U.S. economic outlook: Fiscal policy

It is clear that the U.S. fiscal path is unsustainable. While the economics and finance around supporting the direction of fiscal policy are not in doubt, it is going to be an ongoing source of risk because of the differences in political philosophy between the two governing parties.

Moody’s recent downgrade of the U.S. credit outlook from stable to negative while retaining the Aaa credit rating will surely be part of the policy, economic and financial narrative going forward.

While the U.S. continues to issue debt without any disruptions to the functioning of financial markets, at one point, it will require severe cuts or tax hikes that bring in more revenues, a revamp of the current tax system or all of the above to put the fiscal path on a sustainable basis.

The economics community has long understood that it is a good idea to restrain the level of growth in spending over the medium term to below the rate of growth in the economy. Focusing on bringing down the primary deficit, which excludes interest payments on past debt, will result in lower borrowing costs over the medium to long term.

Fiscal policy by Congress should be understood as a complement to monetary policy. As we have observed during the recovery from the pandemic, an aggressive fiscal policy (as opposed to austerity) in conjunction with a tight monetary policy is a positive for the dollar. It can function as a magnet for foreign direct investment.

The economics and finance of debt and deficit dynamics are not an issue right now. In fact, the smart use of fiscal policy to invest in the economy's future is working to crowd in rather than crowd out private investment.

As we have pointed out before, this is already evident in states like Arizona, as well as in other states like New York and California. And now, this will be the case with the identification of 31 tech hubs to receive investment in long-neglected areas of the country.

Still, there is no doubt that fiscal consolidation is required over time, even if it will not occur during 2024 or anytime soon. 

Federal debt as a percent of gross domestic product has receded, but that is because of the success of the aggressive fiscal policies that propped up the economy during the pandemic and the passage of the infrastructure and industrial-policy initiatives to modernize the U.S. supply chain and promote advanced manufacturing.

Yet federal debt is greater than 100% of gross domestic product, and the cost of servicing that debt is expected to increase along with the rise in interest rates. That suggests that fiscal consolidation is required to prevent the eventuality of a debt explosion.