A question that clients often ask us is how much of a risk the high levels of sovereign indebtedness in the US pose to the global economy and markets. With close to $35 trillion in national debt and a debt to GDP ratio of around 123%, the US government’s debt situation is serious enough to warrant close attention.
This debt pile is growing at an alarming rate, with the US government running a sizeable deficit for much of the past two decades. The last time the government ran a surplus was in 2001. As The Economist points out, the deficit has not been under 3% of GDP – a traditional measure of fiscal discipline – since 2015.
Factors that have fuelled US government debt since 2001 include multiple wars, the Global Financial Crisis (GFC) and world recession in 2008, and most recently, COVID-19. During the pandemic, the national debt spiked due to tax cuts, stimulus programs, higher government spending, and decreased tax revenues.
But the US government has yet to show much appetite to bring down spending and reduce debt, despite high interest rates, the surprising health of the post-COVID-19 labour market, and the resilience of the economy. Indeed, in the past year alone, the federal government has spent $2 trillion (or 7.2% of GDP) more than it raised in taxes.
Whoever moves into the White House after this year’s bruising election campaign, it seems unlikely that the profligacy will end. Judging from his previous tenure, Donald Trump is likely to show a preference for uncosted tax cuts for corporations and wealthy individuals that may reduce the government’s overall tax rake.
If Joe Biden (or another Democrat should he drop out from the nomination process) wins the presidential race, we can expect policy continuity. The continuation of ‘Bidenomics’ measures such as infrastructure investment and social welfare spending may be supportive of the economy in the long term but will assuredly add to the debt mountain.
The dollar’s dominance: Shielding the US from debt fallout
The question that arises is for how much longer this can continue. As frightening as the numbers are, we believe the US may be able to keep a serious reckoning with its debt burden at bay for years to come—in fact, for as long as the US dollar remains the world’s reserve currency.
The US can assume a far larger sovereign debt to GDP ratio than most other nations because it issues debt in its own currency. The mighty dollar enables it to borrow without paying a premium to creditors. Since the dollar and dollar-denominated debt are in high demand, the US is largely shielded from reverberations in the world economy.
If the situation gets more serious, the US has considerable scope to raise revenues through tax hikes because its underlying tax base is deep and broad. As such, apocalyptic scenarios such as the US defaulting on its sovereign debt seem unlikely in the near to medium term.
But that doesn’t mean there are no risks for the US or the rest of the world in the size of the US debt. One concern is that servicing the debt could crowd out more productive spending. The Congressional Budget Office (CBO) forecasts indicate all federal revenues will be required to fund mandatory government spending by mid-2030—largely Medicaid, Social Security, and interest on debt.
Compounding dangers
This danger could be compounded if continuous increases in borrowing lead to higher yields on US Treasuries and borrowing costs for the US government. There is also a small but non-trivial possibility that the dollar could depreciate materially, and inflation could heat up if holders of Treasuries start to worry about the quality of US debt.
A potential catalyst for this might be Trump winning office, then reducing the independence of the Fed and pursuing lower interest rates. Looser monetary policy, unjustifiably low interest rates, and a growing deficit would stoke inflation—in turn, devaluing dollar assets in real terms.
Another risk lies in the fact that the US government may not be able to respond effectively to another crisis on the scale of COVID-19 or the Global Financial Crisis. Its ability to reduce inflationary effects or head off a long, deep recession in the event of a negative macro event could be severely constrained because of the debt it already carries.
With some luck, the world might not need to face a deep debt crisis in the US in the short to medium term. If inflation is tamed and interest rates start to fall, US sovereign debt will start to look a lot more manageable as debt service costs will decrease. Productivity growth could also help to fuel economic growth and tax revenues that help to bring the deficit back under control.
It’s also possible, but seemingly unlikely, that politicians might start to tackle the debt problem with more energy and commitment. This may occur if so-called ‘bond vigilantes’ confront the US government about its debt levels. The US government still has leeway to raise taxes or adjust discretionary spending, even if this would not be popular with the electorate.
Base case: The status quo prevails
Our base case for the next few years, however, is that nothing much will change. A yawning deficit and rising debt will continue to cast a shadow over the economy. But given the global demand for dollar-based assets in the absence of credible alternatives, we believe the risks of a debt-spiral-induced meltdown are relatively minor.
We do, however, continuously monitor the debt landscape in the specific context of our multi-asset portfolio composition, as these comprise cash, bonds and, from time to time, property assets where the value is much more intrinsically linked to the country and currency of origin. We have much less concern regarding US-listed global equity investments, as outlined in this article we previously published, because multinational companies have significant embedded currency diversification, and even dollar revenues will increase in the face of a weaker dollar for businesses that have pricing power.
