For decades we have heard cries about deficits that are too large and the surge in the amount of U.S. debt outstanding. In the Ronald Reagan years deficits of $100 billion were eye opening. Today they are 20x as large. The accumulation of deficits has been financed with debt, of course, now totaling $34 trillion. While none of us can truly comprehend what $34 trillion means, the best way to convey the size is by quantifying how much it costs to service that debt in relation of either total GDP or compared to other expense categories that comprise total Federal spending.
Prior to the pandemic, when interest rates were low, annual debt service was roughly $250 billion. But after years of $1-2 trillion deficits together with higher interest rates, annual debt service is approaching $1 trillion. This is not an imaginary number that Congress can make disappear with fanciful accounting. Debt service is cash outlays payable to owners of U.S. government bonds. This year, for the first time, debt service will exceed defense spending. Based on current projections from the non-partisan Congressional Budget Office, within this decade, debt service will be the biggest single government expense, bigger than Social Security or Medicare.
But does it matter? Given that the dollar is the world’s reserve currency and our government can print all the money it needs to pay the interest, why does any of this matter? The answer is obvious. It doesn’t matter…. until it does. Let’s be absurd for a moment and think of a world where U.S. debt is $100 trillion, annual debt service is $5 trillion and debt service alone is 15% of GDP. Is Federal borrowing power limitless just because Treasury can print money? Inflation is a monetary function of a supply/demand imbalance. Either all the added spending crowds out other parts of the economy or rampant inflation follows.
For a long time, debt service averaged close to 3% of GDP. Growth in consumer wealth could easily absorb the added annual interest burden. But today, that number is 7%, too large a number to assume American investors can swallow all the added debt the government wants to issue. So, who absorbs the rest? Foreign buyers to a large extent. The U.S. currency is still viewed as the safest and, while Congress often plays with the idea of debt default, no one views that as likely. Politics is a factor. The Chinese own a lot of U.S. debt, over $850 billion by last official count. But strained relations between the two countries and slower growth in China are headwinds to the thought they will buy ever more debt. Japan owns even more, roughly $1 trillion. U.S. debt looked attractive to Japan when our interest rates rose to 5%, but as the yen weakens, in large part due to interest rate disparities, the value in yen of Japan’s holdings decline, weakening their appetite to buy more of our debt.
I stated earlier that the amount of debt doesn’t matter until it does. Treasury runs regular auctions whereby it sells new bills, notes and bonds to fund deficits and to refinance maturing securities. To date, there have been buyers for all the bonds offered and then some. But what happens if buyers start to get cold feet? At first, they demand more interest for more risk. Without some form of austerity, the situation escalates. Do you remember what happened in Greece, Spain and Portugal a little over a decade ago? Even if that sort of panic doesn’t evolve, the rise in debt service will take money away from other government activities like defense and entitlements. History isn’t kind to nations where the ratio of debt to GDP rises above 100%. Whether one looks back to the Roman, Ottoman or British empires, all peaked soon after debt to GDP crossed the 100% line. Of course, “soon” could mean decades rather than months or years. But the key point is that the basic laws of economics never react well against a backdrop of imbalances. You can look at any business or even your own family finances. There is always a point of too much debt that, if not attended to soon enough, creates havoc.
This is a problem the next President must deal with. President Biden’s approach is to raise taxes. I should stop there and note, that rising deficits have not been a function of any revenue shortfall. Over the past several decades, Federal spending has averaged about 17.5% of GDP. Now it is about 17.2%. The gap between revenues and outlays averaged a bit over 3.5%. But now spending is close to 24% of GDP, the highest of almost any non-war year since WWII. Normally, spending spikes in bad economic times as safety net outlays increase. Thus, what Biden proposes is to lift revenues to 20%+, a level not seen in over seven decades. But even then, the deficit will still be well above average if he follows the agenda laid out in his most recent budget proposal.
Trump has a different view. He wants to substitute tariffs for taxes. He also wants to roll back several expensive spending programs including student debt forgiveness, reducing the size of the infrastructure program, and reversing key parts of the Deficit Reduction Act. Importantly, both consider both Social Security and Medicare off limits.
All this is a typical Republican/Democratic debate. Democrats want more government involvement; Republicans want less. Neither, however, is willing to get to the real structural problem which is entitlement reform. Biden is highly unlikely, if reelected, to get a tax increase passed anywhere near the size he will request. Trump is unlikely to convince Congress to substitute tariffs for taxes. Even if he did, he would still face a massive deficit.
We all know the three monkeys who see no evil, speak no evil and hear no evil. Every President since George W. Bush has hoped that he would not be in office when the reckoning comes. There are no signs either Biden or Trump feel any differently. Thus, it will be up to markets to decide when the day of reckoning arrives. Last fall, there was a bit of a wobble until Treasury decided to concentrate new debt offerings at shorter maturities. That stabilized markets, but it increased debt service at a time when the yield curve remains inverted. Treasury would like to lower rates but it cannot bring the Fed Funds rate anywhere near zero as it did previously without reigniting inflation.
The bottom line is that there isn’t a limitless source of buyers of U.S debt or, for that matter, sovereign debt around the world. In Europe, leftist free spenders are losing ground in France and Germany. The French stock market lost all its 2024 gains in a week. What has saved the U.S. for years is the fact that the dollar is the world’s reserve currency. Would the fact that the U.S. has accumulated $34 trillion in debt possibly change that? It could if there were a logical alternative. China pegs its own currency to the dollar. The euro is the base currency for a conglomeration of over two dozen nations. Japan is simply too small for its currency to have world-class status. But consider this. In 1908, U.S. financial markets were on the brink of collapse saved by the efforts of J.P. Morgan. Meanwhile, the British Empire spanned the globe from Canada to India. But within four decades, the same financial collapse, the Great Depression, two world wars, and, most importantly, a surge in debt, led to the demise of the British Empire and the replacement of the dollar for the pound as the world’s reserve currency.
History never repeats itself but often rhymes. Concerns about the size of Treasury fundings wobbled markets last fall. The collapsing value of the yen, the surge in inflation over the past several years, and real estate woes in China, are all symptoms of markets stressed by rising sovereign debt levels. So far, our markets ignore the messages. They can’t ignore them forever.
Soccer star Lionel Messi turns 37 today, actress Mindy Kaling from “The Office” is 45, and musician Mick Fleetwood of Fleetwood Mac turns 77.
James M. Meyer, CFA 610-260-2220