The 2023 budget: A final attempt at compromise before policy gridlock sets in

In the wake of the 2022 midterm elections, many observers believe the most likely outcome for fiscal policy over the next two years will be gridlock. This comes after the Democrats enacted major spending programs in the past two years to: (1) provide ongoing relief for the COVID-19 pandemic, (2) fund the biggest public infrastructure bill in history and (3) salvage parts of President Biden’s Build Back Better program in the Inflation Reduction Act that address climate change, health care and tax reform. New spending authorized for these programs exceeds $3 trillion.

Looking ahead, President Biden and congressional Democrats are fully cognizant that their ambitious agenda will have to be pared back considerably because Republicans will take control of the House of Representatives. With Republican gains much smaller than expected, Rep. Kevin McCarthy’s (R-Calif.) status as speaker of the House is still to be determined. But the influence of MAGA Republicans such as Rep. Jim Jordan (R-Ohio) and Rep. Marjorie Taylor Greene (R-Ga.) will increase as they will play prominent roles in House committees.

For their part, the Democrats picked up a one-seat majority in the Senate when Raphael Warnock won the runoff election in Georgia. But this was partially offset by Senator Kyrsten Sinema’s (D-Ariz.) decision to switch her affiliation from Democrat to independent. The switch is not expected to alter the balance of power in the Senate for two reasons: (1) Sinema previously acted independently when she voted against President Biden’s Build Back Better bill and other Democratic-sponsored legislation; and (2) she does not plan to caucus with the Republicans.

Meanwhile, the close election results have spurred both sides to reach agreement on finalizing the federal budget for fiscal 2023. Senate Appropriations Chair Patrick Leahy (D-Vt.) recently announced that a bipartisan framework would pave the way for an omnibus $1.7 trillion spending bill to be passed before Christmas. The plan’s details were released on Monday in a bill that totaled 4,155 pages.

Previously, there had been talk that Republicans would try to block passage of the budget. But after failing to take the Senate and regaining the House by only a very narrow margin, Republicans entered the lame duck session with a much weaker hand than they expected. Consequently, they have abandoned plans to threaten shutting down the government or passing a series of short-term budget resolutions in favor of striking a deal.

The main issue holding up the omnibus bill was disagreement between the two parties over domestic funding levels. Republicans claimed that Democrats had attained their objectives through previous bills; Democrats countered that additional social spending was needed to counter the effects of inflation.

One area they could agree on was defense spending. Last week, the Senate passed an $858 billion defense spending bill that was $45 billion more than Biden had sought. It also included $45 billion in assistance for Ukraine. An amendment proposed by Sen. Joe Manchin (D-W.Va.) that would fast-track the approval process for permits for energy-related projects failed.

According to the Washington Post, the omnibus bill proposal contains $773 for domestic programs, a 5.5 percent increase over the 2022. They include a significant increase in funding for veterans, child care programs, public infrastructure and domestic manufacturing of computer chips. The total is smaller than Democrats had been seeking, but they were willing to compromise because they understand that next year is going to be tougher for them.

Although Senate Republicans were willing to compromise on the 2023 budget, House Republican leaders urged members to block its passage until next year, when they will be in control. Despite their philosophical commitment to smaller government, federal spending has exploded since the COVID-19 pandemic struck in 2020. Since then, $5 trillion have been allocated to provide pandemic relief for individuals and families, businesses, state and local governments and health care entities.

During the three preceding years, federal spending averaged about $4.5 trillion. It then surged by 45 percent in 2020 and has averaged close to $6 trillion in the past three years. This resulted in the ratio of the federal budget deficit to GDP setting a post-war record of 15 percent in 2020 and 12 percent in 2021. It has since fallen to about 6 percent of GDP in 2022, and the Congressional Budget Office’s baseline projections see deficits of 4 percent to 6 percent over the next 10 years. They are well above the post-war average of 3 percent and imply a steady increase in public debt outstanding relative to GDP.

As a result, there is less room for the government to pursue counter-cyclical fiscal policies or social programs should the economy slip into recession.

The initial response to the COVID pandemic was justified when businesses were closed and the economy plummeted, and it is credited for contributing to a robust recovery. However, both parties went overboard extending transfer payments to people and businesses. Several studies have concluded that the extra payments to unemployed workers did not affect labor supply materially. Others see the massive increase in federal spending as contributing to the surge in inflation this year.

With fiscal policy likely to be on hold for the next two years, this leaves the Federal Reserve with the burden of deciding whether to ease monetary policy while inflation is well above its 2 percent target. In this respect, U.S. policymakers will be much more constrained if there is another unforeseen shock.

Nicholas Sargen, Ph.D. is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has co-authored three books, including “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”