- Macro Strategist
United States, Institutional
Change
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The aftermath of historic fiscal stimulus following the COVID-19 pandemic, elevated global inflation, and the most recent US election during which President Trump campaigned on further fiscal easing have put elevated US government debt levels increasingly in focus. Since President Trump's election victory odds troughed in early September last year, term premia in the US have risen by roughly 65 basis points (bps).1 While this increase has been partly driven by more accommodative monetary policy, it also reflects the bond market's assessment of the future fiscal trajectory post-election.
Swelling US federal debt well understood by market participants
The bipartisan Congressional Budget Office currently projects US federal budget deficits will reach 6.1% of GDP by 2035, and US debt held by the public will rise to 118.5% of GDP, representing the second-highest debt burden since 1790. On the expenditure side, the main culprit behind higher outlays is mandatory spending, including programs such as Social Security, Medicare, and Medicaid, which will further increase given demographic shifts in the US over the coming decade. Discretionary spending, both defense and non-defense, stands at the second-lowest share of the economy going back to World War II and is projected to decline over the coming decade. Interest costs are now an increasingly important share of total spending, accounting for 3.1% of GDP — the highest percentage going back to at least 1965. At the same time, total revenues are projected to be roughly stable over the coming decade — even allowing for the potential revenue raised by increasing trade tariffs — and in line with average revenues going back to the early 1960s.
Importantly, these projections do not account for a possible recession over the next decade — which would cause debt dynamics to deteriorate further — and assume all current policies will expire on schedule, including the Tax Cuts and Jobs Act (TCJA) of 2017. Given full Republican control across the presidency, Senate, and House, the TCJA will likely be extended, with a projected cost of US$5.3 trillion over the next decade.
Positive and negative implications for high debt levels
On the positive side, persistent government deficits following the global financial crisis and COVID-19 allowed the private sector to repair their balance sheets, and household debt as a share of GDP has declined to the lowest level since 2000. Non-financial corporates are also in better health, with debt levels at the lowest in a decade. In aggregate, higher public sector debt has helped to ease the debt burden of the private sector, making the aggregate economy more robust and less sensitive to sharp rises in interest rates, as demonstrated in 2022.
On the negative side, there is already evidence that increased spending on entitlements and interest costs is crowding out other forms of federal government investment that historically have served as a tailwind for economy-wide productivity gains. The US has a long history of implicit and explicit public/private partnerships that occur when government investment increases, including in wind power, supercomputing, and the internet. With accelerating capital expenditures devoted to generative AI, in addition to the elevated level of private sector intellectual property and R&D spending, there are clearly positive signs for sustained productivity growth in the US. However, like many new and potentially transformative technologies, widespread adoption often requires increased government investment around issues like skills retraining before economy-wide adoption. A rising government debt burden risks crowding out government investment at a time when it’s most necessary.
That said, the US still has important advantages over other countries with similar debt profiles:
- The US dollar’s global reserve currency status. At nearly 70%, international currency usage of the US dollar has increased relative to 20 years ago, based on various factors. This “exorbitant privilege” has helped keep interest costs and debt levels lower than would be the case if the dollar was not the preeminent reserve currency.
- The Federal Reserve’s balance sheet. An increasingly important tool for monetary policy and the banking sector, the Fed balance sheet currently holds US$4.3 trillion in US Treasury securities. This persistent source of demand is an important factor suppressing bond yields; my own analysis suggests that since 2009, Fed purchases have kept long-end yields roughly 100 – 150 bps below where they should be given fundamentals.
- Many of these issues are solvable. The solution revolves around increasing revenues and/or modifying the trajectory of entitlement spending through means testing and/or increasing the eligibility age. Solutions to set the US on a more sustainable fiscal trajectory have been presented by the Simpson-Bowles Commission and the Penn Wharton Budget Model team. The newly created Department of Government Efficiency also has a wide scope to analyze government debt and efficiencies and make recommendations.
Solutions are there, but they require political will
The cost of not tackling ballooning budget deficits that are typically associated with wars and recessions is steadily increasing, with inflation still well above the Fed’s 2% target and term premia in the bond market starting to rise again. The bond market will be acutely attentive to fiscal developments, and should medium-term reforms not get implemented over the next 12 – 24 months, then it will likely flex its muscles and potentially force painful action.
1Based on the Adrian, Crump & Moench 10-year US Treasury Term Premium model from the Federal Reserve Bank of New York
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