CAMBRIDGE – US President Donald Trump’s administration has now released its budget plans for fiscal year 2018. Among the details provided in the document, entitled America First – A Budget Blueprint to Make America Great Again, are projections for the expected path of gross federal debt as a percentage of GDP, which is shown to decline from its current level of about 106% to about 80% in 2027. Debt held by the public is expected to mirror this path, shrinking from 77% to 60% over this period.
Unfortunately, neither projection is credible. A sustained and marked decline in government debt (relative to GDP) would be welcome news for those of us who equate high indebtedness with the kind of fiscal fragility that reduces the government’s ability to cope with adverse shocks. But, as many critics have pointed out, the economic assumptions underlying the Trump administration’s benign scenario appear improbable. In fact, they are also internally inconsistent.
The Trump budget assumes a steady spell of 3% GDP growth, which appears to be at odds with the prevailing trends of weakening productivity performance, slowing population growth, and a significantly lower level of labor force participation. These factors are all reflected in recurrent downward revisions to potential GDP growth by institutions such as the Federal Reserve and the Congressional Budget Office (CBO).
A new study by the non-partisan Committee for a Responsible Budget presents a very different outlook for US deficits and debt from the one contained in Trump’s budget blueprint. It estimates that under realistic economic assumptions from the CBO, debt in Trump’s budget would remain roughly at current levels, rather than falling precipitously (as deficits would remain above 2% of GDP, rather than disappear by 2027). Furthermore, the study shows that relying on assumptions that are more in sync with the consensus economic outlook implies a deficit of 1.7-4% of GDP by 2027, with debt at 72-83% of GDP.
So far, the chorus of criticism directed at the administration’s budget document has largely focused on its optimistic forecasts for GDP growth. But let’s accept, for the sake of argument, that the United States economy is operating well within its production possibility frontier, owing to various tax and other inefficiencies, and that eliminating or significantly reducing such distortions could significantly boost growth. (A recent IMF study, for example, concludes that countries can raise productivity by improving the design of their tax system, and that eliminating such barriers would, on average, lift countries’ annual real GDP growth rates by roughly one percentage point over 20 years.)
But, even giving the administration the benefit of the doubt and accepting the possibility of sustained 3% GDP growth for the US, another set of critical assumptions drive the rosy deficit and debt projections produced by the Office of Management and Budget (OMB): the expected level and path of interest rates. To state the obvious, lower interest rates imply lower debt servicing costs, which in turn mean lower nondiscretionary outlays, smaller deficits, and lower debt.
On the surface, the projections for short- and long-term (ten-year) interest rates embedded in the 2018 budget are in line with the prevailing Blue Chip forecasts. In effect, for fiscal year 2018, the budget assumes slightly higher short-term rates than the consensus.
In fact, the budget assumes the best of all worlds, not the Blue Chip one in which interest rates remain low but GDP growth ambles along at around 2%. With real (inflation-adjusted) interest rates remaining near record lows, a marked increase in long-term growth, as the administration forecasts, would be historically anomalous.
In the OMB document, the real interest rate on three-month Treasuries is expected to stay below 1% over the decade. Furthermore, in that projection, the term premium disappears almost entirely. At present, ten-year Treasuries offer more than three times the yield on three-month Treasuries. Over the medium term, the budget assumes that ten-year rates will be barely above their three-month counterpart. Historically, flat yield curves have been associated with tight money and high-interest-rate policies.
What kind of policies and environment can deliver significantly faster growth and inflation, without any pressure on interest rates?
A combination of solid growth and sustained low real interest rates was the norm in the US for much of the 1940s-1970s, when (as I have documented elsewhere) financial repression prevailed, owing to heavily regulated capital markets and an accommodative central bank.
In contrast, if history is a guide, a policy mix characterized by financial de-regulation (a Trump favorite) and an independent central bank facing potential full employment and overheating would be a harbinger of higher interest rates. And with higher interest rates comes a heavier debt-service burden (substantially heavier than in the past, given current debt levels), wider deficits, and higher debt.
There seems to be a serious internal inconsistency in the high-growth/low-real-interest-rate scenario presented in Trump’s 2018 budget plan. If not, contrary to the administration’s public statements, financial markets will have to live with a heavy dose of financial repression in the years ahead. Carmen M. Reinhart is Professor of the International Financial System at Harvard University’s Kennedy School of Government.
By Carmen M. Reinhart