The contentious debate over the budget debt ceiling is over with both houses of Congress voting to approve the proposed agreement by President Biden and House Speaker Kevin McCarthy (R-Calif.).
The key element is a two-year spending package that would raise the debt ceiling until after the 2024 elections. Nondefense spending would be flat for fiscal 2024 and increase by 1 percent in fiscal 2025 while 3 percent increases are granted for the military and veterans.
Markets had rallied in anticipation of the news, as passage by both houses of Congress would preclude a default and spending will not be pared back to 2022 levels. Based on the Congressional Budget Office’s scoring, the deal should have only a negligible impact on the economy. That’s the good news.
However, two key issues could leave the economy at risk in the future.
First, what happens if there is a recession? Normally, freezing discretionary spending would leave the federal government hamstrung, although there may be some flexibility due to previously authorized spending in the $1.7 trillion omnibus bill passed in December. Should the economy falter at some point as a result of Federal Reserve tightening, however, it is questionable whether Republicans would approve a supplemental budget with an election approaching.
Second, when will Congress address other key components that shape the overall budget? Democrats refuse to consider entitlement programs, and Republicans rule out tax increases for corporations and the ultra-wealthy. This means that discretionary spending for social programs, education and defense bear the entire burden of slowing the growth of federal debt.
These issues are important because discretionary spending is the main counter-cyclical tool that policymakers have: Ramped-up spending stabilized the economy and financial system during the 2008 global financial crisis and then fueled a strong recovery from the COVID-19 pandemic slump.
During the financial crisis, Congress authorized the Troubled Assets Relief Program (TARP) in October 2008 to rescue financial institutions impacted by the meltdown in mortgage-backed securities. It was followed by the American Recovery and Reinvestment Act of 2009, a $789 billion bill that covered a variety of expenditures to bolster the economy.
By comparison, the fiscal response to the COVID-19 pandemic was five times larger: Three separate packages were enacted from March 2020 to March 2021 that totaled more than $5 trillion in additional deficit spending.
According to economist Mickey Levy, the fiscal stimulus during the 2008 financial crisis matched the decline in real gross domestic product (GDP), but the stimulus during the COVID-19 period was equivalent to 27 percent of real GDP, or three times larger than the decline in real output. While it produced a powerful V-shaped recovery, it also contributed to the steepest rise in inflation in four decades.
Weighing these considerations, what can be done to get the U.S. out of the bind whereby far-right Republicans can threaten a debt debacle periodically?
One must first accept that we are now paying the price for excess stimulus during both the Trump and Biden administrations. While the likelihood of fiscal stimulus was low once Republicans took control of the House last year, it is virtually nil now. This leaves automatic stabilizers as the main tool to foster recovery.
Beyond this, both sides must realize how bizarre it is to have negotiations over the debt ceiling. As Martin Wolf of the Financial Times observes, “It is not normal for a country to have a legislated budget and a separate authorization that this budget entails.”
The origins of the debt ceiling legislation date back to 1917, when Congress ended the practice of approving every Treasury bond issue individually and allowed the sale of Liberty Bonds to help finance the war effort. In 1979, a parliamentary procedure called the “Gephardt rule” was adopted that deemed the debt ceiling to be raised automatically when the budget was passed. However, it was repealed in 1995 when Republicans gained control of the House of Representatives and pressed for a reduction in the size of the federal government.
William Gale and Len Burman of the Tax Policy Center recently have argued that it is time to reinstate the Gephardt rule, but this will require that both sides are amenable. What is the incentive for either side to do so?
I contend it requires reforming the budgetary process such that items that currently are “off the table” can be considered. A “grand bargain” would mean that Democrats accept that entitlement programs such as Social Security, Medicare and Medicaid would be subject to periodic review of their viability. In return, Republicans would accept that taxes on corporations and ultra-wealthy individuals are legitimate items to be considered in the budgetary deliberations.
For many politicians, this is too high a bar to clear. However, consider the consequences if nothing is done: Over time, entitlement programs will continue to expand in relation to total spending as the life spans of Americans increase and medical costs outpace inflation. They now account for 63 percent of total spending versus 5 percent in 1960, when Social Security spending began to ramp up and before Medicare and Medicaid were enacted. Meanwhile, interest on the public debt represents 8 percent of spending and is set to increase further. With both parties reluctant to cut defense spending, this leaves only about 15 percent of spending “on the table.”
Therefore, If there are no tax increases, discretionary spending will continue to shrink as a share of the total. In the end, it is the main tool the government has to bolster the economy, and reform of the budgetary process is needed to put federal debt on a sustainable trajectory.
Amid this one thing is clear: Investors should not bank on a robust recovery from a recession.
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 authored three books including “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”