As Congress pivots to debt, it shouldn’t forget the inflation connection

House Speaker Kevin McCarthy (R-Calif.) is proposing increasing the debt ceiling in exchange for spending reductions totaling $4.5 trillion. Even though it may pass the House, the proposal will not be enacted because most of the reductions would interfere with the president’s spending priorities. 

Nevertheless, it represents an attempt to get the president and Congress to negotiate about how to reduce budget deficits. This is critical not only in order to pay for future Social Security and Medicare commitments to seniors, but for the long-term control of inflation.

The spending side of the story is well-known, but it deserves an update.

In the past, foreign and domestic lenders have been willing to finance America’s deficits in return for the interest they could earn on assets that they considered almost risk-free — U.S. government bonds. As the debt and associated interest payments grow relative to the size of the economy, the possibility of a future fiscal crisis increases. As a report from the Committee for a Responsible Federal Budget put it, “loss of market confidence could quickly drive up interest rates or inflation expectations, devaluing existing bonds and causing severe global financial disruptions.”

Any serious effort to reduce the deficit that could achieve bipartisan support would likely require both tax increases and reduced spending. As for the latter, it would be hard to significantly reduce the deficit without reducing spending on entitlement programs such as Medicaid, Social Security and Medicare. These and other mandatory spending that does not involve annual appropriations now constitute 65 percent of federal spending.

What would significant spending reform look like? 

The National Taxpayers Union Foundation has a set of eight proposals that, combined, would reduce the deficit by more than $2 trillion over 10 years. The top five would each reduce the deficit by at least $100 billion over 10 years. This includes cutting back on three agricultural programs, six selected options for reducing wasteful and unnecessary defense spending, incrementally raising the Social Security full retirement age from 67 to 70 by two months per year, reducing the federal match for Medicaid spending for the wealthiest states and eliminating the deduction of state and local taxes from taxable income. The Congressional Budget Office (CBO) has compiled a list containing numerous other options, each of which could result in a large deficit reduction.

Republicans and Democrats need to sit down and acknowledge the difficult choices that will need to be made. A little bit of everything must be on the table to avoid much more draconian spending cuts or tax increases in the future.

According to CBO, if deficits rise as projected, annual interest on the debt, which was $475 billion in 2022, will rise to $1.4 trillion (or 3.6 percent of GDP) by 2033. At over 14 percent of total federal outlays, that would be more than the projected annual federal spending on Medicaid.

As for how this affects inflation, too few in Washington acknowledge the relationship.

High rates of inflation during 2021 and most of 2022, as well as progress in bringing inflation down during the last few months, illustrate the impact of the Federal Reserve and monetary policy. Spending, however, played an indirect role, and in the long run, persistently large deficits are increasingly likely to impinge on monetary policy.

If the government does not have a credible debt reduction plan, we can expect the Fed to face enormous pressure to fund deficits by increasing the money supply. At some point, this may be the only way to keep ballooning government interest costs manageable.

Case in point is the inflation we’re experiencing. Some good might come from what’s happened if we treat it as a warning.

About half of all the pandemic stimulus spending was financed by Fed money creation. Since then, we’ve essentially been paying an inflation tax instead of having to pay back the additional borrowing with future taxes. If Congress is unwilling to reduce deficits with some combination of reduced spending and higher taxes, we may have the same problem over and over.

Politicians may be tired of hearing it, but we need strong leadership from the president and Congress to substantially reduce the deficit. Otherwise, we can expect the government to default on its debt through some combination of expanding the money supply rapidly (and driving inflation even higher than the 9 percent it reached in June 2022) and not meeting its full commitments to seniors for Social Security and Medicare after these trust funds run out of money (as they’re projected to do a little over 10 years from now).

There are viable ideas out there. Now is a good time to figure out which ones everyone can live with.

Tracy C. Miller is a senior policy research editor with the Mercatus Center at George Mason University.