U.S. Economic Update: Inflation, The Deficit, And The Debt Limit

Tax Analysts’ chief economist Martin Sullivan provides an overview of the state of the economy and how the recent debt limit bill could affect it.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: once more up to the brink.

With a new debt ceiling hike appearing set for final passage, we decided to take a look at the state of the U.S. economy, inflation, and the future budget outlook. As we’re recording this, the debt deal struck between House Republican leaders and the White House has been approved in the House and is headed to the Senate ahead of what would have been a June 5 default, absent a deal.

How will this new deal affect the economy, the deficit, and inflation? And what remains to be done to put the U.S. on a solid financial footing? Here to talk more about this is Tax Analysts’ chief economist and contributing editor Martin Sullivan.

Marty, welcome back to the podcast.

Martin A. Sullivan: Thanks for having me, Dave.

David D. Stewart: When we last spoke, we were talking all about inflation, and how that was the big story. Where have things gone from there?

Martin A. Sullivan: At the time, as you know, President Biden said inflation was the nation’s No. 1 problem, and it probably is our No. 1 economic problem right now. Of course, inflation has receded considerably since its peak about a year ago, but — there’s always a “but” — I am personally concerned about continued inflationary pressure for three reasons.

The first reason is, we still have a labor shortage, which means that wages are going to remain high, and wages are a major force behind inflation.

The second reason I am concerned is that consumer demand is high. The reason consumer demand is high is the government gave out so much money during the pandemic that there is still about $1.5 trillion of excess savings in the economy, which means that’s excess buying power.

There’s not enough laborers, workers; there’s too much demand. So there’s not enough supply, there’s not enough demand, and that means prices should remain high. Then on top of that, the longer inflation lingers, we get into an inflationary spiral.

Even though if you turn on the radio and listen to the news broadcast, you’ll hear opinions, “inflation’s going up,” “inflation’s going down,” I would be on the side of, inflation will remain strong — not as strong as it was — for quite a while.

Also, the big wild card, of course, always, is energy prices. I cannot predict those.

David D. Stewart: Of course. You alluded to the stimulus payments that went out. Now that policy has subsided. There haven’t been any additional stimulus payments, and the Fed has been raising interest rates aggressively.

Is that enough to bring down inflation, or are we going to continue to see additional interest rates hikes? Or are there other mechanisms that need to be brought to bear?

Martin A. Sullivan: OK, you asked four questions there, and I’m going to try to answer them. The stimulus may have stopped, but if I gave you $1 million yesterday, I would still think that you have a lot of fiscal stimulus in your spending portfolio. Even though the stimulus has stopped, we’re still running very large deficits, and there still is that extra savings that I was just talking about.

The Fed’s actions do reduce demand, but I don’t think they reduce it by as much as people think it does. I think government policies are still stimulative. Will the Fed raise interest rates more? I believe they will, even though 60 percent of the commentators say they will stop.

Then on top of that, yeah, there [are] other things we can do because there’s two ways to reduce inflation. One is to tighten monetary policy, which the Fed is doing. The other is to tighten fiscal policy, which is something we are starting to do, maybe with this bill — the debt limit bill — but we’re not doing it nearly enough. We have to keep in mind that tax cuts increase inflation and deficit increases inflation. If we don’t do something about deficit reduction, inflationary pressures will continue.

David D. Stewart: One of the reasons that we’re in a lot of deficit spending was the pandemic and all these reactions to attempt to bring the economy back out of the pandemic. Have we succeeded in doing that part of the job the government was trying to do?

Martin A. Sullivan: Yes, a really good way of thinking about the economy is it’s two parts. One, there was what was going on before the pandemic and there we had a long-term trend towards an aging society, which means larger deficits because of increased spending on Social Security and Medicare, and reduced economic growth because of the smaller workforce. That was the trend before the pandemic.

Then of course the pandemic hit like a nuclear explosion on the economy, and then countering that was an incredible amount of government stimulus. We’re pretty much over the pandemic from an economic point of view, except for inflation, which is a big exception, a big asterisk, but we’re also still on that long-term trend of slower economic growth because of the aging population. We’re also on a long-term trend of unprecedented long-term higher deficits because of the aging of our society.

David D. Stewart: Is that a double whammy there here, because you’re mentioning earlier that we have a difficulty with labor force participation and putting pressure on wages, at the same time we have a larger retired population. Is that its own spiral?

Martin A. Sullivan: Well, the trend, we knew the baby boomers were eventually going to retire. We know the birth rate’s going down. Demography is actually something social sciences can actually estimate pretty well. We knew this 25 years ago; this was going to happen. What we didn’t know was going to happen was we’re going to have the great financial crisis of 2008, which exploded the deficit and then the pandemic exploded it again.

Now we have unprecedentedly high debt levels, which wasn’t so bad two or three years ago when interest rates were rock bottom, but now we have a double whammy of higher debts with higher interest rates.

