Can the US government keep spending forever?

Most analysts misfired on their forecasts for the US economy last year. The widely announced recession never came. Far from sliding into a recession in 2023, the US economy grew at a solid pace. US gross domestic product (GDP) grew 3.1% last year, well above its 2.2% average growth in the 2010s, a decade coinciding with the longest uninterrupted economic expansion in history. We estimate that the average rate at which US GDP can expand in the long run — known as “potential growth” in economists’ jargon — is around 1.8%. We usually see above-potential growth in recoveries following recessions, not in a year that was “supposed” to mark the onset of a downturn.

What recession? The US economy experienced balanced growth in 2023

Contributions to US GDP growth

These recession forecasts didn’t pan out because the average analyst paid too little attention to a chief driver of short-term economic growth: government spending. Public authorities have two major tools with which they can affect the business cycle. First, the central bank — the Federal Reserve (Fed) in the US — controls monetary policy, which mostly consists of setting interest rates. Markets and analysts spend plenty of time analyzing Fed actions in minute detail. But they tend to overlook the second tool, fiscal policy, which can be just as pivotal for the economy. The government implements a loose fiscal policy by borrowing money that it channels — directly or indirectly — to consumers or businesses. All else equal, a larger deficit boosts short-term growth, while a tighter budget works to cool the economy. For the past few years, the US government has been borrowing and spending, fanning the flames of a hot US economy. In 2023, tax credits and loan forgiveness supported consumer spending, while industrial policies stimulated business investment, especially in the manufacturing sector.

 Spending on factory construction doubled with subsidies from the Inflation Reduction Act

Manufacturing structures construction, inflation-adjusted

The US federal government ran a deficit of 6.5% of GDP in 2023. Pre-2020, we’d see the government run comparable deficits when it needed to stimulate the country out of a recession. Today’s economic backdrop is very different. The chart below highlights how unorthodox fiscal policy has been in recent years. We’ve seen serial deficits alongside a booming US economy with a sub-4% unemployment rate.

Massive deficits used to be the exception. Now they’re the norm.

US government calendar-year budget deficit vs. US unemployment rate

As explained in last month’s Emerging theme (“Be careful betting against the US economy”), we expect the US to once again avoid a recession in 2024. Those same forces that bolstered the US economy last year haven’t faded, especially the loose fiscal policy of the Biden administration. We expect the federal government to run a 6.7% deficit in calendar 2024, juicing growth and keeping inflation above 3%. Prior to 2020, the last time we saw such a large deficit was in 2012, when the US unemployment rate was around 9%. We expect it to stay below 4% in 2024.

Net interest payments on government bonds will probably account for half of the government’s net deficit in 2024. Interest payments don’t contribute as directly to short-term growth and inflation as primary deficits. Their likely recipients — savers — typically spend a lower proportion of their income than the average American consumer or business. But if the government doesn’t react to rising Fed rates by tightening its budget to keep overall deficits constant, the resulting higher payments to bondholders could somewhat counteract the Fed’s actions by juicing private spending.

How long can the US government keep spending borrowed money like this? The Congressional Budget Office expects the US federal deficit to stay above 5% for the foreseeable future. In our view, deficits will stay at elevated levels for at least the next Presidential term, as neither Biden nor Trump would act to tighten the budget. 

Mandatory spending and net interest payments

US government deficit by fiscal year

The US government’s deficit-financed spending won’t cause it to hit a brick wall. Because it issues debt in its own currency, there’s no hard limit on its borrowing. Essentially, it can borrow forever, but it can’t borrow forever without consequences. We don’t have to wait decades for the repercussions of excess spending to show up. We’ve already experienced those effects in recent years: high inflation, surging interest rates, and the resulting degradation in Americans’ confidence in their government. The 20% growth in US consumer prices over the past few years is a direct result of that government borrowing and spending.

Elevated US government deficits and an unstable debt path are part of the reason we don’t love long-term Treasury bonds, and remain short bonds in the Mackenzie Global Macro Fund. Three things can happen to stabilize a government’s debt burden following a string of large deficits: a switch to primary budget surpluses in the future, faster economic growth or higher inflation. The first outcome would be positive for long-term bonds, the latter two negative. Over the next few years, we think a mix of solid growth and above-target inflation is a more likely scenario than the US government embarking on a 1990s-style crusade to balance the budget. Political trends reverse quickly, but it sure looks like deficit-fuelled growth is on the agenda for the next few years, regardless of who occupies the Oval Office.

The recently released Canadian GDP data for Q4 sends mixed signals about the economy’s health and the Bank of Canada’s next actions. There is some good news. The print itself (+1.0%) is a bit higher than was expected by the average economist (+0.8%). And it keeps us solidly out of “technical recession” territory. Plus, consumer spending bounced from a dreadful third quarter, a welcome sight.

But the increase in consumer spending is coming solely from spending on durables, interest-sensitive purchases on which consumers are “catching up” now that the Bank of Canada has finished hiking. More broad-based strength in consumption would’ve been a stronger signal of a stabilization of the economy. The other positive surprise was a bounce in exports, which likely has much to do with slumping commodity prices and a delayed rebound from this summer’s wildfires, and little with the underlying strength of the Canadian economy.

The canary in the coal mine is business investment, which contracted for the second quarter in a row. Some will probably use the data to tell a story about the lack of long-term dynamism of the Canadian economy, but weak Q4 investment is mainly a short-term story about an economy that is slowing down quickly after large interest hikes and the ramping down of government largesse. With public spending set to stagnate over the coming year (unless we get a big surprise in the upcoming federal budget), it feels like the only thing that can jumpstart the economy is a few rate cuts.

In last month’s commentary we explained why we expected to see a first Bank of Canada rate cut in April. Since then, we’ve seen a low inflation print and a slightly disappointing GDP print. That has only increased our conviction towards an April cut.

Rebound in exports saves Canada from a technical recession