For years, budget hawks warned about the damaging effects of the mushrooming national debt, which now totals more than $33 trillion. But they had to speculate about how a debt crisis would materialize because it was only theoretical.
We’re now beginning to see the real-life effects of an unsustainable federal debt load. To finance trillions of dollars in spending beyond what incoming revenue can support, the US Treasury is now issuing more debt in the form of Treasury securities than global financial markets can readily absorb. That forces the borrower — the US government — to pay higher interest rates, which in turn pushes up borrowing costs for consumers and businesses in much of the Western world.
It’s not yet a crisis, in the sense of an unavoidable calamity that will wreck careers and trash living standards. But the excessive debt of the United States now impacts anybody who takes out a loan or invests in stocks. Once a routine and unexciting part of the market, debt issuance by the Treasury is now a hot Wall Street topic as investors plot how to avoid losses — or capture profits — from this new source of volatility.
“We are now quickly seeing the magnifying impact of higher rates and higher debt,” Citi Research economists wrote in an Oct. 27 analysis. “If policy makers are forced to address fiscal sustainability in the next few years, a negative fiscal impulse via spending cuts or tax hikes could be enough in isolation to induce a growth headwind.”
The annual US budget deficit hit $2 trillion in fiscal 2023, which ended in September. That was a big jump from the $1.4 trillion deficit in 2022. In theory, the annual deficit should be shrinking, since massive amounts of COVID stimulus spending in 2020 and 2021 have wound down and the overall economy has been solid. Yet the trend is worsening, rather than improving, due largely to decades of fiscal negligence by both Democrats and Republicans.
What really got investors’ attention during recent months wasn’t the 2023 deficit figure, but a July 31 announcement by the Treasury that it planned to borrow $1 trillion in the third quarter alone, $274 billion more than its estimate from just two months earlier. The government needed the extra financing because tax receipts were coming in lower than expected, while outflows were higher.
Since then, 10-year Treasury rates have risen by nearly a full percentage point. The Federal Reserve has been raising short-term rates to combat inflation, which has some effect on longer-term rates such as the 10-year. But the Fed’s last rate hike was in July, before the July 31 Treasury announcement, and most investors think the Fed is done raising rates, which suggests the spike in long rates since then is due to something else.
“The bond market has kind of figured out that government spending relative to receipts is out of control,” economist Ed Yardeni of Yardeni Research said during an Oct. 30 webinar for clients. “Suddenly we find that the bond market cares about supply and demand, ever since the blowout announcement on July 31 about how much the Treasury said it was going to issue.”
Most economists don’t think higher rates caused by excessive federal borrowing are likely, on their own, to cause a recession. But they’re pushing up borrowing costs across the board for businesses and consumers alike. Surging rates also make stocks less appealing, since the return on bonds goes higher and bonds are an alternative to stocks. That is surely a factor in the 9% drop in the S&P 500 since July 31, when the S&P peaked for the year.
Democrats and Republicans blame each other for the nation’s soaring debt, but both parties are responsible. The last year the US ran an annual surplus was 2001, as Democratic President Bill Clinton was leaving office. Since then, costly wars in Afghanistan and Iraq, Great Recession stimulus spending, and the Trump tax cuts of 2017 consistently pushed the debt higher. After COVID hit in 2020, Congress passed more than $5 trillion in stimulus spending in bills signed by both President Trump and President Biden. That’s basically how we got from a $6 trillion national debt in 2001 to a $33 trillion debt in 2023.
So what’s the plan? There are a variety of ways to get the debt under control. It doesn’t require paying off the whole $33 trillion or even balancing the budget on an annual basis. The main goal is to shrink the gap between federal spending and federal revenue so that total debt as a percentage of GDP stabilizes or declines gradually over time. Most budget analysts agree that a solution will require a combination of spending cuts, tax hikes, and reforms to Social Security and Medicare, which are the costliest programs on the federal books and gobble up a growing share of revenue.
Republicans always say they want spending cuts, and part of the recent revolt among House Republicans who fired Speaker Kevin McCarthy in early October was a demand for deeper cuts than Congress has been considering. Even so, those Republicans are targeting fairly small programs and leaving aside the big social programs, plus defense, which is where most of the money goes. There’s no chance of making a dent in the debt problem by shrinking the federal workforce or cutting arts programs.
Biden wants to raise taxes on businesses and the wealthy, but he’d use most of the additional revenue for new programs instead of dealing with the debt. Plus, Biden couldn’t get tax hikes passed when Democrats controlled both houses of Congress during his first two years in the White House. So neither party has endorsed a credible debt-relief plan.
The market could force action at some point if rising rates cause enough pain and voters finally realize that a new regime of higher taxes and lower spending is the least bad option. Or, a recession could hit, and Congress might find it can’t pass fiscal stimulus, as it normally does, without triggering an adverse market reaction.
The government now spends more on interest payments than it does on funding the Pentagon. “Given the timing of the uptick in interest expense, the fiscal situation may be too large to ignore and become a more important election issue next year,” Citi noted. Even if it doesn’t become a top three election issue in 2024, debt management will likely bedevil whoever wins the White House in 2024.