Updated: Mar 2
This quarter, we’d like to offer some thoughts on a subject that seems to go in and out of fashion depending on who’s in charge—our ever‐growing national debt. While politicians may raise the issue when politically expedient, then quickly forget about it when in power, the growth of our national debt has real long‐term effects apart from its value as a campaign issue.
What is the national debt? The national debt is the accumulated debt owed by the federal government to the public (i.e., the buyers of government bonds) and to its own departments (e.g., the Social Security Trust Fund). The debt grows or shrinks based on whether the federal government has run an annual budget deficit (spending is greater than revenue) or surplus (revenue is greater than spending). As discussed in a recent article in The Wall Street Journal by Valerie Ramey, Professor of Economics at the University of California, San Diego, for much of the 20th century the U.S. government operated under the general premise that it should fund its spending through tax revenue instead of through borrowing. Annual budget deficits were seen as temporary—necessary during times of national emergency such as wars or economic recessions, but to be avoided during good, or even normal, times.
This conventional wisdom has gone out the window in recent years. The last time the U.S. government ran a budget surplus was 2001—since then, the national debt has grown nearly 300%, from approximately $5 trillion to over $22 trillion, and is expected to top $25 trillion in 2021. It’s true that this period has included times of national emergency, including multiple wars in the wake of the 2001 terror attacks, as well as the recession brought about by the 2008/2009 Financial Crisis. However, since the Great Recession, the U.S. has enjoyed the longest economic expansion in its history and unemployment hit a 50‐year low. Despite this, for the 2019 fiscal year, the federal deficit rose 26% from the previous year (its highest level in seven years), adding about $1 trillion to the national debt. The relatively good economic times that we currently enjoy would typically present an opportunity to improve the nation’s balance sheet, but instead the deficit has grown year‐over‐year since 2016 and is projected to continue to rise, pushing the national debt higher and higher.
How much debt is too much? Like personal or corporate debt, the best measure of debt is probably not the absolute amount, but a relative amount—in this case the amount relative to the national balance sheet. The amount of debt held by the public (i.e., not held by the federal government itself), relative to the country’s GDP (the total value of U.S. economic output), best serves this purpose. Approximately $17 trillion of the national debt is public debt, equating to nearly 80% of current U.S. gross domestic product. This is not the highest ratio of (public) debt‐to‐GDP in our history—at the end of World War II, the ratio hit 106%. Following the war, the debt‐to‐GDP ratio dropped sharply, due to a period of budget surpluses, which reduced the national debt by roughly 12%, coupled with the rapid growth of GDP. Fast‐forward to today, and you’ll hear echoes of this in arguments from proponents of the 2017 corporate tax cuts: the economic stimulus from the tax cuts will boost economic growth and shrink the debt‐to‐GDP ratio even with a reduction in tax revenues. So far, this has not played out, and the debt‐to‐GDP ratio is projected to rise. Importantly, although economists disagree on how high the ratio can rise without serious adverse consequences, most economists will agree that a ratio above 100% is cause for concern and above 150% would essentially tie the U.S. with Japan as one of the two most indebted countries on earth. Put another way, the financial burden that our generation places on our children will have its limits whether we like it or not.
Can we grow our way out of a debt crisis? Whether or not the U.S. can stabilize its public debt‐to‐GDP ratio is dependent on interest rates, future deficits and economic growth. With forecast deficits of about $1 trillion, the rate of growth of the debt is about 5% per year, ahead of the projected growth of GDP at about 2% per year. Under these conditions, the debt‐to‐GDP ratio will continue to grow. But what if the additional deficit spending could be used to boost GDP? Marginal economics suggests that if additional deficits, financed at today’s low interest rates, could be used to make improvements in GDP at a rate greater than the interest rate, then the net effect builds wealth for the country and slows the rate of debt‐to‐GDP growth. In other words, the country’s capacity to pay grows faster than the interest that it pays. As Oliver Blanchard, the former chief economist at the International Monetary Fund said in a speech to the American Economics Association in early 2019, “The current U.S. situation in which safe interest rates are expected to remain below growth rates for a long time, is more the historical norm than the exception. Put bluntly, public debt may have no fiscal cost.” So, much like a corporation, deficit spending can be used to grow GDP and delever the federal balance sheet if invested in programs that improve productivity, such as improving transportation, education, and healthcare.
Can we save our way out of a debt crisis? Of course, the other way to avert a debt crisis would be to slow or even reverse the growth of debt through spending cuts or higher taxes. The total federal budget in 2018 topped $4.1 trillion, of which about $800 billion was supported by deficit spending. Limiting deficit growth to GDP growth, or say, 3% of $25 trillion, implies that sustainable deficit spending must be constrained to about $750 billion. Notwithstanding the resistance to raise taxes, the various mandatory spending categories such as healthcare, social security, and interest, are forecast to grow at a rate greater than GDP as the Baby Boomer generation ages and more beneficiaries come into the social safety net. The “most likely” growth of these spending categories, as measured by the non‐partisan Congressional Budget Office, are projected to rise as a percentage of GDP (see Figure 5), making it even more difficult for the U.S. economy to achieve the growth necessary to keep the debt in check.
Do we have the political will? Our country’s leadership has all the tools it needs to guide our country to fiscal stability—the three levers of GDP growth, higher taxes and lower spending. Yet partisan gridlock is preventing us from getting the job done. Taken together, the inability of our congressional leaders to pass real productivity‐enhancing legislation and the political difficulty we have in constraining deficit spending suggest that a reckoning is in our future.
Should I prepare for a national debt crisis? To be clear, we don’t think that a debt crisis is inevitable, and if it does occur, we suspect it will be several years in the future. Moreover, partial success in maintaining fiscal discipline could allow us to continue muddling along for years. The trigger for a debt crisis might be a severe downturn that causes GDP growth to stall or even reverse, coupled with monetary and fiscal stimulus, which will quickly expand deficit spending. The already extended nature of the U.S. balance sheet severely constrains these options, which would cause any severe downturn to be extended and painful. Our view is that good, long‐term policies are the best insurance against possible calamity, and thus we do not advocate for deviation from long‐term asset allocation targets. Nevertheless, it remains sensible to insure against crisis by owning diverse investments including some that could do reasonably well in such an event. These would likely be investments in essential services (such as apartment rentals), investments that actually grow businesses (some private equity managers), high‐quality capital‐intensive businesses that are currently cheap (good value stocks), high‐quality bondholders, and gold.
A continued path of growing the national debt faster than GDP is a precarious one. The scenario above is but one that could leave the country in a difficult position. We urge our clients to stay alert to fundamental changes in the markets and to remain broadly diversified by company, currency, and market type (including some of the categories discussed above) to better withstand the possible risks imposed by continued debt‐to‐GDP growth.
As always, we welcome your questions, comments and conversation!
The Mangham Associates Team
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