U.S. tax cuts and increased spending will grow the deficit in an expanding economy, but what will government finances look like when the next recession hits? Leslie Preston, Senior Economist, TD Bank Group, speaks to Sara D’Elia about what the next U.S. recession could look like and what an increasing deficit might mean for politics and the economy. The TD Economics report is available here.
So I just want to kick things off, before we get into your analysis, highlighting that you weren't forecasting for a recession in the next two years, but what you did is you looked at our current situation, saying we're in the late stages of our economic cycle, meaning sensitivities. So talk to us a little bit about your model and what went into what you're calling this recession scenario.
Yeah, so as you mentioned, we're not forecasting a recession over the next two years. So essentially, what we did is a thought experiment, a what-if analysis, essentially stress testing the federal government, that, given current projections for revenues and expenditures, what happens if you get a recession? We sort of arbitrarily chose the beginning of 2020, because we really don't see a recession in the next couple of years. And we used the Federal Reserve's adverse recession scenario, which they use for their own stress testing, which is sort of a typical recession in the US, to forecast what we think would happen to government revenues and government expenditures and what that would mean for the deficit.
Now, in terms of those revenues and expenditures, you actually found that we could end up with some of the largest deficits we've seen since the financial crisis. How does that happen?
Well, basically, the Congressional Budget Office, which is the nonpartisan organization in Washington that does fiscal forecasting, is already projecting that, because of the tax cuts and stimulus that you mentioned, that the deficit's going to rise from just over 3% to all the way to 5% of GDP, because of all this stimulus. When you overlay a recession on top of that, with the decline, the weakness in revenues, and increases in expenditures on things like unemployment insurance benefits or food stamps, you get the deficit going to just over 8%, which is not as large as the financial crisis, but getting pretty close, which is more impressive considering we're not talking about a financial crisis. We're talking about a more sort of standard recession.
When you built out this model, you also took the results or your conclusions and then compared it to other countries. And two you looked at were Italy and Japan. Talk to us a little bit what you found there.
Well, when you look at the case of Italy, one of the risks that would happen is America would have a higher debt load. And what people have found in the past is that countries with higher debt loads, as measured by debt to GDP, coming out of a recession, they enact a lot less fiscal stimulus. And a prime example of this is Italy coming out of the financial crisis. Italy's debt-to-GDP ratio was about 96% at the time of the recession. A lot of European sovereign debt worries, they were highly indebted.
So the country did not enact as much fiscal stimulus. And Italy had a very weak economic recovery. And this is sort of a cautionary tale for the United States, as US debt levels, which aren't currently at the level that Italy's were then, but the projection is that they will get there, that depending on how politicians react, the past experience would show that you'd see less fiscal stimulus coming out of the recession, as governments are worried about debt loads, so you see a weaker recovery or a more protracted recession.
You mentioned the political situation in your last answer there, so I want to ask you. When you combine the economic part and the political piece as well, what do you see as the biggest risk factors right now? Or in this scenario, I should say?
Well, because, barring some other change to the fiscal situation, because these decisions-- at the time of a recession, they'll be dealing with deficits very close to what they were in the last financial crisis, and they'll be needing to make decisions about whether to enact more stimulus to stimulate the economy, to alleviate the effects of the recession, and basically these decisions will be more controversial, because there'll be likely a lot of politicians worried about, look at our debt levels, we can't add more debt for our grandchildren, so depending on how the politics play out, it could be a much more difficult decision to make, given deficits and the debt loads will be worse than they were in the financial crisis. And as many people might recall, it was difficult at the time for the president to get as much fiscal stimulus as he wanted at the time in '08, '09.
And this brings us to the finances piece, which I want to ask you about. So it sounds like, at least for the next little while, our deficit will be building-- or I should say not our, but in the US it will be building. And that's despite the fact that the economy is growing. So what happens in that recession scenario?
As I alluded to earlier, right. This worsening deficit happens even though the Congressional Budget Office is assuming medium term growth of 2.2%. They don't have a recession in their forecast. So when you get a recession, you typically have corporate profits dry up, so income tax receipts at the federal level slow. And so revenues go down and governments also have to spend more money on things like food stamps, unemployment insurance benefits. So when a recession hits, you would see the deficit worsen, even lower than what's already projected as a base case.
And then there's one more thing on the demographic front, which you say makes the situation a little bit more difficult.
Right, because even before this fiscal stimulus was brought in, Washington hasn't dealt with the fact that, as the wave of baby boomers retires, they're going to be drawing more heavily on Social Security and Medicare. So debt levels, to fund these programs, have already been projected to rise over the next 10 to 15 years. So then you overlay fiscal stimulus on top of that, and they're basically ignoring the underlying problem, not that deficits as a baseline were worsening, but basically were already at a 3.5% to GDP deficit.
That did not improve, even before the fiscal stimulus, anywhere in the forecast. Washington hasn't had any plan of how they're going to get back to balance. And it's largely those age-related entitlements-- Social Security and Medicare-- that are driving that fiscal situation. But I'm sure, as people know, this is a very difficult political hot potato. Nobody's keen to-- they're worried about their reelection prospects if they start tinkering with benefits to Social Security or Medicare.
Sounds like there's a lot to consider both from a political and economic standpoint. And then you have the demographic piece there then as well. Thanks very much, Leslie.