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Kelly Evans: Will the deficit require the Fed to restart QE?

Kelly Evans
Scott Mlyn | CNBC

We are closing out the fiscal year with a U.S. budget deficit that is running 7.4% of GDP--a record high for a non-emergency year, as we discussed yesterday.  

How much does the deficit need to come down to stabilize debt and avoid a "fiscal doom loop" where higher interest costs result in higher deficits that result in more debt and future higher interest costs? The short answer is: a lot.  

Basically, we need to cut that deficit by around 5 percentage points, according to the Center for American Progress. The current "fiscal gap," they note, is 2.4% of GDP, meaning if we can stay below that level, we can keep the debt load from continuing to grow.  

So how do we do that? CAP argues through tax increases, to raise government revenues. They believe the Bush and Trump tax cuts together are responsible for continued revenue shortfalls (and historical debt increases) that are resulting in chronic deficits that keep adding to the debt pile. Revenues are currently running just under 17% of GDP, and boosting that by five points, to 22% of GDP, would get us to sustainable deficit levels. 

The trouble is, it's been very difficult historically to raise revenues that high. The fifty-year average of total government revenues as a percentage of GDP is only 17.7%. The St. Louis Fed even keeps a history of tax receipts specifically as a percent of GDP, which since 1950 have averaged almost exactly 17%. The highest-revenue years in recent decades have been those that followed strong economies and monster market moves; specifically, in 2000 and 2022. The lowest proceeds followed recessions.  

All of that said, trying to raise revenues as much as possible through tax hikes is clearly going to be part of the needed solution. And that's because it's equally unfeasible to try and cut government spending by five points points to stabilize the deficit. Of the 24% of GDP the government is spending this year, Social Security is 5 points of that, "other mandatory" is also 5, Medicare is 4, Medicaid and health about 3, defense 3, interest is now 2.5, and that leaves..."non-defense discretionary" at a measly 3.5 (data via Goldman Sachs).  

Clearly, small cuts to all of these categories is the only possible way to bring spending back down to historical levels, of just under 20% of GDP on average--and even that will be a hugely difficult feat. Looking at the experience of other countries that have successfully lowered their deficits, the Tax Foundation says a "rough guideline" should be to aim for "60 percent or more of a plan's savings coming from spending cuts, and 40 percent or less from revenue increases."  

Point being, getting us back to something "sustainable" is going to be very, very difficult. Is it impossible? The CBO expects the deficit to be 5.5% or more of GDP for the next decadeEven the expiration of the Trump tax cuts won't bring it below that level, they note. And interest payments are perhaps the single biggest reason for these chronic shortfalls; although without them, the "primary deficit" is still troublingly high by historical standards, approaching 3.5%.  

So again, we have to raise revenues, cut spending, and hope that interest rates return to much lower levels if we want to quickly close the budget deficit. Investors are understandably skeptical, and already pondering other backstops. The most obvious one? The Federal Reserve. It was an overwhelming buyer of Treasuries for the past decade-plus, as it engaged in several "quantitative easing" efforts to lower rates and boost the economy.  

Now, the Fed is going the other direction, and rapidly shrinking its balance sheet. But if push comes to shove, could it--and would it--start massively buying government debt again? There is "no prospect of controlling the rise of debt unless you think future nominal GDP is going to be much higher," warned Deutsche Bank's Jim Reid in a note this morning. "If anything, investors might want extra yield to compensate for the extra supply, which will make the debt build-up worse."  

In closing, he wrote: "My long-term thoughts are that we will need QE in some form again, and in big size, in the future to control the rise in debt. Either that or a big change in government spending versus revenues." Godspeed, Congress.  

See you at 1 p.m... 


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