Markets and Economy

Managing the Budget Deficit

The Congressional Budget Office projects that the federal budget deficit will steadily widen in coming decades, making it perhaps the biggest long-term threat to the US economy. But structural reforms along with accelerating economic growth could keep the deficit manageable.

For decades, dire predictions about the impacts of the federal budget deficit, including hyperinflation and skyrocketing interest rates, have proven wildly off-base. But as the Congressional Budget Office (CBO) projects that the budget deficit will widen to $1.5 trillion annually within the next 10 years, there may be a structural deficit looming—which could be markedly more challenging for the US economy than the cyclical deficits of the past.


Despite this reality, bond yields have remained low. Even though bond investors are aware of the current fiscal predicament, it’s likely that they disagree with pessimistic economic assumptions—choosing instead to trust that structural flaws in government entitlement programs will be addressed. And while traditional remedies of cutting spending and raising revenues will not fix the nation’s structural problems, accelerating economic growth could help address the coming deficit.

Tuning Out the Cyclical Noise

The debate over government spending largely focuses on cyclical fluctuations in the deficit, which tend to be self-correcting. When the economy contracts, the deficit naturally rises. Falling tax revenues, rising social safety net costs and stimulus spending can all contribute to a temporary spike in borrowing.

During the 2008 recession, the deficit briefly rose to more than 10 percent of GDP. But since demand for private-sector investment fell dramatically, Treasury bills faced little competition for capital in the bond markets. In 2009, the federal government issued $1.4 trillion in new debt; yet Treasury yields steadily fell, reaching historic lows.

As the economy recovered, tax revenues rose, and the deficit receded to a sustainable range of 2 to 3 percent. The debt issued during the recession did little long-term damage to the economy, and stimulus measures helped people who might have otherwise faced years of unemployment. The coming structural deficit, however, will be different. It will not fade with the business cycle; instead, forecasts call for a permanent imbalance that will relentlessly drain investment from the private sector during good times and bad.

Running a significant deficit wasn’t disruptive when the economy was operating well short of its full potential, but doing so at the peak of the business cycle could be more damaging. If the federal government is competing with the private sector for capital when businesses want to expand and consumers are eager to buy big-ticket items like cars, spiraling interest rates could curtail capital investment and consumer spending, hampering economic growth.

Structural and Entitlement Reform

Rising healthcare and retirement costs are two of the drivers of the long-term deficit. Since Medicare and Social Security are entitlement programs, their spending is on autopilot—as the population ages, more people will inevitably draw their guaranteed benefits. Funding these programs will require structural reforms.

Even drastic cuts to discretionary spending would do little to offset rising entitlement spending. To fully fund the government’s projected obligations, the aggregate tax burden would have to rise from the current 18.1 percent of GDP to a crippling near-30 percent of the economy. As this would be unsustainable, a more fundamental fix is necessary.

Entitlement reform could help reduce costs in the long run. The average American’s life expectancy has risen by six and a half years since the Social Security program was created; as the population ages, longer lifespans are overburdening the program. Reforms that reflect that new reality could put the program on more solid footing.

Healthcare spending might be reduced through reforms that address the divide between private and public-sector insurance. Currently, private insurers have little incentive to invest in preventive care and wellness programs that will yield results in old age, since their customers’ chronic health problems will be borne by the government when their customers retire. Legislative fixes could also encourage competition in the healthcare sector and promote the adoption of cost-saving technologies.

Growing Past the Baseline

Despite its potential, entitlement reform can only go so far. Ultimately, the nation’s fiscal outlook depends on growth, which is projected to slump over the coming decades due to the slow expansion of the workforce and stagnant productivity. But neither of these factors is set in stone. Immigration could supplement the workforce, with foreign-born taxpayers contributing to Social Security and Medicare to offset the aging of the native-born population.

Productivity trends are difficult to predict, as technological breakthroughs occur in volatile bursts. But over the course of decades, investments in supply-side growth can set the stage for a more productive future. Building new highways, modernizing the power grid, and incentivizing research into promising technologies can provide future workers with the resources necessary for faster growth.

If growth exceeds the CBO’s projections by a single percentage point, the long-term structural deficit would become manageable, even with no changes to revenues or spending. This may be why bond markets have been tranquil in the face of dire forecasts—the future is not fixed, and the economy’s structural problems may be helped by modest structural solutions.

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Jim Glassman Economy Interest Rates

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