Stories to Watch: Unsustainable Fiscal Policy

Noah Smith is on the story; Bridgewater on the near term outlook

What time is it? Noah Smith says that it is time to think about fiscal austerity.

If interest rates stay well above zero and productivity fails to experience a late-90s-like boom, expect more articles like this. As interest costs rise and start squeezing the rest of the budget, expect Democrats to call for higher taxes and Republicans to call for cuts to Medicaid and other social programs. Expect to see analyses from think tanks detailing all the wonky little ways we could restrain federal spending. In other words, expect somewhat of a return to the intellectual and political climate of 1992.

He says that in the past decade low interest rates lulled people into thinking that the government could just keep running higher deficits forever. He makes some basic economic points, including:

A rule of thumb for whether government borrowing is sustainable is whether the interest rate r is less than economic growth r. Intuitively, r is the rate at which the debt naturally grows, and g is the rate at which the tax base grows. If g > r, then you can run a deficit forever without increasing the ratio of debt to GDP, because you’re always growing out of your debt. But if r > g, you have to run a budget surplus in order to stop debt from growing as a share of GDP.

Technically, I believe that the last sentence should read “primary surplus,” which leaves out interest spending.

The other key point:

When population is growing rapidly, programs like Social Security and Medicare are like sustainable Ponzi schemes — young working people pay into the system via taxes, and then during their retirement they get more out than they put in, because a new bigger crop of young people is now paying in. But when population growth slows down, this becomes less sustainable. Fewer young people to pay into the system, plus more people who depend on the system, means that we will either have to cut benefits, raise payroll taxes, or start paying Social Security benefits from general revenue.

Looking at the near term, Bridgewater’s Karen Karniol-Tambour and Shane Murphy write,

Each major channel of government spending has expanded over the past year: direct spending, which directly flows through to demand and GDP and is set to remain high due to legislative priorities, e.g., past infrastructure bills and ongoing defense spending increases; transfers, which will continue to rise as spending on social programs increases due to aging populations and higher inflation being locked in through COLAs; and interest payments, which will also continue to rise as the need to refinance at higher interest rates flows through the government debt stack.

…We expect this combination of forces—the Treasury needing to issue more debt at the same time as the Fed is continuing to sell bonds via QT—to add a significant amount of duration to the market, pulling money out of cash and assets and, all else equal, resulting in higher interest rates and lower asset prices.

Pointer from Moses Sternstein

substacks referenced above:

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Random Walk at Night: The Almighty Consumer is different now

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An Age of Austerity is probably on the way