Downside risks in the fiscal outlook

| February 7, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The federal government is on pace to run a budget deficit of over $1 trillion for the first time since 2012.  Projected budget deficits over the next few years are large but not entirely unmanageable, just below 5% of GDP. However, there are two troubling aspects of the fiscal outlook: 1) there appears to be no appetite among policymakers to address the red ink; and 2) while a positive economic scenario would at best maintain deficits at roughly current levels, a recession could produce a damaging setback in the government’s finances.


There has been much controversy tied to the revenue side of the federal budget in recent years. The December 2017 tax cut certainly led to a drop in near-term revenues, contributing to the widening in annual budget deficits over the past few years.  At the same time, to the extent that corporate tax reform ultimately yields faster growth and more investment, the federal government should rake in more revenues in future years.  Federal revenue growth was anemic in 2016 and 2017, i.e. well before passage of the tax cut, and barely advanced in 2018, reflecting the impact of the tax cuts. However, federal revenues increased by 4% in FY2019, roughly mirroring nominal GDP growth, and are likely to expand even faster than nominal GDP gains over the next few years, returning to a more normal relationship to the economy.

Thus, in a sense the economy is back on track in terms of federal revenue growth and may remain so as long as the expansion continues. In the absence of an economic downturn, projections are for federal revenue growth of close to 6% per year over the next several years, which would raise the revenue-to-GDP ratio from 16.4% in FY2019 to around 17% by fiscal year 2022.  To put those numbers in perspective, from 1970 to 2019, revenues averaged 17.4% of GDP.  The shortfall relative to that average in 2019 works out to about 1% of GDP, or just above $200 billion. If revenues do recover to around 17% by FY2022, the shortfall relative to the historical average for the revenue-to-GDP ratio would only be worth around $100 billion (it should be noted that the average federal budget deficit over that 1970-to-2019 period was 3.0% of GDP).


The outlay side of the federal budget equation is troubling at the current time. Federal spending as a percentage of GDP spiked after the financial crisis but then fell noticeably toward the middle of the last decade, reflecting austerity on discretionary spending (recall the sequestration budget battles) and rock-bottom interest costs that accompanied the Fed’s zero-rate policy.

Unfortunately, both of those restraints on spending have lifted. Annual appropriations have surged in recent years, primarily beginning in 2019, when President Trump and Republicans bargained for sharp increases in defense outlays by acceding to Democratic demands for large hikes in domestic discretionary spending.  Another deal along those lines for the FY2020 budget was passed in late 2019.

Although interest rates remain extraordinarily low, they have risen well above zero, and federal interest costs have jumped along with the burgeoning size of the federal debt. Net federal interest outlays were in the neighborhood of $250 billion for several years while the Fed held rates at the zero bound, but recently ramped up, hitting $350 billion in FY2018 and almost $400 billion in FY2019. Despite the drop in Treasury yields, net federal interest costs are on a trajectory towards $500 billion over the next few years.

The third major piece of the federal budget, entitlement spending, is probably the most troubling of all in terms of the budget outlook. For at least 20 years budget experts have looked at demographic projections and warned of the train wreck coming when Baby Boomers hit retirement age and began to draw from Social Security and Medicare. That issue is finally upon us, and the budget numbers are beginning to show it. The growth in Social Security and Medicare outlays is well in excess of nominal GDP growth and will continue to accelerate (in the absence of policy changes) for years.

Adding it all together, federal outlays averaged between 5½% and 6% growth over the past two fiscal years and appear poised to remain on a 6% pace of increase for the foreseeable future.  In FY2019, federal outlays constituted 21% of GDP, only modestly higher than the 1970-to-2019 average of 20.4%.  However, that figure is likely to continue to move higher, perhaps hitting 21½% by FY2022, a level that has only been seen in modern times during and just after recessions (when spending on aid programs automatically rises and the denominator in the ratio is weak).  Looking further ahead, assuming current policy, the CBO projects that the outlays-to-GDP ratio will approach its post-Financial Crisis highs by late in the decade.


Combining the two sides of the ledger, the federal budget deficit rose to $984 billion in FY2019, 4.6% of GDP.  My projections call for gradually rising budget deficits in dollar terms over the next few years but relatively constant deficits in relation to GDP.  While this is not grossly out of line with the historical average (1970 to 2019) of 3.0%, it is troubling that deficits are so large a decade into an economic expansion. Typically, budget deficits should be relatively small and declining at this stage of the business cycle.

I am more optimistic than most regarding the economic outlook over the next few years, so my projections could be considered something close to a best-case scenario. A recession in the next few years would probably result in a disastrous deterioration in government finances. For perspective, the deficit-to-GDP ratio in FY2007, the last full year before the financial crisis, was 1.1%, so that there was room for the inevitable rise in red ink when things went south in 2008 (the deficit surged to a high of nearly 9% of GDP in FY2010). As things currently stand, the federal government will be starting from a much worse position when the economy next turns down, whenever that turns out to be, and a recession in the near term would be particularly problematic fiscally.

Prospective Policy Changes

Of course, fiscal policy is very much up in the air in the 2020 election season. However, no one seems the least bit concerned about fiscal deficits and debt.  If a Democrat wins the White House in November, budget projections may have to be entirely revamped, depending on how the Congressional balance of power evolves.  Several candidates have proposed massive tax increase packages, but all of those proposals have been crafted in an attempt to pay for (or more accurately, to partially pay for) new spending initiatives. In contrast, President Trump is suggesting that he would like to push for a new round of tax cuts in 2021 if he wins and Republicans control Congress. In either scenario, it seems that if there are policy changes in 2021 and beyond, they will be pushing us toward larger, not smaller, deficits.

Again, as long as the expansion continues, the current trajectory is likely sustainable for a while.  However, the business cycle will presumably turn down at some point, and anything more than a marginal recession could ratchet up the pressure on the long-term budget outlook.

In addition, through most of the 1990s and 2000s, there appeared to be a loose consensus in Washington that something needed to be done to fix Social Security and Medicare before the full brunt of Baby Boomer retirements hit. There were blue-ribbon commissions, bi-partisan committees, budget summits, etc. periodically over that period, though Congress never got around to doing much. Since the financial crisis, any appetite for even considering entitlement reform dissipated, and neither political party appears willing to bring it up any time soon, which promises years more can-kicking until the entitlement situation begins to approach crisis status.  As of now, the main trust fund for Medicare is projected to be depleted in 2026, while the primary Social Security trust fund is projected to be depleted in 2034.

john.killian@santander.us 1 (646) 776-7714

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