Government spending and budget deficits are just too big. During the COVID years, governments got used to spending a lot of money and seem to have just kept on doing so. The last time we had full employment, economic enthusiasm, and soaring tech stocks was the year 2000. Bill Clinton was in power, Microsoft, Cisco and Intel were surging. The US government was running a budget surplus of around 2% of GDP. Today, the US budgetary position is a wapping 8 points worse with a deficit of around 6% of GDP. Given that the US economy is still growing with unemployment very low, this is an astounding statistic. What it suggests is the US, in common with many governments in the West, no longer have the capacity to react to a market shock or recession.
If we look back at recessions that have hit the US since the end of WWII, we can see that the budgetary position deteriorated, on average, by 3.8%* (*not including covid, as we believe this was not a standard business cycle recession. If we had included it, the average would have been higher). The deterioration in government finances during a recession is only logical: tax receipts fall as earnings fall and government spending rises to plug the gap.
For much of the period from the end of WWII right up until the 1970s the budgetary position was one where, prior to a recession, government spending and earnings would essentially be in balance. Since 2000, though, the picture has steadily been getting worse. In the 1980s, the US debt to GDP ratio was around just 30%. By 2022, it had grown to 129%. If the economy experiences even an average recession, the current 6% budget deficit would likely reach something like 10%. Historically, this is a huge number. It would give whatever government is in power very little room to manoeuvre. Other than during COVID, it would be the highest budget deficit experienced in the US since WWII. It would also mean that the US debt to GDP ratio would start to surge.
There can only be a few possible outcomes from this situation and none of them are positive.
The first outcome would the see the US government undertaking the sensible task of balancing the books. This would require large spending cuts and tax increases, for which there is little political appetite. It would be the right thing to do, economically, but it would certainly cause a difficult recession. The second outcome, if governments do not act soon, would be one where the bond market, scared of long-term insolvency, collapses, catalysing a crisis in which the government would be forced to get its books in order anyway. Historically, very few, if any, countries that have found themselves in a similar situation have made difficult decisions until markets have forced them to do so. The third outcome would be one that sees consistently high inflation. This is how the UK managed to work its debt to GDP down following WWII. However, this is a more difficult today. Most Western central banks have formal inflation targeting mandates, so for governments to inflate their way out of the situation they would have to change the mandates of their central banks. Doing this would likely cause profound currency weakness and ultimately a bond market riot.
While many investors have been concerned about levels of government debt for some time, 2024 could easily be the year when the concerns become reality. The trajectory of government debt appears increasingly unsustainable. Elections lie ahead this year, both in the UK and the US, and few politicians are talking about either cutting spending or putting taxes up. Before the end of this year, we may well see markets forcing them to do so.