The arrival of a new presidential administration invokes new beginnings and a break from the past. Still, realities from previous administrations remain, such as a fiscal challenge that demands immediate attention. It may weigh on the newcomers even more than they realize today. We can only hope they take it more seriously than their predecessors have done.
The longstanding notion that debt accumulation is benign, based largely on interest rates that for a time fell below growth rates, has proven dangerously misleading. This flawed thinking ignored both human nature and economic reality: Politicians rarely limit borrowing to one-time emergencies (as the theory requires), and interest rates inevitably rise. Today, we face the consequences of these miscalculations.
As economist Hanno Lustig of Stanford University rightly noted on X, “Right now, with the 10 year US Treasury yield trading well above 4.5% and the federal government spending roughly the equivalent of the defense budget just on interest expenses, a fairly broad-based consensus seems to be developing among economists that the fiscal path we’re on is in fact not a sustainable one, as (Federal Reserve Chair) Jay Powell pointed out 4 weeks ago.”
Treasury Secretary Janet Yellen agrees. She recently said, “Well, I am concerned about fiscal sustainability,” adding, “I believe that the deficit needs to be brought down, especially now that we’re in an environment of higher interest rates.”
With inflation risks persisting and entitlement spending surging, the situation cannot be ignored. So here’s hoping Lustig is right that “2024 may also be remembered as the year U.S. fiscal exuberance died.”
My complaint, however, is that we got to this point to begin with.
Yes, incentives make politicians eager to spend while letting their successors figure out how to pay. However, encouraging this irresponsible behavior with theories about free lunches and interest rates always being low was always unwise. It was never a secret that spending was set to explode far beyond what the feds raised in revenue, followed eventually by an increase in interest rates.
Politicians who never needed the encouragement went all out for decades and sped spending up during the pandemic without reversing course afterward. Inflation emerged, interest rates went up, interest payments skyrocketed, and now we are on thinner fiscal ice than ever before.
Many people share the blame. Politicians, of course, but also Yellen and Powell, who a few years ago encouraged spending exuberance and cheered the pricey American Rescue Plan.
The situation has reached a critical juncture. Social Security and Medicare costs are projected to rise dramatically as the baby boomer generation keeps retiring, adding further pressure to an already strained federal budget. Politically, it would be easy to extend Donald Trump’s 2017 tax cuts without offsetting the lost revenue, which could worsen our fiscal trajectory.
There’s also Trump’s foolish determination to impose growth-slowing tariffs. Some of the negative effects would be offset if the administration is successful in deregulating the economy, and the energy sector in particular. These reforms would boost productivity and economic growth without requiring additional federal spending, strengthening the economy while maintaining fiscal discipline. However, this will be remarkably hard and slow work.
At the end of the day, reforming entitlement programs is necessary. This includes gradually raising eligibility ages, implementing means-testing for benefits, and introducing market mechanisms to control costs while maintaining essential services.
And while the extensions of existing tax provisions must be offset with some spending reductions, Congress should use the opportunity to boost the economy through long-needed tax reform. This approach should be reinforced through strict budget enforcement mechanisms, including statutory caps on discretionary spending and enhanced pay-as-you-go rules for new legislation.
But above all, politicians must refrain from believing any enablers who claim austerity can wait. Theories about growing out of our future debt aren’t credible. Neither are theories about fiscal discipline through the imposition of tariffs, nor theories about achieving fiscal stability without touching entitlement spending.
A credible commitment to fiscal responsibility will yield significant economic advantages. Markets will respond to reduced government borrowing with lower long-term interest rates. Private investment will expand as fewer private projects are crowded out by government borrowing. Uncle Sam will maintain the ability to respond to genuine emergencies while improving intergenerational equity by reducing the burden on future taxpayers.
We have seen the limitations of wishful thinking that debt doesn’t matter. The incoming administration should usher in a new day by recognizing reality and acting decisively to address fiscal challenges. Failure risks America’s economic stability and prosperity for generations to come.
Veronique de Rugy is the George Gibbs Chair in Political Economy and a senior research fellow at the Mercatus Center at George Mason University.
