Chief Global Strategist
Money was tight in our early married years. We bought a house we couldn’t afford, purchased a car we couldn’t afford and had all the expenses attendant on the raising of two young boys. However, as we wandered the local mall gazing at all the other things we couldn’t afford, we were always willing to stop into Godiva to get chocolate squares. Godiva was, of course, more expensive than Hershey bars. But no one was going to go broke buying chocolate squares – it just wasn’t a big enough item to feature in our budgetary woes.
The U.S. federal debt, by one measure, crossed the $40 trillion mark for the first time last week. Political commentary around this issue usually descends into partisan talking points about health care spending on illegal immigrants or the cost of the White House ballroom. However, these are side issues that divert attention for the real reasons for rising debt. For investors, it is important to understand the true sources of the debt problem and the investment implications of the likely scenario in which we don’t fix it.
The Nature of the Debt Surge
Last Tuesday, the “total federal public debt outstanding” rose to over $40 trillion for the first time. It should be noted that economists focus on a slightly different measure, “federal debt in the hands of the public”, which excludes roughly $7.8 trillion that the government owes its own trust funds. That being said, debt in the hands of the public, which we now project to end this fiscal year at $32.3 trillion, or 100.5% of GDP, is also at an all-time high.
This is a very far cry from the fiscal situation at the start of the century. In fiscal 2000, the federal government ran a budget surplus of $236 billion and by the end of that year, federal debt had fallen to $3.4 trillion, or 34.7% of GDP1. In a speech in April 20012, Fed Chairman, Alan Greenspan, fretted about complications that would be caused by a full paydown of the federal debt and the subsequent accumulation of private sector assets by the government.
He needn’t have worried. Within a few years, the budget impact of the 2001 recession, the Bush tax cuts and the wars in Iraq and Afghanistan had eliminated any prospect of a budget surplus. Deficits exploded with the Great Financial Crisis and its aftermath and then worsened further in the years that followed, largely due to rising federal health care spending, continuing defense costs and the 2017 Tax Act. The pandemic and the policy response resulted in further huge increases in debt. Finally, despite significant reductions in federal employment, last year’s tax cuts and increasing interest costs have added to the debt pileup. As the Congressional Budget Office noted in its latest monthly budget review, the budget deficit for fiscal 2026, which ends in just over a month, is likely to exceed $2 trillion.
Prelude to a Surge
To understand what has gone wrong with the debt since the start of the century, it’s important to first understand how we achieved such a relatively healthy budget position in 2000 but also how that success engendered a dangerous complacency.
When Jimmy Carter left office in January 1981, the unemployment rate was 7.5%, the year-over-year CPI inflation rate was 11.8% and the 30-year mortgage rate was 14.9%. Meanwhile, the federal budget deficit for fiscal 1980 was 2.6% of GDP and the debt at the end of that year was $712 billion, or 26% of GDP. By today’s standards, these economic numbers look horrendously bad while the fiscal numbers look remarkably good.
Importantly, economic orthodoxy at the time held that inflation was, in part, the result of budget deficits that pushed aggregate demand in the economy well above aggregate supply. It was also believed that high budget deficits led to high interest rates that could crowd out private investment. As a result, the deficit was public enemy number one.
Under Ronald Reagan and George Herbert Walker Bush, the country ran significant budget deficits to finance tax cuts and a defense buildup. However, the rhetoric against deficit financing continued to be loud and, in 1985, Congress passed the Gramm-Rudman-Hollings Act designed to force a balanced budget by 1991, with an automatic sequestration of discretionary federal spending if deficits exceeded targets. The law was largely sidestepped by Congress and then replaced by a so-called PAYGO system in 1990 whereby all new spending increases or tax cuts needed to be financed by spending cuts or tax increases elsewhere. However, Congress also found ways to work around PAYGO.
After the fall of the Soviet Union in 1991, defense spending fell as a share of the budget while tax increases implemented by Bill Clinton, though unpopular at the time, also reduced red ink. However, given the failure of Gramm-Rudman-Hollings and PAYGO, Republicans included a balanced budget amendment to the Constitution in their “Contract with America” campaign in the 1994 mid-term elections. When they took control of the House and the Senate in 1995, they came within one vote of the two-thirds majority in both houses necessary to put the amendment to the states.
While legislative action to rein in deficits was never fully effective, the constant political pressure to balance the federal books did help rein in the budget. Moreover, a booming economy in the late 1990s, along with a soaring stock market further improved the fiscal situation. In fiscal 1998, the budget deficit turned into a surplus and by fiscal 2000, the surplus amounted to $236 billion, cutting the federal debt from a peak of 48% of GDP in 1993 to just 35% by the end of fiscal 2000.
Years of political pressure to balance the budget, combined with two long and largely non-inflationary economic expansions had actually brought the budget into balance. However, by the turn of the century, fears of what deficits might mean for inflation or interest rates had faded, setting the stage for an abandonment of budget discipline in the years that followed.
Sources of the Debt Surge
A full forensic analysis of the sources of the debt surge since the start of the century would require a work of many volumes. However, the broad narrative is that, since 2000, debt in the hands of the public has ballooned from $3.4 trillion to $32.3 trillion because we failed to pay for the cost of three wars, three recessions, three tax cuts and rising health care spending.
One way to see this is to look at cumulative revenue and spending in key areas over the past 26 years compared to the period between fiscal 1996 and fiscal 2000, all relative to GDP.
