Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

The national debt: prepare for liftoff

Good news: the federal budget deficit shrank by half in the fiscal year ended September 30 to a paltry $1.4 trillion. The dramatic improvement was due to the runoff of Covid stimulus and an increase in tax revenues from economic growth. By any standard, the report was welcome as the gap between spending and income has surged over the past 30 years. But the relief (if one can call it that) is merely temporary, as without substantial spending reductions and tax increases future deficits and debt are about to rocket into the stratosphere. Perhaps this is a good time to thank our grandchildren in advance for paying our bills.

Unlike state and local governments, Congress is not required to balance its budget. In any given year, the excess of spending over collected tax revenues is called the budget deficit and is financed by issuing US Treasury bonds. (While it is theoretically possible to run a surplus, it has happened only 3 times since 1970). 

The national debt represents the accumulation of all prior deficits less surpluses, and now stands at a whopping $31 trillion. Of that total, $6.6 trillion is “intragovernmental” debt, owed by one department or program of the government to the US Treasury in trust funds like Social Security and Medicare. The difference, around $24 trillion, is called “debt held by the public” and is the relevant measure of net federal indebtedness. This massive obligation now equals nearly 100% of GDP, or about as big as the entire US economy. Only in 1946 following WWII has the debt been as high. Two thirds of this debt has been amassed since the Great Recession of 2006, and about one fourth has accumulated since the pandemic response of 2020. Note that while cutting last year’s deficit in half is laudable, we still added another $1.4 trillion to the tab.

Unlike virtually anything else in Washington, the propensity for overspending has been bipartisan. Since fiscal year 1978, the national debt has grown by $10 trillion under Democratic presidents and $17 trillion under Republicans. Spending is the great uniter.

For the past 20 years interest rates have remained so extraordinarily low that the damage of excessive indebtedness has been minimal. That is about to change for a number of reasons and defusing the massive future debt bomb will present a critical test of leadership and political resolve.

About 65% of all federal spending is mandatory, authorized by prior legislation to fund entitlement programs like Social Security and Medicare. Only 30% is truly discretionary, allocated among various programs like education, defense, research, and infrastructure. Since only 5% currently goes to pay interest on the debt, the unsustainability of large deficits has not received enough attention. However, with rising interest rates and surging borrowing, the picture is about to darken. According to the Congressional Budget Office’s annual review, interest cost alone will exceed 20% of total spending and 40% of tax revenues in 30 years, surpassing all other programs in the budget including Medicare and Social Security and crowding out almost all discretionary spending. 

In addition to the higher cost of debt service, the CBO expects mandatory spending to continue its inexorable rise due to inflation and demographics. CBO projects that without major changes, public debt will swell from 100% of GDP in 2021 to 185% in 2052, but this projection is likely understated. The Social Security trust fund is slated to be depleted by 2034 while the Medicare trust runs dry in 2028. These programs will need refunding and it seems unlikely that Congress will fully fund them with additional tax revenue, which means even more borrowing.

The US enjoys a unique advantage in its ability to borrow more cheaply thanks to the status of the Dollar as the global currency, and the presumption that America could never default on its obligations. Yet all economies have an upper limit on borrowing above which financial markets price in higher risk which translates into higher borrowing costs. Recall that the US was already downgraded from its AAA rating long before the debt ratio reached 100%. According to research from the Federal Reserve Bank of Kansas City, the current level poses relatively little immediate risk of default, but the probability increases significantly if we reach 185% of GDP in the absence of major entitlement reform. Global markets will react appropriately by demanding higher rates and potentially shunning the Greenback.

Consistently running large deficits has a direct impact on American families. Since 1970, mandatory spending has doubled as a percent of the budget, while discretionary outlays including infrastructure investment have fallen by half. That means slower growth in output and wages, along with the opportunity to watch from behind as China sprints ahead. High debt levels reduce flexibility to respond to recessions or unexpected events like Covid, and even increase the probability of triggering a crisis. Excessive government debt also crowds out private investment, adding additional drag to an economy already straining under the weight of an aging population and lethargic productivity growth. 

Perhaps more importantly, our fiscal largesse represents a massive intergenerational transfer of debt and the promise of lower incomes to future generations to finance our current consumption.

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