Washington must take real steps to avoid risk of rising debt, inflation

Though it is often unavoidable, I try not to conflate politics and economics. And I make a concerted effort to ensure sound economics reasoning supports my political views, not vice versa. So I regularly find myself outside of the majority on many issues.

But now that we are past the election, it is time for me to offer a few politically tinged opinions on behalf of U.S. manufacturers and anyone else who relies upon the U.S. economy for their livelihoods.

I remember a time when the Republicans enjoyed a reputation for fiscal prudence. Our method of government is rife with inefficiencies, and it is extremely susceptible to periodic bouts of excess. Republicans traditionally promoted budgetary discipline, usually by advocating restrictions on spending. This approach to government was not perfect, and the traditional Republican philosophy was not always the best way to promote the general welfare of America. But it often provided balance and a bulwark against the vulnerabilities to wanton, and ultimately destructive, excess.

Sadly, this is no longer true about the GOP. In fact, it has been a long time since Republicans behaved this way. The siren song of budgetary excess has ensnared them. Nevertheless, now that they find themselves once again in control of the federal purse strings, it is imperative for them to resurrect the spirit of fiscal prudence. Our economy's ability to secure the blessings of liberty is increasingly at risk if they do not.

To support my opinion, I offer two charts for your consideration. On the first chart there are two lines, one showing the growth rate of the U.S. GDP and the other showing the growth rate of the U.S. federal debt levels. There are two important takeaways from this chart.

First, there is a large and obvious divergence in these lines during times of economic recession. The federal debt grew much faster than GDP shortly after the Great Recession in 2009 and 2010, and there was a huge gap created between the lines during the recent pandemic. That's to be expected.

But what is not expected, and certainly not prudent, is for the growth rate for federal debt to exceed the growth rate for the economy when the economy is not in a recession. Set aside 2020, the year the economy was intentionally shut down, for a moment. During the three years from 2017 through 2019, the first three years of the first Donald Trump presidency, the federal debt grew by an annual average of 4.8 percent while GDP grew by only 4.3 percent per year.

During 2021 through 2024, the last three years of Joe Biden's presidency, the federal debt spiked up by an estimated 8.5 percent. GDP has also averaged about 8.5 percent growth during this time, and be fair, the Biden administration inherited a lot of pandemic spending. But he did not restrict spending sufficiently once the economy was back on its feet.

The short-term effects of this recent federal spending binge have mostly been positive, at least on the surface. The stock market is currently trading at record highs, and the statistics for the labor market have rarely ever been stronger. But underneath these bright spots, which to my eye look unsustainable, there are some more ominous trends.

The housing market is not functioning properly, the manufacturing sector is in a state of gradual contraction, and despite the efforts of the Federal Reserve Board, the outlook for the rate of inflation remains tenuous.This brings us to the second important takeaway, and that is the recent divergence between the trends in the two lines.

The growth rate for debt levels is now well above the growth rate for GDP and it is accelerating, while the growth rate for the economy is decelerating. This is a condition that often precedes an increase in the rate of inflation.

You do not have to take my word for this, because the bond market is already positioning for it.

On the second graph, I have charted the daily yield (aka the interest rate) for 10-year treasury notes during the past three months. The last day I was able to put on this chart, a day which saw a substantial increase in the interest rate, is the day after the election.

This graph hit a cyclical low point in the middle of September, about the time the Federal Reserve Board announced the first cut in its Fed Funds rate. You will recall this first cut was a larger than usual reduction of 50 basis points. The great irony here is that even though the Fed made it clear that it would be lowering its short-term rates during the foreseeable future, the market has steadily pushed long-term rates higher.

This is a particularly bad trend for the overall manufacturing sector and other segments of the economy such as first-time homebuyers. And if this uptrend in long-term interest rates persists, it will eventually pull the stock market down as well. At the moment, it is too early to tell just how high long-term treasury yields will go, but there is certainly a risk they will go even higher.

The Fed will be powerless to offset this trend. And to add insult to injury, this trend could reignite inflation because the U.S. Treasury will be obligated to pay its debts, even if it means inflating the money supply to do it. This is the dreaded condition of stagflation you have heard about, a period of high inflation without any real economic growth.

As of now, I am not forecasting this is a situation we will experience anytime soon. The first step in avoiding this outcome seems simple to me. The policymakers in Washington just have to get the rate of growth in the federal debt levels below the rate of growth in the overall economy. A balanced budget should ultimately be the goal, but I'll take baby steps at the beginning.

Nobody knows with certainty what the new president and the new Congress will do once they get sworn in. If Trump sticks with his campaign promises, then the bond market is preparing for more inflation and more government debt. At some point, this will cause a massive disruption to the economy, and the manufacturing sector will be amongst the worst of the casualties.