Navigating the Debt Dilemma: The Impending Conundrum of U.S. Federal Deficits and Monetary Policy
“What cannot happen, will not happen” is a phrase Liberum Investment Strategist Joachim Klement used to describe the faultiness of the debt-bomb argument in a blog post from Substack. “If the consequences of an action are too extreme and painful, people will find ways to turn away from the precipice and change course.” The debt-bomb argument, Joachim identifies, was in some form conceived by British philosopher David Hume in 1764. In brief, due to growing government debt in the UK, which was held mainly by foreigners and could amount to blackmail if sold off, government policies would have to either raise taxes to pay off its debts or default if the debts became too large. Joachim points out that in 260 years, the United Kingdom has never defaulted on its debt, never experienced hyperinflation, and still holds one of the world’s five most important currencies.
However, history doesn’t negate the problems caused by huge government debts characteristic of many current economies. Across the developed world, governments spent unprecedented amounts of money to put the economy on hold during the pandemic. Then, even after these large deficits, which proved to be inflationary much longer than policymakers insisted at the time, many governments continued spending. In the United States, the Congressional Budget Office (CBO) of the US Treasury estimated the deficit for year-end September 30, 2023, to total $1.7 trillion. Excluding the cost savings associated with a Supreme Court Decision to end student loan forgiveness in June, a $1.1 trillion increase in the deficit since 2022 is attributable to a 9% decrease in total receipts and increased outlays for Social Security, Medicare, Medicaid, and interest.
Source: CBO
American debt will total 124% of GDP by year-end according to the CBO, and the debt is expected to rise going forward. As The Economist explains in its September 28th article, much of the long-term budgetary pressure in the USA comes from mandatory increases, such as Medicare (for those aged 65+ years old). This “will increase by 30% relative to GDP over the next ten years,” meaning both sides of the American political aisle must confront the problem regardless of their partisan budgetary views since these outlays arise from previous commitments. Mounting debt means interest expenses will eat away at the budget. In 2023, the USA spent $660 billion on interest payments, and the CBO estimates (even assuming a rate decrease) that 2028 interest payments will exceed the defence budget at around 3.1% of projected GDP.
At some point in the 1980s, the U.S. surpassed Brazil and Mexico to become the world’s largest debtor nation in dollar terms. That observation is made by measuring a country’s Net International Investment Position (NIIP); it is the difference between a country’s total assets and liabilities, signifying that the U.S. had more liabilities owed to other countries than assets held in return. Since the 1980s, its position has trended downwards, -$18trn for Q2 2023, according to the Bureau of Economic Analysis (BEA), which is 65% of Q2 GDP. America’s net liability positions rival similarly to those of Spain, Greece, and Portugal, which have all faced a recent debt crisis. For reasons given by a 2021 Brookings Institute Press article here, such as the tendency of Americans to borrow in USD and make FDI in foreign currency and the strong valuations of the American stock market and dollar since 2010, there is no catastrophic risk to worry about.
To reintegrate Joachim’s point, the American government will likely avoid the disastrous effects of a debt bomb as monetary policy is formed conscious of the mounting federal interest bills. However, how the central bank unwinds current macroeconomic headwinds may prove strenuous to individuals and businesses and cause uncertainty in financial markets.
Interest rates have held steady since the FED’s September announcement to keep rates between 5.25% and 5.50%. Furthermore, the FED has engaged in Quantitative Tightening (QT) since last year. QT is when treasuries, mortgages, and corporate bonds are allowed to mature (or are sold) off the Central Bank’s balance sheet. This increases long-term interest rates since there is less demand for them and takes money out of circulation in the economy, which should bring down inflation. It is the most extreme QT measure in history, with a target of $95bn to roll off the FED Balance Sheet since the program started in 2022. Such effects can, in part, be seen in the 10-2 spread. The spread measures the difference between 10-year and 2-year bond yields and is the most frequently watched figure regarding the yield curve, which has been inverted since last year. An Economist article explains that analyzing this graph can be like “reading tea leaves” since the policy changes enacted by the Central Bank and their corresponding effects are extremely hard to isolate and attribute to one factor. Narrowing of the 10-2 spread, which upon observation seems to be caused by a rise in 10-year rates, can be attributable not only to QT and interest rate hikes but also to rising debt term premiums. Investors demand higher returns for the risk of holding long-term debt.