Third, the U.S. Treasury raises money in a global market for government bonds. Even as the United States faces a rising debt-to-GDP ratio in the years ahead, other governments may be more frugal and thus reduce the strain on markets from U.S. borrowing. In particular, in its October 2023 World Economic Outlook, the International Monetary Fund estimated that the net government debt of the Euro Zone, the U.K. and Japan would all fall as a percentage of GDP between 2023 and 2028.
The Cost Of Not Fixing The Debt
All of this reduces the risk that long-term interest rates will spike higher because of the federal government’s borrowing needs. However, it is hardly a cause for celebration or complacency. The reality is that all of this rests on an assumption of attaining and maintaining low inflation and a strong dollar. Without low inflation, the Federal Reserve will likely keep QT going for longer and resist calls for reductions in short-term interest rates. If the dollar were to fall sharply, both U.S. and international investors would likely demand a premium to invest in U.S. securities rather than accepting a discount.
The problem is, the low inflation achieved between the 1980s and the start of this decade was facilitated in part by rising inequality which tended to boost the demand for financial assets and homes and limit the demand for basic goods and services. The strong dollar, so important to global demand for our stocks and bonds, has cost millions of manufacturing jobs and left the United States with a permanent trade deficit, adding annually to our foreign obligations.
It is a sad predicament when our ability to finance our government debt hinges on our willingness to maintain yawning inequality today and reduce our prospective standard of living in the years to come. Moreover, to state the obvious, chronically high budget deficits reduce our ability to respond to geopolitical issues, domestic disasters or recessions.
Investment Implications
Rising interest payments have been the biggest reason for a sharp increase in the budget deficit recently. However, any attempt to reduce the deficit in the long run would have to come from reducing the primary deficit—that is the gap between non-interest spending and revenues. This, in turn, requires voters to be willing to elect politicians who promise to do unpopular things. The usual whipping boy of those who pretend to be deficit hawks, is discretionary, non-defense spending. However, as we show on page 20 of the Guide to the Markets, this broad basket of government services only accounted for 15% of federal spending last year. Indeed, even a cursory glance at the federal finances makes it clear that any attempt to achieve balance would have to rein in spending on Defense, Medicare, Medicaid and Social Security while raising taxes.
There is no evidence that voters are ready for this. And so, most likely, the deficit and debt will continue to worsen, gradually adding to the underlying level of real interest rates.
For investors, this suggests three broad implications. First, the debt-to-GDP ratio will continue to rise for many years to come. However, this should merely put some upward pressure on long-term interest rates—there is no reason to believe that it is about to trigger a short-term financial crisis.
Second, in the medium term, budgetary pressures will likely require some increase in taxes and some cuts in spending. Taxes will likely be raised on the rich while spending growth will likely be curtailed for older Americans. If you are richer and older than average, the government will likely tax you more and spend on you less, making it even more important to build a bigger private nest egg.
Finally, as with any risk, it is important to consider how to mitigate it. Surging levels of government debt, combined with a high exchange rate, are more of a problem in the United States than in, for example, the Euro Zone. For those worried about a U.S. debt meltdown, the most obvious way to reduce risk is invest more around the world. This should be good protection if someday, the sales force in the Treasury department, finds themselves with a product they just can’t sell at any reasonable price.
David Kelly is chief global strategist at J.P. Morgan Asset Management.