October 1st. That deadline has been missed with growing frequency in recent years. To prevent a government shutdown, lawmakers pass a bill to continue funding while the bills are compiled into one piece of “omnibus” legislation. Gaetz & co. argue this prevents proper scrutiny of proposed budgets. They say McCarthy reneged on his promises when he helped pass a stopgap bill to continue government funding for 45 days beyond the October 1st deadline. 


Hard-line Republican opposition to these spending bills is partly ideological. But it also reflects a growing unease about government finances in light of rising borrowing costs. Congress only approves discretionary spending, around 25% of the federal budget. The remaining mandatory spending concerns entitlement programs like Social Security, Medicare and interest spending on the federal debt. As this latter cost increases, the pressure is on to find spending cuts elsewhere.     

Short-term treasury yields have risen in line with the federal funds rate for some time. But since the summer of 2022, the curve has been inverted meaning short-term bonds are paying higher interest rates than long-term ones. It’s a classic indicator of an upcoming recession with the market anticipating an economic slowdown. However, the US economy is proving remarkably resilient. While the curve is still inverted, it is normalising. This reflects growing sentiment that the economy is in for a “soft landing”. Investors are therefore internalising the Fed’s messaging that rates will be higher for longer.    


It’s a positive indicator of the country’s economic strength. But rising long-term yields are a problem for the fiscal deficit. The current 10-year rate of 4.9% is not historically unusual. Rates were last at this level pre-GFC in 2007. However, US debt levels are now 3 times higher and so servicing this debt is much more costly. The decade or so from the GFC to the pandemic was an anomalous period where the low rates environment meant fiscal hawkishness was absent from both sides of the aisle. Trump’s sweeping tax cuts were supported by conservatives even as they widened this deficit. These cuts expire in 2025 and will likely be renewed by a new incoming Trump administration. The already troubling US public finances forecast currently excludes this prospect. 

On these current forecasts, the Congressional Budget Office predicts debt interest payments will constitute 35% of federal expenditure by 2053. In 2025, interest payments will surpass defence spending and they will top Medicare by 2026. US Treasury Secretary Janet Yellen said recently that debt costs are “manageable”. Other economists though, previously relaxed about government borrowing, are concerned about rapidly rising rates. Jason Furman, a Harvard economist and former economic advisor to Obama, had estimated that inflation and economic growth meant federal debt interest would remain sustainable for some time. Now rates have climbed so substantially, the calculus has changed, Furman argued.   


Current rates mean it is highly likely the Fed has reached the end of its hiking cycle for now. Dallas Fed President Lorie Logan said these rises “could do some of the work of cooling the economy for us, leaving less need for additional monetary policy tightening.”  But the government still faces the problem of filling the air pocket of demand for bonds that would lower borrowing costs. The Fed is shrinking its balance sheet of bonds as it reverses Covid-era stimulus policy. Demographic changes are also pulling in the wrong direction. The wealthy boomer generation are now entering retirement and no longer generating demand through pension funds. And banks are not incentivised to lever up and buy bonds at the current funds rate. 


This phenomenon is not confined to the US. With the exception of Japan and its central bank’s capping policy, bond yields are rising in tandem across advanced economies. The scale of the problem varies according to countries’ debt levels. In Europe, Germany faces a lesser issue. The UK and France are somewhere in the middle. The latter was recently criticised by the country’s fiscal watchdog for not cutting public spending fast enough to avoid breaching EU fiscal rules. Its credit rating was downgraded by Fitch in April. 

Italy is the cause for most alarm. It recently increased its planned bond sales for 2023 due to worsening public finances. The country already faces a record $3 trillion public debt. Italy is already paying more to borrow than its southern European maritime neighbour, Greece. Its high budget deficits mean it could soon lose support from the European Central Bank. Unsurprisingly, Prime Minister Meloni is keen to promote her socially conservative agenda to keep this economic news off the front pages.  


The circus around the US speaker may be symptomatic of the country’s partisan and disjointed political landscape. But it also represents the significance of rising borrowing costs and anxiety about global debt levels. Recent events in the Middle East suggest supply shocks will be a continuing near-term factor. It’s therefore increasingly unlikely we will return to a lower rates environment any time soon. Therefore, governments will need to cut spending or increase revenues to address these concerns. Further infrastructure spending on the energy transition and unfavourable dependency ratios make the former look difficult. Therefore, without any radical upside in growth rates from speculative factors like generative AI, tax rises are the most straightforward route to smaller deficits. Matt Gaetz will not be pleased to hear it but an era of bigger government beckons. 



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