It is becoming increasingly difficult to reduce the fiscal deficit as government debt continues to rise and efforts to boost revenue through taxes remain stagnant.
The Congressional Budget Office (CBO) estimates a deficit of up to US$2 trillion, or 7% of GDP, for 2024.
America’s “exorbitant privilege” to run deficits is not guaranteed; signs show it is fraying at the edges.
Nomfins examines three possible scenarios for the US fiscal outlook: the good, the bad, and the ugly.
The US fiscal problem is severe, with public debt on an unsustainable path. Last month, the CBO projected a deficit of up to US$2 trillion (7% of GDP) for 2024. It expects federal debt to rise to 109% of GDP by 2028 and 122% by 2034. The pandemic and global financial crisis drove massive deficits, while the Fed’s prolonged low interest rates and quantitative easing during weak growth periods—with limited tightening during recoveries—kept borrowing costs low, reducing incentives for fiscal consolidation.
Fiscal consolidation is increasingly difficult amid rising debt servicing costs, an aging population, deglobalization, national security concerns, and costs related to climate change. Cutting nondefense discretionary spending in areas like infrastructure and education risks weakening economic growth, while reducing mandatory spending such as Social Security and healthcare is politically challenging due to social backlash.
There may be hope on the revenue side. America’s tax revenues as a share of GDP are low compared to advanced economies, at 17.2%. The IMF recommends measures like eliminating many tax deductions and raising indirect, corporate, and individual taxes. However, implementing these fully would be political suicide.
America’s post-WWII experience with financial repression to reduce a historic public debt ratio of 106% offers a cautionary lesson for current US Treasury debt holders. Some argue that America’s superpower status and issuer of the world’s reserve currency grant it the “exorbitant privilege” to run deficits without urgent debt reduction. Japan is cited as proof that advanced economies can manage debt exceeding twice GDP.
But America is not Japan. Japan is the world’s largest net creditor, while the US is a major net debtor. Japan’s private sector savings finance its deficit, while it has suffered decades of deflation and low growth with an aging, risk-averse population. It is hard to see America becoming as frugal or channeling as much private savings into government debt.
Moreover, America’s exorbitant privilege is not guaranteed. The US dollar’s share of central bank foreign reserves is declining, yielding ground to other currencies and gold. The Fed is reducing its US Treasury holdings. Increasingly, private investors such as mutual funds, banks, and pension funds hold US public debt, heightening fiscal vulnerability due to their market sensitivity. The Treasury has shifted to issuing more short-term debt (one year or less), which poses refinancing and interest risks if the Fed does not cut rates substantially.
Three Scenarios to Consider
We have highlighted the challenge of reducing the US fiscal deficit amid signs of the “exorbitant privilege” fraying. Here are three scenarios for the US fiscal outlook:
- The Good: Fueled by the generative AI revolution, the economy enjoys a golden age of strong growth and low inflation. The Fed cuts rates aggressively by at least 100 basis points in both 2025 and 2026. A divided Congress helps reduce the budget deficit, aided by lower interest rates and stronger growth. Deficits remain large, and the federal debt ratio continues rising but at a shallower pace than CBO projections.
- The Bad: Inflation remains sticky and the Fed cuts rates less than markets expect in 2025 and 2026, causing below-trend growth. Little progress is made in reducing the large deficit, and the Treasury faces refinancing challenges. Private investors demand higher premiums for long-term debt, raising borrowing costs and crowding out private investment. This leads to higher interest payments, weaker growth, and rising debt ratios, steeper than CBO forecasts.
- The Ugly: Conditions worsen beyond the bad scenario. The private investor base loses confidence in US Treasuries, causing borrowing costs to soar and triggering a fiscal crisis. Investors fear loss of Fed independence and expect severe financial repression to force deeply negative real yields and liquidate debt. The 2s10s Treasury yield spread would decompress to levels unseen in generations. The yield curve has been inverted for a record 24 months, surpassing even the Great Depression’s 23-month inversion.