Revenues: Between 1996 and 2000, federal revenues averaged 19.1% of GDP. Since then, largely because of tax cut acts in 2001, 2017 and 2025 they have averaged 16.7% of GDP. If they had stayed at 19.1% of GDP then, all other things being equal, federal revenues would have been a cumulative $11.1 trillion higher from fiscal 2001 to fiscal 2026 .
Defense: Between 1996 and 2000, federal spending on defense averaged 3.5% of GDP. Since then, largely because of wars in Iraq, Afghanistan and, most recently, Iran, they have averaged 4.4% of GDP. If they had stayed at 3.5% of GDP then, all other things being equal, federal spending would have been $3.9 trillion lower over the past 26 years.
Health and Social Security: Even in the year 2000, it was recognized that a sharp rise in the elderly population, combined with better but more expensive medical treatments would lead to rising costs. Between 1996 and 2000, federal spending on Social Security, Medicare, Medicaid and other federal health programs averaged 7.8% of GDP. Since then, this has averaged 10.1% of GDP. If it had stayed at 7.8% of GDP then, all other things being equal, federal spending would have been $12.5 trillion lower since 2001.
Other Spending: Between 1996 and 2000, all other federal spending, excluding net interest, averaged 4.5% of GDP. Since then, while outlays in these areas have actually trended down relative to GDP, spending surges in response to the Great Financial Crisis and the pandemic recession boosted the average to 5.6% of GDP. If it had stayed at 4.5% of GDP, then all other things being equal, federal spending would have been $5.2 trillion lower over the past 26 years.
These four items add up to $32.7 trillion, not including interest costs, and more than account for the debt surge of the 21st Century.
Of course, all other things are not equal.
This analysis ignores the fact that, particularly when the economy was operating well below its potential in the aftermath of recession, federal spending and tax cuts likely pushed the economy back to full employment more quickly, thus helping the budget situation. Conversely, it neglects the obvious point that our current debt is being serviced by over $1 trillion in annual interest payments. More budget discipline over the past quarter century would have paid an important dividend in the form of much lower federal interest costs.
That being said, this analysis does underscore the central reality of the U.S. federal budget. Anyone on wants to address the problem of rising debt has to be willing to either raise taxes or cut spending on defense, Medicare, Medicaid and Social Security.
Why We Probably Won’t Deal with the Debt and Investment Implications
Unfortunately, the U.S. political system is very unlikely to tackle rising debt until it has caused significant economic pain and, perhaps, an eventual economic disaster. One reason for this is that the connection between high deficits and high inflation and interest rates has broken down. From a macro-economic perspective this is likely due to two factors.
First, it is the change in the deficit, not the level of the deficit that can cause overall demand in the economy to suddenly exceed supply sparking inflation. That did occur in the aftermath of the Covid pandemic when a quick restart of the economy coincided with a surge of stimulus checks directed at average Americans. However, supply can adjust to a slow rise in a big deficit, such as was the case in Japan for many years, nullifying any inflation effect.
Second, over time the U.S. economy has just become less inflation prone, due to falling unionization, the impact of information technology and globalization in making markets more competitive and increasing income inequality that has directed income towards the purchase of stocks and bonds rather than goods and services.
Whatever the reason for the breakdown in the relationship between deficits and higher inflation and interest rates, the fact that the public doesn’t now see one causing the other has eliminated any urgency to tackle the debt. The reality that the broad mass of Americans are saddling themselves and their children with enormous debt payable mainly to the richest Americans or that the debt buildup will inevitably mean higher taxes, lower benefits and potentially financial crisis, simply isn’t enough to motivate hard choices today. Even if it were, our polarized and partisan political system and a lack of adult debate about the subject, would likely lead to only politically acceptable but utterly ineffective solutions to the problem.
It should be stressed that the road to fiscal healing doesn’t require an immediate move to a balanced budget. Indeed, given the size of the debt, even reducing the deficit to $1.4 trillion in the next year or two would be enough to stabilize the debt-to-GDP ratio and would represent a good first step to fiscal reform. However, since this is very unlikely to happen, investors should be prepared for the consequences.
One consequence has been visible in bond markets in recent weeks. Since the start of the year, the yield on 10-year Treasuries has risen by 0.51% while the yield on 10-year TIPs has risen by 0.44%. The difference between them, which is a measure of long-term inflation expectations has only risen by 0.07%, from 2.25% to 2.32%. This suggests that the backup in long-term yields isn’t a fear of inflation but rather a realization that the Fed will be less accommodative going forward and a growing fear about the volume of government debt to be issued.
This trend will likely continue, with rising interest rates slowly eating into the total returns of current bond-holders but also making fixed income yields look more attractive relative to equities. Since stocks are essentially a perpetuity, rising long-term rates could be expected to ultimately inflict more damage on the stocks than bonds, arguing for some rebalancing away from equities and towards fixed income.
In addition, if rising interest rates hurt both stocks and bonds, investors may want to look at alternative investments in areas such as infrastructure and real estate that may provide some diversification.
Also, particularly if rising U.S. budget deficits contribute to a falling U.S. dollar, investors may want to increase international allocations, especially to jurisdictions that have a more responsible approach to their public finances.
While much of this may make sense in a long-term strategy to maximize returns, it also could provide important insurance if the fiscal situation were to deteriorate much more quickly. Absent some dramatic political change, investors should expect that the federal government will go broke slowly. However, they should be prepared in case some exogenous force or even greater political irresponsibility causes a slow deterioration to turn into a free fall.