The debt ceiling agreement and the financial health of the U.S.

REAL ECONOMY BLOG | May 30, 2023

Authored by RSM US LLP

President Biden and Speaker Kevin McCarthy reached an agreement over the weekend to lift the debt ceiling by more than $4 trillion until 2025, narrowly avoiding the financial turmoil that would have ensued following a default.

Because of the approximately 10% increase in fiscal year 2023 spending which will spill over into fiscal year 2024 we do not see the fiscal drag introduced by this agreement reducing overall growth during the two years when the “spending restraint” imposed by the agreement is in place.

But the fiscal restraint under this agreement, which still needs to be approved by the House and Senate, is far from the austerity imposed under the debt ceiling agreement in 2011.

Moreover, if the economy were to slip into recession during the next two years, the provision would not restrict automatic countercyclical spending on social assistance, food stamps and unemployment insurance. The agreement’s spending restraints are non-enforceable beyond fiscal year 2025.

Details of the agreement

The framework of the bill revolves around holding discretionary spending—which excludes military, Social Security and Medicare outlays that make up the bulk of the federal budget—flat during fiscal year 2024 and sets a 1% cap on spending the following year. Based on the 99-page legislative text, the agreement keeps non-defense spending flat within current fiscal year levels.

Other details from the bill include:

• $886 billion for defense, a 3% increase in line with the fiscal year 2023 agreement.
• $121 billion for veterans medical care.
• $637 billion for other nondefense programs, roughly equal to the fiscal year 2023 agreement.

The deal also forces a 1% cut in government spending if bills are not passed by the end of each year.

With military spending set to increase to $886 billion in fiscal year 2024 (a 3% increase) with the probability of supplemental bills to provide more funding to support Ukraine and replenish the domestic weapons stock, we expect this activity along with strong consumer spending to offset a slower pace in discretionary spending.

We do not see the debt ceiling agreement as imposing any real spending restraint that would tip the economy into recession.

In addition, the agreement would result in a potential clawback of $20 billion of the $80 billion increase in funds dedicated to the Internal Revenue Service that was recently passed by the Congress. But there is an immediate $1.4 billion rescission and an agreement to look at clawing back another $10 billion this fall, which would then be used on non-defense discretionary spending in annual appropriation bills that have yet to be written.

In addition, there is a clawback of roughly $29 billion of the approximately $56 billion in unspent pandemic-era aid.

The text contains a “pay as you go rule” which would in theory require new spending to be offset by cuts elsewhere.

But the text also indicates that the Office of Management and Budget could waive that requirement for the “necessary delivery of essential services,” or “necessary for effective program delivery.” This part of the text appears more of a fig leaf than a real restraint on spending.

Finally, there would be an increase in work requirements for low-income people between 18 and 54 without dependents who receive food aid. The top age is an increase from the current top of 49.

Those increased work requirements would not affect veterans and the homeless.

The agreement will also result in a modification of the formula used by states to estimate cash assistance for those who receive aid from the Temporary Assistance for Needy Families program.

This part of the text would potentially affect 275,000 low-income Americans. No work requirements were imposed on Medicaid recipients.

The text would also require the administration to restart student loan collections while charging interest after a three-year hiatus imposed during the pandemic.

Our back of the envelope estimate implies close to a $40 billion reduction in disposable personal income as student loan payments restart.

The agreement also included language to speed up the approval process for energy projects.

The agreement does not include any changes to the Inflation Reduction Act’s climate and clean energy provisions. It does, however, approve all the remaining permits to complete the Mountain Valley Pipeline, which is an Appalachian natural gas project.

Other than that pipeline, the text does not imply any significant near-term changes and appears to be more an agreement that would clarify agency jurisdiction to address the turf wars inside the federal bureaucracy over energy infrastructure projects.

While we are encouraged by the agreement, the risk to the economic outlook cannot be completely dismissed until the final vote is tallied. One should not forget the September 2008 failed vote on the Troubled Asset Relief Program, which caused significant turmoil in asset markets.

That turmoil forced Congress to turn and then pass the TARP bill four days later as the economy careened toward the worst economic catastrophe since the Great Depression.

The financial health of the United States

It is common to hear some observers state that the United States is broke and cannot afford to continue spending and borrowing at its current pace.

Indeed, that is the argument put forward by some to justify the fourth debt ceiling standoff over the past 12 years.

While all points of view are welcome on this topic and one can make a credible argument to pull back on the pace of growth in federal and state spending during a time of inflation, it is simply not true that the United States is broke and on the verge of a debt and deficit crisis.

Here we take a look at the financial health of the United States with respect to public and private debt within the context of the total value of U.S. assets.

Once one looks at the underlying asset base of the private and public economy, a much different picture appears.

The total debt of governments (federal, state and local) is $33.6 trillion, with the federal portion accounting for $31.4 trillion. At first glance, that figure underscores the argument to cut back on spending and the need for a periodic crisis to create the conditions for spending restraint.

Bu once that figure is considered within the context of the total economy, one obtains a very different outcome.

Total government debt comprises about 23% of total non-financial assets of $143.6 trillion. That implies that the U.S. economy—despite large nominal private and public debt—sits on an asset base four times larger and an economy that generated a nominal gross domestic product of $26.4 trillion through the first quarter of this year alone.

When viewed within that context, as well as the annual growth of GDP, $33.6 trillion in government debt, as high as it seems, is manageable.

The plain fact is that the U.S. regularly issues Treasury notes that generate strong domestic and global demand. Investors and other countries line up to purchase U.S. securities.

Not only does that unmask the flawed arguments that look to justify a standoff over raising the nation’s debt ceiling, but it also illustrates the risk around even a technical default on just a part of the roughly $31 trillion American fixed income market.

That’s not to say we should ignore government policy or the mismanagement of government finances. In fact, the use of fiscal policy, whether it is higher taxes or lower spending, to cool off the economy during a period of elevated inflation is entirely reasonable even that’s not what is being used today.

Economic and financial shocks

It is particularly important to note the long-term consequences to the economy and society of creating the conditions in which another financial crisis occurs.

The 1928 stock market crash became a bank run and then the Great Depression. High-risk mortgage securitization eventually brought down financial centers across the globe and created the Great Recession.

Government finances were still dealing with the consequences of additional unfunded spending when the pandemic brought on another shock to the global economy.

There have been two jumps in government debt relative to nonfinancial assets since 1980.

The first jump started in the 1980s during a period of high military spending, tax cuts and in an era in which growth averaged 3.5%.

That was followed by an era with increased revenues resulting from the 1990s tech boom and a jump in productivity, which resulted in a period of strong tax revenues, balanced budgets and fiscal surpluses.

The second jump in government debt relative to non-financial assets was caused by the Great Recession and the slow recovery after the 2008 financial crisis.

It is also important to note that the economic recovery that followed the financial crisis was slower than it would have been otherwise because of fiscal austerity caused in part by the 2011 debt ceiling agreement.

The budget and deficit spending

As we show above, U.S. government finances have been improving compared to total nonfinancial assets. And in terms of the budget, expenditures have been receding as the pandemic income assistance programs ended and the economy went into overdrive.

Tax revenues have increased along with higher rates of employment and higher wages for low-income workers. The data presented here should serve as a potent counterweight to the notion that the U.S. is on the verge of debt and deficit crises or can no longer finance its operations in the open global market.

The takeaway

The American economy is not on the verge of systemic crisis because of government debt.

But as long as a debt ceiling exists, there is always the chance of a miscalculation on one part of the political authority that will plunge the United States into a default and, in turn, a financial crisis.

The debt ceiling is a relic of the past that ought to be put to sleep. Permanently.