America is living beyond its means

The U.S. government has been borrowing from Peter to pay Paul for decades. That should come as no surprise to most, but the speed by which we are piling up debt to support our spending has become alarming.

The Federal budget deficit is the difference between how much Washington spends and how much it receives in taxes. That concept should be familiar to all of us who count on our income to support our family’s spending. Imagine if the amount you owed (your deficit) doubled from last year.

That is what happened to the nation’s budget deficit over the last year, to the tune of $1.7 trillion.

If you look at the big picture, the U.S. total federal debt topped $33 trillion this year. That amounts to 121% of 2022’s GDP. Usually, the U.S. deficit expands during hard times for the economy since tax receipts fall. The opposite occurs when the economy grows. However, that relationship has come apart.

The U.S. economy has been growing since the pandemic and yet tax receipts continue to fall. Much of the blame for this situation can be laid at the doorstep of various administrations and Congress. Tax cuts by George W. Bush, Barack Obama, and more recently Donald Trump have reduced the amount of taxes coming into the government’s coffers.

In typical political fashion, the present White House under President Biden has pinned the blame for lower tax revenues on the former president. Trump indeed left the country in far worse shape than his predecessors. His more than generous corporate tax cuts failed to jump-start the economy. Instead of investing in capital formation, corporations used those savings to increase dividends and stock buybacks.

Federal spending now accounts for 25% of GDP. In defense of government spending, you might say the last few years have been unusual and you would be right. The COVID-19 pandemic triggered a huge spending program to save the economy and voters. In addition, the need to do something about the country’s deteriorating infrastructure was finally addressed after years of inaction. Since then, Russia’s invasion of Ukraine and the terrorist attack in Israel have added even more pressure to increase spending.

But the really big programs that have consumed so much of the government’s spending commitments are Social Security and Medicare, which account for almost half of U.S. spending.

Back in 2011, the Congressional Budget Office (CBO) predicted the fiscal deficit would average 1.8% of the economy in the ensuing decade. This past May, in the CBO’s latest projections, that number has increased to 6.1% of Gross Domestic Product. Altogether, federal spending will account for almost 25% of the U.S. GDP over the next decade while tax receipts will account for 18% of GDP. If we continue this trend, Penn Wharton School researchers predict that the U.S. could default on its debt as soon as 20 years.

Up until now, the financial markets have largely ignored the deficit, and the endless debates and false promises by legislatures who talk a good game but simply move the deck chairs around on a sinking ship once they are in power. The bond market, however, is beginning to take notice.

As the nation’s borrowing grows larger to finance a growing deficit, bond vigilantes are taking matters into their own hands. They are selling U.S. government bonds, which is pushing yields higher and higher on government debt. It is the private sector’s response to Washington’s profligate spending and irresponsible deficits. In the current fiscal year interest spending should surpass $800 billion, which is more than double 2021’s $325 billion number.

By 2026 net interest expense should reach 3.3% of GDP. That would be the highest on record. If interest rates remain where they are, and fiscal policy continues its spending path. If unchecked, the cost of servicing this debt could be larger than defense spending by 2025, and top Medicare spending by 2026. I believe the present push by Republicans in Congress to cut spending is both necessary and urgent. It will be painful. It should also be accompanied by tax increases across the board, but that may be too much to ask for given elections next year, but one can always hope.

Bill Schmick is a founding partner of Onota Partners Inc. in the Berkshires. None of his commentary is or should be considered investment advice.  Email him at bill@-schmicksretiredinvestor.com.