The squeeze on the U.S. Congress that is trying to balance the budget or reduce the deficit when the amount of interest payments that are going to go into the debt in the next 10 years is going to triple. Triple. It’s going to really put a squeeze on everything that we’ve done.

Let me stress that these trends — we’ve always been complaining for my entire career; we’ve been worrying about the debt and the deficit, but the trend right now is really scary, and there doesn’t seem to be any easy way out. On top of that, you have a political situation where gridlock is common. It’s really, I’m sorry to say, not a good forecast for where we’re headed with the debt and then long-term growth is probably not going to be high.

David D. Stewart: Now turning to the question of this large long-term debt issue — we’ve been watching as the White House and Congress have been negotiating to raise the debt limit. Now, before we get into the specifics of what seems to have been agreed to, with this debt limit, what’s your sense of what would happen if we didn’t get to an agreement and if we didn’t pass an increase to it before hitting the date where Treasury says we’ll run out of money?

Martin A. Sullivan: Well, the conventional wisdom is it would be catastrophic. You don’t want to go there. You don’t want to find out. The U.S. government treasury’s securities, it’s the backbone of the world’s financial system. You just don’t want to mess with that. You don’t want to mess with that because it could upset financial markets around the world. Also, it’s very detrimental to the U.S. itself because we’ll obviously raise our interest costs.

Let’s just assume, which I think is a good assumption, that we do pass this debt limit or do extend and raise the debt limit. I’m more concerned about the effects that occur even if we do not default on our debt.

In 2011 we had a similar episode and we ran up to the wire and they got to the finish line and they raised the debt limit and everybody sighed a breath of relief. But two weeks later, after the debt limit was raised, our credit rating was reduced and our interest costs went up, and the markets freaked out a little bit. Now even if we do extend the debt limit, I think there’s permanent damage to our economy by just playing this game.

There’s damage right now to the economy because short-term interest rates for bills that mature over the next few weeks are sky high, because there’s a risk of default and you don’t want to be caught. It’s like musical chairs. You don’t want to be caught with those bonds, with those bills when the music stops.

I don’t think it’s this all or nothing. I think there’s a problem, as closer we get and the more we play this game of chicken, people start looking and go, “Hey, maybe they’ll get it this time, but what’s going to happen next time?” This is not a AAA-bond situation, and we don’t want our credit rating to go down. 2011 is evidence of this. We’ve done this before.

David D. Stewart: Is this something where the debt limit has passed its usefulness and it’s something that we should just get rid of entirely?

Martin A. Sullivan: Yes. It’s the stupidest thing in the world. It should be gotten rid of. No other country has it. It just creates an artificial crisis. We don’t need more crises of our own making.

David D. Stewart: You didn’t mince words on that. Let’s then turn to what appears to be the solution, at least for the next period of time, to the debt limit. Could you tell me about this plan that seems to have emerged?

Martin A. Sullivan: It’s just in its broad brush strokes, but I can tell you compared to what the House passed a couple of months ago, the Republican House, their deficit reduction bill, this bill has about one-third the amount of deficit reduction.

Politically, whether that’s good or bad, you’re going to hear about that all day. I think the important thing to point out here is that even with this, words like, “Oh, the greatest deficit reduction bill of all time,” you’re going to hear in press releases, or the [House] speaker calls it “transformational.”

Well, it may be all of those things, and there may be X billion or trillion dollars of deficit reduction, but folks, even with this tremendous amount of deficit reduction, our debt and deficits will continue to grow. They’re growing every year despite this bill.

The reduction is relative to a baseline that should be put in every time they say there’s a reduction. Relative to a baseline. There is no absolute reduction in dollars. There is no absolute reduction in debt to GDP.

If you’re going to look at the projections before and after this bill of what’s going to happen to our debt, you can hardly notice the difference because the overwhelming trend is the deficit is going up, up, up. And after this bill, it’s going up, up, up at a lower rate, but it’s still going up, again to unprecedented, scary levels, even with this bill.

David D. Stewart: Do you expect any reaction from the economy from at least the minimal cuts in spending?

Martin A. Sullivan: Yes, I do. I think when people get over this distraction of passing the debt limit, which is just doing what you’re supposed to do, and start looking at the substance of what’s going on in our fiscal situation, you will see that we’re still going into a horrible area and there is no easy way out unless you want to consider tax increases, oh my gosh, or reducing Social Security and Medicare.

If you can’t do that, you’re not going to have any success. Then you go, “Well, maybe these economists are wrong. Maybe interest rates will come down, or we’re going to have a big boon.” I’ve played out scenarios like that in the simulation models. Even with some favorable unexpected economic outcomes, we’re still heading into a very bad area on the deficit.

The flip side is, things could get worse than expected. We could have higher interest rates and lower economic growth than expected. I don’t even want to think about how bad that would be for the federal finances. Can I say anything else to cheer you up?

