The US is about to discover if deficits don't matter

It’s hard to think intelligently about public debt and deficits. The economics of fiscal policy is complicated and defies straightforward prescriptions. What’s most striking about budget-making in Washington today, though, is not that legislators are confused about what good debt-management requires. It’s that they’ve just stopped thinking about it.

If passed by the Senate, last week’s vast House budget bill would add between $3 trillion and $5 trillion to deficits over the next 10 years. Yet the plan hasn’t divided the country’s politicians according to whether it’s fiscally reckless. Nowadays, that issue rarely comes up. All that matters is who gains and who loses from the proposed changes to taxes and spending. Whether the economy is heading for fiscal breakdown isn’t Washington’s concern.

In 2002, Vice President Dick Cheney famously said deficits don’t matter, noting that the national debt soared during Ronald Reagan’s time in office (from 21% of GDP to 35%) as the economy boomed. Conscientious fiscal neglect, as one might call it, is nothing new. The difference is that Cheney’s comment was provocative and meant to be: It drew attention and was argued over. Not any longer. Nobody in Congress or the White House thinks it necessary to insist that deficits don’t matter. They’ve simply stopped caring.

This suspension of fiscal anxiety might seem puzzling. Perhaps the public debt is now so big, and on such a fast-rising trajectory, that bringing it back under control seems impossibly difficult. A politician might therefore ask, why worry about it? Without this bill, debt was already on track to exceed 150% of gross domestic product by 2055. But there’s no politically feasible way to rein it in. So why not cut taxes by another few trillion dollars over the next 10 years? Sure, this will raise the debt by another 10 percentage points, but the debt was “unsustainable” anyway, so what’s your point?

It turns out that this pattern — the bigger the debt, the less likely politicians are to address it — is lurking in the data, and not just in the .. An International Monetary Fund study in 2010 found that adjustments to fiscal policy in a group of 23 advanced economies were more sensitive to rising debt at low levels of debt than at high levels of debt; beyond a certain point an increase in debt actually resulted in a smaller change in budget policy.

A new study of the US found that “fiscal feedback” — the extent to which fiscal policy is tightened when projected deficits go up — has fallen markedly (alongside rapidly rising debt) since 2004. Admittedly, for much of the past two decades, the view that US deficits don’t matter has been legitimately defensible. The reason is complicated debt dynamics.

The gap between the real interest rate on government debt and rate of economic growth plays a crucial role in deciding what’s sustainable. If the interest rate is lower than the growth rate, output will expand faster than the debt plus the cost of servicing it. In other words, given sufficiently low interest rates, the government can run a modest primary (non-interest) budget deficit and still watch the ratio of debt to GDP decline.

For a time after the crash of 2008, and again during the pandemic, the real interest rate was not just less than the growth rate but actually negative. Under such conditions, budget deficits and a falling ratio of debt to GDP can go hand in hand. Unfortunately, the real interest rate is now back above 2%, which outstrips most estimates of future growth.

If this difference persists, a small primary budget surplus will be needed to stop the debt getting any higher. The prospect, even without the House budget bill, is for substantial primary budget deficits as far as the eye can see — and the bill makes these expected deficits materially bigger. The difference between the required primary surplus and the projected primary deficits is a measure of the fiscal adjustment needed merely to hold the debt ratio constant. It’s about 2-3 percentage points of GDP — between $6 trillion and $9 trillion of tax increases and spending cuts over 10 years — again, not counting the new budget.

You can see why politicians might prefer not to think about this. And it’s always possible that the problem will indeed go away if it’s ignored. A lot can change. Faster growth (maybe thanks partly to the budget bill’s tax cuts, or an AI revolution, or who knows what?) would restrain or even reverse the rise of debt. Spending and revenue projections are usually wrong: With luck, they’ll be wrong in a helpful way. Moreover, estimates of the bill’s fiscal impact leave tariff revenues out of account; these are especially uncertain, with policy fluctuating day by day, but they could put a dent in the projected future deficits. Still, the fiscal risks seem heavily loaded to the other side. As the debt grows, the fiscal adjustment required to hold it steady keeps getting bigger.

All these projections assume no recessions, which would put further upward pressure on deficits. The House has held down the cost of its budget with a new batch of supposedly temporary measures and other accounting gimmickry; correcting for this, the ten-year addition to deficits will be closer to $5 trillion than $3 trillion. The Trump administration’s tariffs, and all their associated frictions, will likely mean lower growth. The U.S. also faces an aging population and the prospect of more tightly restricted immigration — together acting as a further drag on growth and accelerator of entitlement spending.

Looming over all is the likely cost of borrowing. Until recently, very low interest rates granted unbounded fiscal space. Not only that, but they were also an expression of financial markets’ confidence that all would be well — particularly reassuring, given that investors have every incentive to look forward and weigh risks. But lately rates have not only risen, they’ve also registered episodes of alarm about aspects of economic policy. Add the administration’s evident preference for a depreciated currency, and investors can no longer take for granted the safety of US government debt. It might require a bigger risk premium. This suggests an inflection point, at which higher risks raise interest rates, which destabilises the debt, which raises interest rates, and so on. If things unravel, it could happen very quickly.

Here’s one way to look at it. In recent years, US politicians and investors have agreed, for their different reasons, not to think about rising public debt. If investors change their minds about this, begin to wonder where it all leads, and start to place their bets accordingly, an entirely new fiscal regime kicks in. And if that happens, the politicians’ complacency will hit a wall.