Bidenomics-fueled economic growth does not come for free

The debt burden of the US became a hot topic again last week when the rating agency Fitch downgraded the country’s credit rating from its highest AAA rating to a lower AA+ rating. The downgrade was not a major catastrophe for investors and did not lead to significant index changes on Wall Street. It does, however, again highlight the long-term challenge of the country's economy: an ever-increasing debt burden. The change is unlikely to affect the political consensus recently summarized by the Wall Street Journal as follows: Washington is fighting too much, spending too much public funds and cutting taxes too much.

While planning the next budget year, it has become clear that stabilization of public economy is not supported by either the Republican or Democrat camps. Instead, the gap between income and expenditure has continued to grow, partly due to higher interest rates. According to the WSJ, interest expenditure in the US has been USD 131 billion this year, 25% more than a year ago. At the same time, tax revenue has dropped by 11%.

One shouldn’t underestimate the magnitude of interest expenses, as according to the Congressional Budget Office, they will amount to 3.7% of the US GDP over the next ten years. The rise in interest rates has therefore hit public finances. And if credit ratings continue to decline and investor confidence crumbles, the cost of government loans will continue rising. Thirdly, social spending will continue to grow as the population ages. Medicare and Medicaid programs account for 2/3 of federal spending, and it is estimated that their share of GDP will grow from 5.8% (estimate for 2023) to 6.6% by 2033.

Deficits are part of the political game
So, why doesn’t Washington react to growing deficits? The main reason is the political game. Neither party wants to lose voters, and therefore cutting popular health services, for example, would be disastrous for future support. In addition, election strategies are already being honed in view of the 2024 presidential election, so the timing of the cuts is difficult and it is easier to pass on the grievance to future presidents and congresses.

Then there is Bidenomics, or President Joe Biden’s legislation that increased infrastructure investments and investments in the green economy and semiconductor plants. A prominent part of the legislation has been the Inflation Reduction Act that is aimed, e.g., at strengthening the country’s own industry. In total, Bidenomics-related activities will amount to USD 1,000 billion in the coming years, which will also bring a significant contribution to economic growth. Increased public aid may well result in the US avoiding a recession and economic growth continuing as positive also in the future. For example, the credit rating agency Moody’s estimates that Bidenomics could bring nearly half, or 0.4 percentage points, of the projected 1% economic growth in the US next year. Impacts are already visible: factory construction has doubled this year from last year and private investments are growing. Instead of falling economic growth forecasts, estimates for GDP development for the current year have started to rise.

Bidenomics as a source of inflation
However, growth does not come for free, as Bidenomics has also receives strong criticism about its timing. Its effects are evident in an economy where the labor market has already seen signs of overheating and the inflation problem is not overcome. There is a real risk that inflation, as a by-product of economic growth, will start picking up again, as investments require, e.g., workforce, which is already in short supply. So, the Inflation Reduction Act can also be a source of inflation, contrary to its name.

If inflation accelerates, the Federal Reserve will have to return to interest rate hikes. This would mean a cold shoulder for investors and, at the same time, a loose economic policy would be on a collision course with a tightening monetary policy. I have pondered these ideological differences within monetary and economic policy in the past, and I think they can, based on their objectives, be summarized as follows: politicians care about political continuum, i.e., re-election, Central Banks care about price stability. Thus, politicians do not share central banks' tolerance for recession, and feel it must be avoided at all costs. Supporting economic growth has always been harnessed for election campaigns, which is also the case in the upcoming presidential elections.

However, the current conflict is not the first of its kind. In the years following the financial crisis, economic policy held a tight austerity line, but central banks were living in a time of zero interest and quantitative stimulus. At that time, nominal interest rates fell to their lowest level in centuries. Today, monetary and economic forces are struggling in completely different directions, which in turn may result in growing interest rates for a longer period.