U.S. Fiscal Future Won’t Be Like Its Carefree Past

(March 30, 2018 - by Greg Ip)

The country is shrinking its tax base just as interest expenses surge and social programs get harder to cut

If you think the federal debt is bad, the bigger picture is worse.

A recent report from Moody’s Investors Service shows why. Moody’s is to governments what Experian is to individuals: a monitor of creditworthiness. The U.S., Moody’s report shows, is blessed with extraordinary advantages when it comes to borrowing. Yet it is about to experience a dramatic loss of financial freedom because it is shrinking its tax base just as interest expenses surge and social programs get harder to cut. It is like someone who borrows freely thanks to his rich parents but can’t keep a steady job and won’t curb his lifestyle.

No, the U.S. isn’t about to turn into Greece. Indeed, Moody’s rates U.S. government credit as AAA, the highest possible, which means the probability a Treasury bondholder gets back less than 100 cents on the dollar is effectively zero. Moody’s notes the U.S. capacity to borrow is in a class of its own: trading in Treasury bonds exceeds that of the rest of the Group of Seven major industrial countries together. The dollar’s share of global currency reserves is double that of all others combined. All this means that there are ample lenders when the U.S. wants to borrow.

The U.S.’s underlying economic prowess is also without peer: it is rich and diversified, produces most of its own food and energy, has a growing population, and it is entrepreneurial and competitive.

But those assets are all legacies of the U.S.’s past, and some are eroding: business dynamism by some measures and economic growth have both declined, and the population is aging. If the U.S. pivots toward less trade and immigration, the ratings company warns, that may “swing the balance of risks for long-term growth to the downside.”

Slow growth can be managed with the right fiscal policies. This is where it gets worrisome. In the U.S., interest swallowed 8% of federal revenue last year, the highest of all AAA-rated countries. As interest rates return to normal and debt keeps rising, Moody’s thinks it will hit 21.4% in 2027. This severely limits the government’s flexibility to respond to emergencies, whether a financial crisis, a recession, or a war, not to mention longer-term priorities such as education and research. It is “a good proxy of the stress you may see on the prioritization of funds,” says William Foster, an analyst at Moody’s. “As interest is rising, that crowds out other spending.”

U.S. taxes are relatively low, which in theory leaves plenty of room to raise them if needed. But creditworthiness depends not just on the ability but the willingness to pay. No country’s voters like to pay taxes but Americans are much more resistant than their counterparts in, for example, Scandinavia, where high government spending corresponds to high taxes.

While Moody’s doesn’t address partisan divisions in the U.S., those have also narrowed fiscal options. Republicans adamantly oppose tax increases, and indeed just passed a tax cut on party lines that is projected to slash revenue to just 16% of GDP, a level normally only seen when the economy is weak, not at full strength as it is now. Democrats have proposed rolling back some of those tax cuts—to fund new spending.

Republicans have long argued the solution to deficits is less spending, not higher taxes. This, however, vastly oversimplifies matters. Much of the upward pressure on federal social spending comes from aging, which can’t be reversed, which means benefits would have to be cut. Moody’s says in a crisis wealthy countries in theory can tolerate lower social benefits because that doesn’t impoverish people. But it goes on to note that income inequality and poverty are both higher in the U.S. than among its wealthy peers, and thus “it may have less flexibility” to cut entitlements.

Even Republicans have little appetite for cutting spending. President Donald Trump threatened Friday to veto a bill funding the government for the rest of the fiscal year because it didn’t spend enough on a border wall. “We’re in a full-blown era of free-lunch economics where no one says no to anyone anymore,” says Maya MacGuineas, president of the Committee for a Responsible Federal Budget, a watchdog.

Does it matter? Japan’s debts are higher and the country long ago lost its AAA rating, yet it has no problem whatsoever borrowing. After Moody’s competitor, Standard & Poor’s Corp., stripped the U.S. of its AAA in 2011, interest rates went down, not up. As Moody’s says, the global pool of savings from which the U.S. borrows tends to grow in times of stress.

There are at least two reasons it matters. First, when the next recession hits, the U.S. may want to open the fiscal taps but instead have to do the opposite as tax collections sink and deficits mount. Second, while markets and the Federal Reserve both doubt interest rates will go much above 3% for the foreseeable future, the U.S. is acutely vulnerable if they are wrong because the debt is so large and so much of it comes due each year, and would have to be refinanced at higher rates.

“We are the greatest country with the strongest economy yet we seem intent on finding out when we can’t borrow any more in a painless way,” Ms. MacGuineas says.