US Government Faces Mounting Debt Crisis as Deficit Soars
The US federal budget deficit has reached a staggering $1.7 trillion, equivalent to around 7% of GDP, according to the Congressional Budget Office (CBO). This comes as the International Monetary Fund (IMF) predicts that the deficit will remain at this level for the next five years. Additionally, government debt has tripled since the mid-1960s, now standing at approximately 120% of GDP.
Investors are growing increasingly concerned about these soaring numbers. US Treasury bond yields have risen sharply in recent months, with the market experiencing volatility and intraday swings of more than 20 basis points. The demand for higher yields is seen as a rational response to the swelling deficits and debt.
However, this heightened investor anxiety is exacerbating the situation. Interest expenses for the US government have surged by a third, reaching $711 billion in fiscal 2023. This amount exceeds the total bill for Medicaid and nearly equals a year’s worth of defense spending. Unlike many corporations and households, the US government did not secure low-interest rates by issuing long-term debt, leaving it vulnerable to the impact of higher rates.
Stanley Druckenmiller, a renowned investor, has criticized this strategy, referring to it as “the biggest blunder in the history of the Treasury.” Financial markets are now fearing that the US government, as the largest economy and issuer of the world’s reserve currency, is at risk of falling into a debt trap. This concern arises from the potential for a vicious cycle of larger deficits and higher borrowing costs, leading to an uncontrollable increase in debt.
This growing worry is leading to a shift in the market for US government bonds. Investors are no longer solely focused on pricing the Federal Reserve’s next moves but are now questioning the sustainability of public debt. This shift has broader implications for other G7 countries facing similar challenges.
Analysts suggest that investors should assess the limited options available to the US government to address its massive debts. The conventional method for analyzing debt sustainability involves considering an economy’s growth rate, the government’s “primary” fiscal balance (excluding debt servicing costs), and the interest rate paid on outstanding debt.
The first option to regain sustainability is to achieve higher economic growth. However, boosting overall productivity is a challenging task. President Joe Biden’s approach of increasing spending under trade protection may temporarily improve the debt ratio, but history shows that such measures can lead to negative consequences. If the US is running a fiscal deficit of 7% of GDP during a nearly 5% annual growth rate, investors rightly question how much the budget shortfall would increase during a recession.
The second option is to target a primary fiscal surplus by implementing a combination of spending cuts and tax hikes. However, G7 nations like Britain already face obstacles in this regard, with spending driven by social entitlements that are difficult to cut and taxes already at historically high levels.
The third option is to keep real interest rates low. This strategy involves financial repression, compelling financial institutions and central banks to provide funding for the government at below-market interest rates. While this approach may temporarily lower the debt ratio without the need for austerity measures, it can hinder financial intermediation in the long run. Nevertheless, given the starting point for many countries, it may be the least detrimental choice.
Unfortunately, this route is also blocked, as central banks are adhering to inflation-targeting mandates and tightening financing conditions for consumers, companies, and governments. The Bank of Japan, the last G7 central bank considering yield curve control, has even recently stepped back from this policy.
The combination of the practical challenges of achieving long-term growth, the difficulty of addressing the primary balance, and the lack of coordination between fiscal and monetary policy creates a potentially explosive situation. Until the US and other G7 members overcome these obstacles, creditors are justified in seeking safer investment options. Governments are genuinely ensnared in a classic debt trap.
More detail via Reuters here… ( Image via Reuters )