A view from London

Forecasts for global growth have fallen in response to the news on tariffs with the US seeing an especially marked downgrade. But at least for now greater optimism on trade has quelled talk of the US falling into recession this year.

While the media and markets have been transfixed by the tariff news the US Congress has been working on a new federal budget. Republicans want to renew Donald Trump’s 2017 tax cuts, which would otherwise lapse, and to make good on last year’s campaign pledges to reduce other taxes, including removing tax on tips and overtime income. The substantial costs of these measures would only be partially offset by planned spending cuts and revenue raising measures. Congress seems unlikely to support the sort of swingeing cuts in welfare, including Medicaid, which would be necessary to fully cover the cost of the proposed tax cuts. Republicans, who control both houses of Congress, want to pass the legislation needed for tax reductions and spending by 4 July using a procedure called reconciliation. 

Once again borrowing is set to take the strain. The US federal government has been on a multi-decade borrowing binge. In only 4 of the last 40 years, all of them in the second Clinton administration in the late 1990s, has the US run a budget surplus. Deficits are the norm, averaging 3.0% of GDP between 1985 and 2020. COVID saw the deficit balloon to the 13% mark, but even in the ensuing robust recovery from 2021, the US has posted sizeable deficits.

The US has locked into a vast budget imbalance, one where revenues permanently run behind federal outgoings even in periods of strong growth. The problem is getting worse. The independent Congressional Budget Office (CBO) forecasts that the deficit will average around 7.0% of GDP over the next eight years.

America’s stock of debt is on a sharply rising path. The ratio of debt to GDP stands at 100% today, up from just 35% in 2007. The reconciliation bill would take debt to 134% of GDP by 2034 and 211% by 2055, according to the CBO. 

Falling interest rates and, since 2008, quantitative easing, under which the Federal Reserve bought government bonds, have so far made a rising debt burden manageable. But things are changing. Interest rates have broken out of the sub-1.0% range that prevailed for much of the last 15 years and the Fed is no longer buying government bonds. As US government bonds issued at rates as low as 0.5% mature the US Treasury is having to refinance them at current market rates, closer to 4.5%. Rising debt servicing costs result in larger deficits, more borrowing and a heavier debt burden. 

US debt is on an unsustainable path, a point reinforced by last week’s decision by the ratings agency Moody’s to strip the US of the highest triple-A credit rating on concerns about a widening budget deficit.

Yet there is no immediate and obvious catalyst for a fiscal crisis. US Treasury bonds are still the world’s most liquid, deepest and safest asset class; the dollar is still the world’s reserve currency. This is not an argument for complacency. As the UK found in 2022, under the Liz Truss government, market appetite for government debt can disappear overnight. A recession, sharply higher interest rates or an egregious policy mistake could quickly sharpen America’s debt problem.

According to the University of Pennsylvania and Wharton budget model, even under today’s favourable conditions, debt levels in excess of 200% of GDP would be unmanageable: “Under current policy, the US has about 20 years for corrective action after which no amount of future tax increases or spending cuts could avoid the government defaulting on its debt whether explicitly or implicitly [through inflation]”.

The surest way of resolving America’s debt problem would be for Democrats and Republicans to agree on a set of tax rises and reductions in public expenditure that would, in time, bring spending back into line with revenue. In today’s partisan political environment that sort of grand bargain looks almost inconceivable. That means that debt levels will keep on rising. This is one economic problem that isn’t going away.