CBO has updated the budged outlook for the US (here); results are worrisome. In this note, we show fiscal simulations using FRB-US. The results are striking:
- No matter what fiscal consolidation plan we assume, the debt/GDP ratio increases at least until 2026-2027. The same is true for net interest payments.
- Cutting public spending (“G”) has limited effects in stabilizing the debt/GDP ratio.
- Targeting the stabilization of the deficit/GDP requires a significant increase in the average tax rate on personal income, possibly too large to be feasible. In any case, stabilizing the deficit/GDP is not enough to stabilize the debt/GDP.
- Targeting the stabilization of the debt/GDP implies sizable spending cuts and much higher (personal income) tax rates. Even in this scenario, the only way to achieve a stable debt/GDP dynamic is a decade-long fiscal consolidation plan with the idea of reaching the desired target by 2034. Shorter horizons imply unfeasible or counterproductive paths.
- Assuming a high growth scenario (2.5% real GDP YoY) and no fiscal consolidation does not have positive effects on the debt/GDP ratio, as the fiscal issue is too large to be offset by higher growth.
- A recession makes everything worse, as lower yields are more than offset by larger primary deficits.
We remain unsure how many politicians, economists, and market participants are aware of the real situation.
What follows is a collection of fiscal scenarios that we have constructed using FRB-US. For each scenario, we explain the technical assumptions and we show the dynamics of the deficit/GDP and debt/GDP ratios. We have prepared a PPT that contains for each scenario the evolution of several variables, including real GDP growth, the unemployment rate, the FF rate, financial variables (i.e. 5y or 10y yield), the average tax rate on personal income, and the net interest payment / GDP. In all charts, the scenarios are shown with solid grey lines and compared to the current baseline shown with a dashed red line.
Results of the FRB-US simulations
Scenario #1. Federal spending cut
Assumptions: 1% permanent cut in government spending (cutting discretionary spending) achieved by lowering federal purchases by about 20%.
Results: cutting “G” lowers real GDP growth for 1 year, increases the unemployment rate, and results in a more dovish FF rate. It also reduces marginally the deficit/GDP ratio but it does little on the debt/GDP dynamics which remains explosive. The reason is simple: the issue is much larger than 1% of GDP.
Scenario #2. Deficit targeting scenario
Assumptions: we asked the model to stabilize the deficit/GDP ratio by 2026 without cutting “G”.
Results: as requested, the deficit/GDP ratio stabilizes at around 8% by 2026. However, according to FRB-US, this implies raising the average tax rate on personal income by about 4pp (from around 14% to around 18%). Nevertheless, despite the significant tax increases, the debt/GDP continues to grow, as the deficit is too large.
Scenario #3. Debt targeting scenario
Assumptions: we asked the model to stabilize the debt/GDP ratio by 2026 achieved without lowering “G”.
Results: as expected, the debt/GDP ratio does stabilize. However, this implies lowering the deficit to zero by 2026:Q4, doubling the average tax rate on personal income, and two years or zero-ish real GDP growth and rising unemployment rate. The net interest payments (to GDP ratio) stabilizes in 2026. We judge this scenario as politically unfeasible.
Scenario #4. Combination of spending cuts and deficit targeting scenario
Assumptions: a combination of scenarios #1 and #2 with a permanent cut of “G” of 1% and an increase in the average tax rate on personal income of 3pp by 2026.
Results: real GDP growth remains anemic throughout the entire medium-term, unemployment trends higher, the deficit/GDP ratio does stabilize but the debt keeps trending higher. In other words, a combination of a permanent cut of “G” and higher taxes is not enough, unless one assumes to double the average tax rate as in scenario #3.
Scenario #5. Permanently higher real GDP growth
Assumptions: real GDP grows at 2.5% permanently going forward. We achieve this in the model distributing add factors to each component of GDP.
Results: higher GDP results in a less unfavorable debt/GDP dynamic. However, the path of the debt/GDP ratio remains explosive as the higher real GDP growth is in any case more than offset by the large deficit. Translated: hoping that higher growth will fix the debt problem is vain.
Scenario #6. Recession scenario.
Assumptions: we assume a mild exogenous recession (-0.5% of real GDP) hitting the US in 2025.
Results: the deficit widens, as it usual does during recessions. The larger deficit (and lower GDP) more than offset the drop in yields. Consequently, the debt/GDP dynamics is more unfavorable than in the baseline.
Scenario #7. Extending the horizon
Assumptions: we extend the horizon to achieve the desired targets to 2034. In order to do so, in FRB-US we switched from VAR-consistent expectations to model-consistent expectations.
Results: we show the results for the deficit targeting scenario. Once the model is allowed to extend the horizon, for a given target it finally delivers a reduction of the debt/GDP ratio under various scenarios. However, it should be noted that in any case, the model requires an immediate increase in personal income taxes (of about 6 to 10pp), kept higher for at least a decade (see PPT for details).
(If the reader is curious to understand why in this scenario the baseline is different than in the other scenarios, the answer has to do with the VAR-based vs model-based expectations. Please, get in touch for details)
Conclusion
There is no free lunch in life. The narrative “big fiscal was a success” is wrong. Instead, the correct narrative is that while after the GFC we did too little and we ended up with a semi-depressed US and EA economies, after Covid (in fact, it started back in 2016) we have exaggerated. The model prediction is crystal clear: there is no free lunch and it will likely take a decade to fix the excessive deficit issue. The worrisome part is that the situation requires a protracted period of fiscal consolidation; a year or two is not even close to be enough. The worrisome question is: who can fix it?