David D. Stewart: Let’s go down the terror rabbit hole just one little bit further. Is there some inflection point where you get beyond basically a point of no return? Is there some debt-to-GDP level where it’s like this is no longer possible to sustain?

Martin A. Sullivan: Dave, I think people are focused on the debt-to-GDP level and it’s very widely used, and it is a very useful metric, but it is only a metric. It is only one metric of fiscal soundness.

I think where it’s going to really hit Congress between the eyeballs is not on the debt-to-GDP ratio, but on the interest costs that they’re going to have to pay.

Think about it this way. Let’s say you’re a guy and you got to buy a car, and all you really care about, you don’t care about the price of the car, you care about the monthly payments because every month you’ve got to deal with that.

Your car could be a $100,000 car, but if the payments are low, you’re cool. If they change the price to $120,000, you may not even notice, as long as you can make the payments.

Now what’s going to happen is Congress could go, “Oh, our debt-to-GDP ratio is so high; I’m so worried,” but they really don’t have to deal with that. What they have to deal with every year are the interest payments on that debt.

We have been spoiled to death the last two decades with low interest rates. Now that interest rates have gone back up, oh my gosh, it is really going to hit them very hard. I think that is the point, that is the pressure point that’s going to get people to take notice that we really have to do something about this, even though there’s absolutely no prospect of that happening in this current political environment where there’s a split on Capitol Hill.

David D. Stewart: I know you mentioned that there would need to be perhaps changes to Social Security and Medicare, but from the tax side, is there anything that is low-hanging fruit, anything that they can do that would start to move things in the right direction?

Martin A. Sullivan: For the Republicans, the low-hanging fruit was to get rid of all the energy credits. Five-hundred, can’t remember now, about $500 billion, an enormous amount. They tried to do that in this bill because that’s President Biden’s signature legislation. He insisted that that remain.

Another piece of low-hanging fruit is to increase funding to the IRS, because for every dollar you spend on that, you get $4 back. But again, the Republicans insist we can’t do that. Those to me seem like possibilities.

I’m not endorsing any one of them in any way, but then you have things like a carbon tax, which would make enormous sense. Instead of doing energy credits, which cost the government money, you could do a carbon tax which raises money for the government and have largely the same effect, but that is absolutely out of consideration.

Then every conference I go to, somebody asks me, “Well, what about a value added tax?” I go, “Next question,” because it’s just, it makes a lot of sense, every other country in the world has it. It’s a decent way of raising revenue, but it is absolutely off the table.

Republicans just object to any tax increase, especially such a broad-base tax increase. Then the Democrats always resist a value added tax because they perceive it as regressive, as unduly burdensome on low incomes.

David D. Stewart: When this inflection point happens, when we must confront this, when the Congress must confront this, what do you see breaking? What of these third rails get touched?

Martin A. Sullivan: I think what would have to happen, it’d have to be bipartisan, because even if you had a trifecta with all Democrats in the House, Senate, and the White House — or vice versa, Republicans in the House, Senate, and the White House — you may enact everything that you want to enact. If that was a Democratic trifecta, we’d have tax increases and loophole-closing and increased IRS funding.

If Republicans came in, we’d be cutting spending left and right. But even if you did that, at the next election, when you no longer have that majority, it’s all going to go away. We need permanent, long-term deficit reduction, and to have permanence it has to be bipartisan.

You can’t just say, “Oh, I’m going to do everything I want to do because I have power right now” because the next minute they’re going to pull the plug out.

It would be something like, and people make fun of this, the old Simpson-Bowles Commission, where you have somebody get together, propose tax increases that Republicans hate, they propose spending cuts that Democrats hate, and you go, “OK, well, we’ll have to suck it up, guys. We’re just going to have to do this because things have gotten so bad.” Now, that was after the great recession when the debt-to-GDP ratio went from 35 to 70 percent, and everybody said, “Oh my God, we have to do something.”

Now that it’s at 103 percent, nobody is saying anything. Nobody is really concentrating on this. Maybe we need another jolt, maybe another pandemic, maybe a real war, or maybe another financial crisis to really shake people up and go, “We absolutely have to do something.”

But can you imagine anything that would get Republicans to agree to tax increases or get Democrats to agree to massive spending cuts right now? It’s just got to be something that shakes up the political system to its core.

David D. Stewart: All right. On that note of optimism …

Martin A. Sullivan: I’m really enjoying the NBA playoffs. There’s a lot of great games.

David D. Stewart: OK.

Martin A. Sullivan: It’s a lot of good stuff going on.

David D. Stewart: All right. Bread and circuses, yes.

Martin A. Sullivan: Bread and circuses.

David D. Stewart: Marty, thank you so much for being here. This has been fascinating.

Martin A. Sullivan: Thank you.

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