US Debt Forecast: The Frog in Hot Water
The US economy may be cooling down, but the country is like a frog in hot water. This analogy perfectly captures how incremental changes can accumulate to dangerous or even fatal levels if ignored. The Congressional Budget Office (CBO) recently released its Budget and Economic Outlook, revealing that deficits will gradually rise from 5.6 percent to 6.1 percent of Gross Domestic Product (GDP) over the next 10 years under current law. To put this in context, the average deficit over the past 50 years has been 3.7 percent of GDP.
Unfortunately, the US is slowly boiling away, and the frog is oblivious to the danger. Government debt held by the public is projected to grow from 99 percent of GDP this year to 116 percent by 2034, well above the record high set in 1946 after World War II. We are the frog, trapped in water that keeps getting hotter.
This didn’t have to happen. Just at the start of the century, the water was a lot cooler. The budget was in surplus, and the debt stood at a mere 31.5 percent of GDP, less than a third of the current level. But as the temperature steadily rose, we failed to take the opportunity to jump free. Now, it’s a valid question whether we have waited too long.
Answering this question requires acknowledging three fundamental facts about the current situation. Firstly, we need broader spending restraint. This goes beyond just annual appropriations and includes mandatory programs like Social Security, Medicare, and Medicaid, as well as interest on the debt. These programs are the driving force behind higher spending. The CBO projects that mandatory spending plus net interest will increase by 2.0 percent of GDP over the next decade, while discretionary spending will shrink by 1.1 percent. By next year, mandatory spending plus interest on the debt will consume all revenues. In other words, even if discretionary spending, including defense, is eliminated in 2025, there will still be a deficit. Without a more comprehensive approach to spending reductions, our fiscal policy will remain unsustainable.
Secondly, we need more revenue. As a result of population aging, rising healthcare costs, and increased debt servicing expenses, future revenue needs will be higher than in the past. Revenues have averaged 17.3 percent of GDP over the past 50 years, but during the last four years of budget surpluses from 1998 to 2001, revenues averaged 19.3 percent of GDP, two points above the 50-year average. The CBO projects a slow climb in revenues from 17.5 percent to 17.9 percent of GDP over the next decade, assuming temporary tax cuts expire after 2025. However, if these tax cuts are extended, revenues will remain flat, driving deficits even higher. Considering that it required revenues above 19 percent of GDP to balance the budget several years ago, it’s implausible to think that we won’t need at least that amount in the future. Besides necessary spending restraint, higher contributions on the revenue side will be crucial to put the budget on a sustainable path.
Lastly, we need more workers. Higher economic growth can help support the growing debt burden, but the potential workforce growth is slowing down due to an aging population and low fertility rates. The CBO projects a two-thirds drop in potential workforce growth over the next decade. Beyond 2034, net immigration will increasingly drive population growth, accounting for all population growth by 2040. In other words, by 2040, the United States will experience more deaths than births. Due to these demographic constraints, the CBO estimates that annual real GDP growth will plummet to just 1.5 percent in the 2040s, compared to an average of 2.4 percent from 1993 to 2022. If we don’t find a way to increase workforce growth, whether through immigration or other means, the future economy will struggle to handle the growing debt burden.
Addressing these challenges will require difficult trade-offs and extensive bipartisan cooperation. We have to make the choice between facing the reality and taking action or remaining in the water and boiling to death like the frog in the allegory.
Analyst comment
This news can be evaluated as negative for the market. The growing deficits and government debt, along with the projected decline in economic growth and population aging, indicate an unsustainable path for the economy. Without broader spending restraint, increased revenue, and a strategy to boost workforce growth, the market may face challenges and potential instability in the future. The market needs bipartisan cooperation and difficult tradeoffs to address these issues and avoid negative consequences.
