One question I’ve heard at virtually every client meeting over many years is, “Are you concerned that U.S. government debt is too high?”
My somewhat glib, although honest, answer has always been: “It will become a problem when it becomes a problem.” That is, when foreign and domestic investors decide they no longer want to own U.S. Treasury securities.
It’s difficult to know when that day will arrive, but it has become a problem for other countries when their debt levels grow to be larger than their gross domestic product (GDP). In the past when that occurred, if a country had interest rates that were higher than its economic growth rate, the incremental revenue generated by the economy each year became smaller than the interest payments on the debt, and the debt began to grow all by itself.
The U.S. had been far from reaching that threshold. Until now.
The Congressional Budget Office (CBO) estimates that next year U.S. government debt held by the public will exceed 100% of GDP and move rapidly higher in the ensuing decades. Worth noting is that the CBO forecast assumes that all legislation will be enacted as it is currently written — meaning that federal tax cuts passed in 2017 would expire. If that doesn’t happen, the numbers could go higher.
Total U.S. debt exceeded $33 trillion as of June 30, 2023. It’s one of the issues that nearly led to a government shutdown this month and could lead to another next month as Congress wrangles over budget priorities.
Will there instantly be problems when debt outstanding surpasses 100% of GDP? Probably not. Other countries have seen higher debt ratios without significant disruption. However, in some of those cases, the country had a unique dynamic that the U.S. may not have, such as a large pool of domestic savings that made them less reliant on foreign investors to hold their debt.
Conversely, the U.S. dollar is still the reserve currency of the world and is likely to remain so. All of this makes it difficult to predict when, or even if, debt might become a problem or to look to other countries’ experiences for guidance. Many countries throughout history have defaulted on their debt, but it was usually associated with a war or natural disaster.
That said, U.S. debt dynamics are evolving in a way that requires attention. Over the next five years, net interest payments on the debt are expected to surpass defense spending. Over the next 10 years, those interest payments are projected to rise from $476 billion to $1.44 trillion. This means interest payments will consume an additional 10.6% of federal government revenue by 2033.
Ever-rising debt levels may force the federal government to make tough policy choices, potentially impacting companies, industries and individual consumers. One obvious consequence would be structurally higher interest rates, as a greater supply of Treasury securities would lead to higher rates. Higher taxes might be required to meet debt service payments.
Slower economic growth also could be expected, given that government spending would need to be re-routed to debt service. For investors, this could lead to lower stock market returns over time, given the strong long-term correlation between GDP growth and market returns.
Not surprisingly, the debt question continues to be asked at client meetings. But it is now usually followed by a statement along the lines of: “The Federal Reserve cannot keep raising interest rates because doing so makes the government’s debt unaffordable.”
Keep in mind, the Fed is under no obligation to help the government afford its debt payments. The Fed’s mandate is to maintain full employment and stable prices. The only reason central bankers might consider making policy decisions with debt affordability in mind is if they saw it as a threat to achieving their mandate. And even then it would require some circuitous logic to link the two.
A Congress that is unsatisfied with the Fed’s perceived lack of concern for the government’s fiscal position could change the Fed’s mandate or put it under their control. However, history suggests that the economies of countries whose central banks have lost independence do not often fare well.
None of this is meant to suggest that a U.S. debt crisis is imminent or that the Fed is in danger of losing its independence. However, given how much the situation has deteriorated over such a short period of time, it is getting more difficult to argue that the debt doesn’t matter.
There are no easy solutions to solve the nation’s debt dilemma. But at $33 trillion and growing, policymakers will inevitably have to address the situation or deal with the market and economic repercussions in the not-too-distant future.
Darrell R. Spence covers the United States as an economist and has 30 years of industry experience (as of 12/31/2022). He holds a bachelor’s degree in economics from Occidental College. He also holds the Chartered Financial Analyst® designation and is a member of the National Association for Business Economics.