US Government Shutdown Is Not Just Theater

The impending US government shutdown does not have significant macroeconomic implications given that the debt ceiling agreement would kick in by year-end and restore normal operations at similar levels. In this regard, it will mirror most previous shutdowns, with consumption and investment patterns largely unaffected. The shutdown nonetheless portends future fiscal stress as well as political risks going into the 2024 election cycle.

Government shutdowns began and were frequent during the Carter and Reagan eras, though most lasted only a few days before the US government passed a budget to ensure regular government operations resumed. The most recent shutdown in late 2018 lasted 34 days, but only a fraction of the government was closed in practice. So why should we be concerned about the 2023 shutdown?

US Fiscal Position Is Worsening Rapidly

There are two relevant signals emanating from this government kerfuffle. First, the fiscal trajectory is worsening at the steepest pace on record.

Figure 1 illustrates federal government interest payments as a share of federal government revenues. While the current level is still within the historical range of the 1980s and 1990s, this metric is likely to break historical records for three reasons:

1. The pace of interest rate increases has been steeper than previous tightening cycles.
2. The overall rise in the debt burden means that interest rate risk is more potent. In practice, despite extending average debt maturity to six years, a much higher volume of debt is being refinanced at today’s higher rates.
3. In addition to debt rollover costs, the US fiscal deficit remains surprisingly large at nearly 8% of GDP. This means that net new issuance is remarkably high and expensive.

All of these explain the numerator effect, but notably, the denominator — tax revenues — has underperformed meaningfully this year too. Corporate earnings forecasts and expected wage growth do not suggest that this 2023 underperformance will be compensated in the coming year either.

Overall, debt servicing costs are going to continue to rise, leading to the second signal: difficult politics ahead.

Fiscal Austerity on the Horizon?

Unsurprisingly, as Figure 1 also shows, major deficit reduction measures have occurred during times of divided government. The Reagan and Clinton budget deals were struck at a time when debt servicing costs were historically high. In comparison, similar measures during the Obama administration took place when interest payments were modest in absolute terms but still near ten-year highs. Similarly, major tax cuts typically have been enacted during periods of low debt servicing costs and unified government.

The risks here are that this weak fiscal position and election politics would limit fiscal support for any US downturn ahead of the 2024 election, thereby making any downturn longer and deeper. Election analysis suggests a unified government is improbable albeit not impossible — so major deficit reduction, i.e., fiscal austerity, beckons in 2025.

Shutdown Puts Deficit Center Stage in US Elections

The government shutdown is the curtain opener for the US election season. It portends the return of fiscal deficits back to the center stage of political debates. In this regard, even rate cuts in the ‘soft landing’ scenario would not be enough to reverse the structural drivers constraining fiscal space as outlined above.

Consequently, the Federal Reserve Board (Fed) will remain the key policy player in any economic downturn, as fiscal policy grows increasingly congested and becomes a headwind to US growth in the coming years.