Government debt and deficits: Crisis or concern?

By Russell Price, Chief Economist, Ameriprise Financial

Key Points

  • U.S. government debt is high and projected to rise much further.
  • Policymakers should address the nation’s debt challenges sooner rather than later.
  • High debt levels could crimp federal policy options in the future.
  • Over the long-term, high government debt levels could be a source of added volatility for financial markets.

U.S. government debt is often in the news and for good reason — the figures can be daunting.

Total U.S. government debt recently passed a worrisome milestone of $22 trillion. This figure, however, includes the “I.O.U.s” held in the Social Security Trust Fund, debt that is not actually held by the public. 

Outstanding federal debt held by the public was $16.2 trillion at the end of March, equivalent to about 78% of the underlying U.S. economy, a ratio referred to as “debt-to-GDP.”

Regardless of the measure used, U.S. government debt is high, too high, in our view. Unfortunately, the more troublesome problem is that U.S. debt-to-GDP is projected to steadily rise in the decades ahead as annual deficits (yearly spending in excess of tax revenue) is expected to remain elevated. The Congressional Budget Office (CBO) currently projects annual deficits to run at an average of 4.4% of GDP over the next ten years (2020 to 2029) versus a 1969 to 2018 average of 2.9%, leaving debt to GDP at 92.7% by period’s end.

 

How high is “too high?”

There’s no official number whereby the government’s debt officially becomes “too high.” Over time, however, buyers of Treasury debt may demand higher yields to compensate for the added risk. We are not at that point yet, as yields on U.S. Treasury securities have remained low and even declined somewhat in recent months.  

The projections above also factor in the expectation of higher interest rates in the future. The CBO expects 10-year Treasury yields to average 3.7% to 3.8% between 2021 and 2029, versus a recent rate of about 2.5%.

 

Why debt levels keep rising

There are two leading drivers of debt and deficit growth in the years ahead:

  • Federal spending on major government health care programs is projected to grow to 6.8% of GDP by 2029 from 2018’s 5.2%.
  • Interest expense on our growing debt levels is projected to rise to 3.0% of GDP from its current level of 1.8%.

Meanwhile, government revenue (i.e., taxes) is projected to average 17.5% of GDP, basically in line with its 1969-to-2018 average of 17.4%.

 

 

How to fix it

Trying to immediately balance the federal budget would likely create more economic problems than it would solve. A sharp increase in taxes or a sudden drop in government spending could harm economic growth. Such an action could actually have the effect of boosting the debt-to-GDP ratio rather than taming it.

What needs to happen is commonly referred to as “bending the long-term curve.” In other words, some combination of policy changes must be implemented whereby the debt-to-GDP ratio begins to decline. No single avenue of policy options can achieve this challenge. The solution will surely require some combination of revenue increases (tax hikes), spending cuts and/or non-financial policies that boost the pace of economic growth.

 

What it means for investors

In the years ahead, concern over government debt is likely to grow until federal fiscal policies are adjusted to put projections on a more sustainable path. The longer such adjustments are delayed, however, the greater the tax hikes or spending cuts that will be necessary to rectify the situation.

Although we believe there is still time to adjust fiscal policies to address this problem, financial markets may be subject to greater volatility over the long term if the government’s ability to respond to economic downturns or national emergencies is perceived to be constrained.

Investors close to, or in, retirement may want to consider this risk when discussing portfolio allocations with their Ameriprise advisor. Consult your advisor to discuss the best ways to position your portfolio for this potential scenario and to weather market ups and downs along the way.