In this fever pitched election cycle there will come a point where the conversation shifts to fiscal policy. In our opinion, given the current U.S. debt and deficit, fiscal policy will be the greatest challenge for the next administration and several administrations beyond. While our two-party system tends to oversimplify as “tax and spend” or corporate cuts and “trickle down,” policy is far more nuanced than that. Politics aside, congress and the next administration will need to embrace a realistic accounting of the situation and the numbers do not lie. Good financial decisions will have to be made across party lines to get the debt and deficit back in line and heading in the right direction.
This is not as impossible as the current political climate may suggest. We have seen it work as political rhetoric has, at least in the recent past, given way to bipartisanship and fiscal responsibility. One of the best examples of getting the U.S. on firmer footing was Bush 41 when he went back on his “read my lips” campaign promise and compromised with Democrats to do what was fiscally necessary and raised taxes. Clinton inherited a healthier tax base as well as the Peace Dividend resulting from the end of the Cold War, and then benefited from increased tax revenue driven by a booming economy that eventually created a surplus and allowed for a cut to the capital gains tax rate. Bush 43 inherited a falling stock market and brief recession, then implemented the Bush Tax Cuts to help stimulate growth while the War on Terror increased defense spending.
The point here is that the U.S. economy and federal budget will not be solved in a day and most likely not in the next four years by either of the current candidates. The ripple effects of the fiscal plan will be far reaching and will have serious investment and economic implications.
When conducting our analysis, it is important to use a frame of reference to provide context over decades and with large sums, such as when comparing U.S. government revenues and spending. For example, we can judge government revenues and spending as well as the resulting surpluses and deficits over the decades by comparing them to the size of the economy using gross domestic product (GDP) as a frame of reference.
In the following chart, we see federal surpluses and deficits as a percentage of GDP going back to 1929, or nearly 100 years. Deficits tend to grow during economic difficulties, such as recession and during times of war. The Great Depression all the way through the most recent recession in 2020 related to the COVID-19 lockdowns resulted in deficits. Conversely, deficits typically shrink or even go into surplus during periods of economic stability and growth. Though it is rare that the federal government would run large deficits during peacetime and economic growth like we see today, history shows the prescription for debt sustainability.
Relative to the size of the economy, receipts tend to decline during recessions while spending tends to increase as both automatic stabilizers kick in and the government actively spends to stimulate economic growth.
In fact, over time the growth in government income is closely related to the growth of the economy. This makes sense as the potential revenue base grows with the size of the economy.
Given that the long-term growth rate of the economy is driven primarily by the growth rate of the labor force, the productivity growth of the labor force, and an inflation factor, much of the next decade of growth is already set. Though there will be variability, we think the next decade will be more like the 1990s than the previous business cycle of the 2010s as we believe our economy is set to embark on a new golden age of growth.
With the private sector driving economic growth and revenue, the government will need to be more disciplined in its expenses so that the growth rate of spending falls below that of revenue. Getting back to sustainability does not require spending to fall, only that the growth rate of spending needs to be below the revenue growth rate. This is what we saw during most periods of peacetime economic expansion, especially in the 1990s.
Fiscal discipline is key, and we have seen the government be more fiscally disciplined before. In addition to greater fiscal discipline, innovation can accelerate economic growth, just as we saw in the late 1990s with the information technology related boom. Perhaps today’s focus on AI-led innovation can lead to a similar result in the years to come.
From 2020, the economy has grown by a healthy 6.28% per year on average with federal government receipts growing by 6.60%. This relationship between economic growth and revenue growth has been consistent over the post World War II decades. The recent challenge has been that government spending has increased at a pace rarely seen in history.
This increased spending has led to today’s larger deficits. To fund the excess spending and cover the deficits, the Treasury has sold more bonds to the public, which has driven up the debt-to-GDP ratio to the highest levels since World War II.
Looking further ahead, we can see a path to more sustainable debt levels. For example, the following graph shows the current debt-to-GDP ratio and what two different forward-looking scenarios may look like. In one scenario, we assume GDP growth similar to what occurred during the 1990s, which is our base-case, as well as a scenario where GDP growth is similar to the 2010s.
Assuming GDP growth close to the 2010s business cycle average of 4% per year, with receipts growing at the same rate and spending growth slowing to 1% per year as a result of more fiscal discipline, we forecast that debt to GDP can get back to the pre-COVID levels over the next decade. However, if economic growth is similar to the 1990s as we expect, reigning in spending growth to 1% per year would see a debt-to-GDP level similar to the pre-COVID environment in approximately five years.
We are not saying that either one of these scenarios will become reality, but that is the math behind GDP growth and receipts as seen over the decades. The challenge will be to slow spending growth as the U.S. economy has plenty of long-term economic momentum to increase government revenues, near-term economic risks notwithstanding.
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