By Tim Courtney, Chief Investment Officer
All three major ratings agencies have now lowered the United States’ debt from their highest credit ratings position. The Moody’s downgrade of the U.S. credit rating to AA1 culminates a 14-year span of downgrades, following Fitch in 20232 and S&P in 2011.3 These agencies are sounding the warning that the U.S. spending and deficit path is unsustainable.
The U.S. now spends over $1 trillion annually on interest.4 And the administration's current policy bill, as passed by the House of Representatives, would add another $2.4 trillion to the deficit over 10 years, according to the Congressional Budget Office.5 While average annual deficits in billions would be a welcome change from recent annual deficits in trillions, actual spending has had a way of going well over estimates.
Some (Modern Monetary Theorists) say that we should stop issuing debt and simply create new dollars to pay our bills.6 However, we just concluded an experiment of dollar creation and the result was inflation. In the wake of COVID, trillions of new dollars were introduced into the system, a move meant to stabilize the economy.7 The impact was swift as inflation spiked almost in perfect lockstep with the expansion of the money supply. A roughly 30% increase in dollars circulating reset prices 24% higher since COVID.8 And that was with the U.S. dollar increasing in value over those five years.
The Federal budget remains far above pre-pandemic levels. Stripped of inflation and higher interest costs, we’re still roughly $900 billion over what we spent in 2019.9 Efforts to rein that in, even under pressure, have yielded very little. Government spending hovers above 23% of GDP (up from 21% in 2019), a level not seen outside of wartime.10 Spending is growing faster than our economy.
There are some common ways of dealing with deficits over time. One is higher taxes. The U.S. already has one of the most progressive tax systems among developed nations. To make a meaningful dent in the deficit, the top half of earners would have to shoulder even more, or the base of taxpayers would have to broaden.
Inflation is another common way of dealing with deficits. After World War II, the U.S. allowed inflation to erode the real value of the debt over a decade. Sustained annual inflation of around 5% quietly chipped away at the country’s debt over the post-war decade,11 making it easier to repay what was owed using devalued dollars.
Something similar could unfold now. Our base case assumes inflation will run between 2.75% and 3%—not dramatically high, but above the Federal Reserve’s target. The Fed has struggled for a century to consistently hit that 2% goal,12 and there are reasons to believe it will continue to fall short.
Even though recent inflation numbers have been falling (still above 2%)13, it makes sense to plan conservatively, and that means not having overly rosy tax and inflation scenarios in future cash flow planning (we use eMoney for our clients’ future cash flow planning). If you have any questions, please contact your Exencial advisor.
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