A Fiscal Crisis in the Making
The United States’ public finances are approaching a historic turning point.
With Donald Trump’s re-election to the presidency in November 2024, it is clear that American fiscal policy is moving towards a critical point.
In this article, I present an econometric analysis of the US budget deficit, which shows that we will soon reach a deficit of 10% of GDP – a level that would have been unthinkable just a few years ago.
To understand the gravity of this development, I have conducted an analysis of US budget figures from 1970 to 2024.
The results are disturbing. We are not merely seeing a temporary deviation from normal fiscal policy, but a fundamental transformation in how American fiscal policy functions.
The econometric model I have estimated isolates the structural changes from normal business cycle fluctuations. By including the output gap as an explanatory variable, we can distinguish between cyclical fluctuations and more permanent changes in fiscal policy.
The results show a markedly negative shift in the budget balance that began under Trump (version 1) and continued under Biden.
The hard numbers are unequivocal. Under the Trump administration (2017-2020), we saw a permanent decline in the budget balance of 3.1 percentage points of GDP.
This was not a result of economic downturn or external shocks – it was the consequence of deliberate political choices, primarily driven by major tax cuts and increased defence spending.
The Biden administration, despite promises to the contrary, worsened the situation by an additional 2.9 percentage points through expansionary fiscal policy measures.
The most remarkable finding in the analysis is that the financial crisis – often highlighted as the main cause of persistent deficits – actually plays a lesser role than assumed.
When the model includes dummy variables for the Trump and Biden periods, the post-2008 variable loses its statistical significance. This is a crucial result that fundamentally challenges the conventional narrative about the causes of US fiscal problems.
The graph speaks for itself. The blue line shows the actual budget balance, and the red dotted line represents the model’s estimates.
Clik here to view.
This indicates that the model has identified the main drivers behind the development in public finances.
This is not just another discussion about fiscal priorities. It is a fundamental change in how American fiscal policy functions. The traditional mechanism, where deficits grew in bad times and fell again when the economy stabilised, no longer exists. Instead, we see a persistent slide towards larger structural deficits, independent of economic cycles.
An Econometric Analysis of the Structural Transformation
To quantify the transformation in American fiscal policy, I have estimated a linear OLS regression model with the budget balance as the dependent variable. The model is specified as follows:
Budget_Balance(t) = β₀ + β₁Output_Gap(t) + β₂Budget_Balance(t-1) + β₃Trump_Dummy + β₄Biden_Dummy + β₅Post2008_Dummy + ε(t)
where Budget_Balance(t) is the public budget balance as a percentage of GDP, Output_Gap(t) measures the difference between actual and potential GDP, and Budget_Balance(t-1) is the lagged value of the budget balance.
Trump_Dummy and Biden_Dummy are binary variables capturing the respective presidential periods, while Post2008_Dummy controls for potential permanent effects of the financial crisis.
The regression results are remarkable.
The Output_Gap coefficient is statistically significant, confirming the well-known relationship between the business cycle and budget balance.
But it is in the political regime variables that we find the most striking results. The Trump dummy variable has a coefficient of -3.1 (statistically significant at the 1% level), while the Biden dummy variable contributes an additional -2.9 percentage points (also significant at the 1% level).
Particularly interesting is that the Post2008_Dummy variable loses its statistical significance when the political regime dummies are included.
This is a central finding that fundamentally challenges the common perception of the financial crisis as the main cause of persistent deficits. It is not the financial crisis driving the structural deficits – it is the political decisions made under Trump and Biden.
The estimated model reveals a marked deterioration in the structural deficit over time:
Before 2017: Structural deficit of 0.8% of GDP
Under Trump (2017-2020): Increase to 3.9% of GDP
Under Biden (2021-2024): Further deterioration to 6.8% of GDP
The lagged budget balance is highly significant in the model, indicating considerable persistence in the deficits. This means that once a high deficit level is established, it tends to persist.
The transformation of American fiscal policy under Trump was driven by specific political initiatives, including comprehensive tax cuts through the Tax Cuts and Jobs Act, increased defence spending, and a massive fiscal response to the COVID-19 pandemic.
Under Biden, the expansionary fiscal policy continued with the American Rescue Plan (2021), increased social benefits, and comprehensive infrastructure investments.
The econometric results are unequivocal: We are seeing a fundamental change in American fiscal policy that cannot be explained by business cycles or aftereffects of the financial crisis.
It is the result of deliberate political choices that have created a new fiscal regime with persistent high structural deficits.
Projections and Consequences
The empirical results from the econometric model provide a basis for projecting the development of the US budget balance.
The projections, based on the estimated relationships and current political course, paint a bleak picture.
The model predicts an acceleration in the negative trend with budget deficits that will reach:
8.2% of GDP in 2025
9.4% of GDP in 2026
Approaching 10% of GDP in 2027
In the projections, it is assumed that the output gap gradually closes (it is positive now) over the coming couple of years.
These projections are even based on a relatively optimistic assumption about stable interest rates on US government debt.
But herein lies a significant risk that markets seem to have underestimated thus far: If financial markets lose confidence in the American government’s willingness or ability to improve public finances, we could see a sharp rise in interest rates on US government debt.
Such an interest rate increase would have a self-reinforcing effect on the deficit. Higher rates mean increased interest payments on existing debt, which in turn worsens the budget deficit.
In such a scenario, the deficit could very quickly accelerate towards and beyond 10% of GDP – substantially faster than our baseline projections indicate.
We might even risk seeing a negative spiral, where rising deficits lead to higher interest rates, which in turn increase the deficit through higher interest payments. This will further weaken confidence in US public finances and drive rates even higher. This is precisely the type of dynamics that has historically led to financial crises in other countries.
The crucial difference from earlier periods is that these deficits are no longer cyclical. The mechanism where deficits grew in bad times and fell again when the economy stabilised no longer exists. The budget deficit should have fallen when the pandemic crisis policy ebbed away. But it didn’t. The deficit has become structural.
The US effectively has only three possible ways out of this situation:
- A continuation of the current debt spiral until it becomes unsustainable – a development that could be markedly accelerated by a sudden interest rate increase
- A drastic fiscal tightening, for which no one has yet presented a credible plan
- The classic way out for highly indebted economies: Let the printing presses run and let inflation eat away the debt
What is remarkable is not just the size of the deficits, but the speed at which they are growing.
The empirical results are unequivocal: US fiscal policy is no longer governed by economic cycles or temporary crises, but by a new political logic where neither Republicans nor Democrats show any will for fiscal discipline.
The interest rate risk constitutes the decisive wild card in this game. Thus far, financial markets have shown remarkable tolerance towards growing US deficits. But history shows that market patience can disappear quickly and unexpectedly.
When that happens, the adjustment could be both abrupt and painful.
Democrats and Republicans will continue to blame each other. But I look at the numbers. And they show one thing: US deficits have already run amok – and no one yet knows how it will end.