In The Era Of Fiscal Activism

Regardless of who was going to become the next US President, Kamala Harris or Donald Trump, US debt is headed one way and that is up, it is only a question of magnitude. It is not just the US, globally public debt is rising, led by advanced countries and China. World public debt is forecast to exceed US$100trn in 2024, of which 35% will be accounted for by the US and 100% of GDP 2030 according to IMF forecasts (Figure 1).

We are witnessing an era of fiscal activism. The drive for a green transition, increased defence spending, costly industrial policies, protectionism, rising income inequality, and heightened socio-economic tensions that are translating into growing support for anti-establishment parties at the ballot box have all spurred greater intervention . But this shift is also about a change in mindset. The invisible hand of Adam Smith’s free market is increasingly being countered by the visible hand of the state. David Ricardo’s principle of comparative advantage—central to specialisation and globalisation—is being eroded by government subsidies and protectionist policies, while individual freedom is challenged by the “nanny state.”

US debt rising but unlikely to hit IMF forecast

At the height of the pandemic, in 2020 the US government ran a budget deficit of over 10% of GDP. The deficit has narrowed since but remains substantial, averaging 7.3% of GDP per annum between 2021 and 2023 and 6% in the current year to September. This compares with a pre-pandemic, 2012 to 2019, average of 5.1%.

The IMF projects an average U.S. budget deficit of 6.7% of GDP p.a through 2030, significantly above the global average of 4.2%. Consequently, U.S. government debt issuance is expected to increase sharply, reaching 132% of GDP by the end of the decade.

We are not convinced the US public debt will rise as sharply as the IMF is predicting. The direction of travel though is clear. Even if Mr Trump scraps the Inflation Reduction Act, dilutes the Chips and Science Act and ends US financial support for Ukraine the budget deficit will remain significant, if as we expect the corporate tax rate is cut.

The worry is the US dollar role as the global currency is diminishing, and with it, seigniorage. Today the US accounts for 58% of international foreign exchange reserves, down from a peak of 86% in 2Q73 (Figure 3). The point is that if there is a fiscal crisis it will come from domestic investors abandoning US bonds. They own 77% of outstanding Treasuries. Sustainability is a concern because foreign central banks, which hold U.S. government debt to balance their U.S. dollar-denominated assets and liabilities, may offer more stability than U.S. private investors. Unlike private investors, these central banks are generally less focused on returns and more obligated to maintain balanced balance sheets, making them relatively reliable holders of U.S. debt.

Europe fiscal pressures to increase

The European public finances picture is equally, if not more, disturbing. At first glance budget balances and public debt are moving in the right direction. Euro-area government unfunded spending during the pandemic was half that of the US. At the peak in 2020 the euro-area in aggregate ran a budget deficit of 7% of GDP compared with 13.9% in the US. Since the budget deficit has narrowed steadily with euro-area government expenditure as a share of GDP declining from 54% to 49.8% in 2023. This year the IMF forecasts a budget deficit of 3% after 3.6% in 2023.

However, European public finances at the national level are flattered by fiscal spending moving from national government to Brussel’s balance sheet and by massive debt mutualisation. Europe is spending plenty, close to the level of the US. The difference is it isn’t reflected in national government balance sheets and therefore in a straight aggregation of member country budget balances and public debt levels.

Donald Trump winning the US Presidential elections is further bad news for Europe. A forced settlement of the Ukraine-Russian war that irreparably damage US-European-NATO relations and heightens national security concerns will push up Europe defence spending and add to fiscal pressures. Another fiscal crisis is probably inevitable. Timing it is difficult. The probable outcomes for the euro-area though are clear. Either it will lead in the to a full-fledged fiscal union or a breakup of the monetary union.

Asia fiscal prudence prevails

Asia is another matter, well Japan aside, and probably now China. Inherently fiscally prudent, Asian governments have been reining in spending to bring budget balances back into control (Figure 4). As it stands the emergency responses of Asian governments as well as central banks to the pandemic was measured compared with their US and European counterparts. The exceptions are India and China. Asian government budget deficits in the three years to 2023 continue, on average, to be larger than pre-pandemic 2012-19 levels. Taiwanese government’s revenues are outpacing spending, although budgetary surpluses are smaller than in the past.

In conclusion

The pandemic might be over but in the current era of fiscal and political activism public debt continues to rise globally. A fiscal crisis is not imminent. However, the downside risks are rising for the US as the dollar’s role as the global reserve and trade currency diminishes. EU public finances are equally worrying even if member county government finances do not reflect it. Asia ex China and Japan remains one of the last bastions of small government where debt sustainability is not an issue.