The American government budget is not on a sustainable path.
The United States is borrowing roughly $7 billion per day to finance its operations with the deficit heading toward $2 trillion this fiscal year, according to the Committee for a Responsible Budget. And it’s only going to get worse as expansionary fiscal policies take effect in the new year.
While the United States can find investors willing to finance such profligacy, a look at the primary budget deficit—the deficit excluding interest owed on past debt—now stands at 3.78% of gross domestic product, which is simply not sustainable.
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Under a fiscally prudent administration, the U.S. would be planning a period of fiscal consolidation under conditions of near 2% growth to put the fiscal path back on a sustainable footing.
Yet that is not the case nor is there any support for doing so on both sides of the aisle in Washington.
Yes, the American dollar is the global reserve currency, which allows the U.S. to live well beyond its means because of the size of daily global currency and bond markets that are based on American finance.
But the price of money in global markets will be affected by the trajectory of the U.S. borrowing, which as it increases will raise financing costs for American households and businesses.
In an era of economic populism, such ideas tend to fall on deaf ears in the political sector.
But in the financial sector, the rise in public debt is being taken quite seriously. Higher term risk premiums are being attached to U.S. public debt, and long-term interest rates are rising even as the Federal Reserve cuts its policy rate.
The surge in government debt over the past 15 years and the lip-service response by a succession of administrations across the globe should be a concern for all.
Following the structural break in the global economy following the pandemic, higher inflation and interest rates are now the norm.
The rise in government debt has been accompanied by an increase in nonbank financial intermediation and highly leveraged short-term positions, as highlighted in a lecture by the general manager of the Bank for international Settlements.
These institutions are more lightly regulated, which only adds to the risks.
The financial crisis showed just how much risk that nonbank financial institutions can add to an economy. The recession that followed required both monetary and fiscal responses that caused further distortions in financing and added to the public debt.
In the end, a surge in public debt can crowd out private investment, lowering potential economic growth.
Defining the debt problem
U.S. government debt compared with the size of the economy has been increasing since the 1980s.
During the Reagan years, public debt moved back above 40% of GDP, then climbed rapidly to 132% in 2020 after a series of negative shocks and unfunded spending.
Unfunded spending is defined as commitments to spend that are unmatched by increases in revenue, which requires the increased issuance of Treasury bills, bonds and notes.
To be sure, economic shocks like the pandemic require unfunded spending to prevent an economy from falling into a deep recession.
But during times of growth, expansionary fiscal policies should be avoided as growth in the private sector drives an increase in tax revenues.
Yet, a pro-cyclical expansionary fiscal policy is exactly what is about to occur, carrying risks of inflation and higher interest rates.
Despite the assertion that economic growth by itself will close the deficit, just one look at the record of unfunded spending since the 1980s shows otherwise.
The real question then is how much longer will this unfunded spending prove sustainable?
Finally, we should note that the U.S. bond market has shown itself more than capable of finding buyers of that debt. Our trading partners are more than willing to fund our domestic spending in return for the guarantee of geopolitical safety and access to the U.S. consumer and financial markets.
Still, the global financial system has undergone a change because of the surge in government debt and the ability of participants to profit from the availability of funds.
The sustainability of high government debt
This recent period finds the overload of government debt increasingly attractive for short-term speculation by less-regulated market participants.
In contrast to previous global financial crises that were the result of unsustainable private-sector debt and the lack of sufficient oversight, the focus of market speculation has shifted to short-term speculation on the overload of public debt.
In addition, the traditional role of banks in public finance has been usurped by the growing presence of less-regulated activity of nonbank financial institutions in sovereign bond markets.
These nonbanks include investment funds, hedge funds, insurance companies, pension funds and other financial intermediaries now able to make money on extremely short-term and highly leveraged positions.
According to the World Bank, half of all financial assets worldwide are now held by companies that are not regulated as banks.
Now, governments have new lenders providing liquidity for U.S. Treasuries, midsized businesses have gained access to new funding sources, and consumers and small businesses have more borrowing options.
What could possibly go wrong?
First, the World Bank writes that the growth of nonbanks has broadened the scope for a run-on-the-non-banks scenario in which money market funds make long-term investments but promise customers the ability to withdraw at any time.
A cash crisis among nonbank institutions would call for government help, with central banks taking on the risk for these nonbanks.
To account for that risk, the World Bank calls for improved data and risk analysis and supervision of these nonbanks.
Second, an analysis by the BIS points to the growing trend of low-level haircuts in sovereign bond transactions. A haircut is the cost of borrowing between financial intermediaries, with the borrower using highly leveraged funds to profit from market moves.
The BIS continues that the prevalence of zero haircuts in bilateral repo borrowing raises the question of who benefits from such attractive terms and what are the accompanying risks to financial stability.
The analysis suggests that larger hedge funds are able to attain high levels of leverage relative to their smaller peers. which can likely be traced to their greater market power.
This combination of unregulated nonbank participants in the sovereign debt market and the presence of costless highly leveraged positions pose a threat to financial stability. This rising risk calls for a prudent approach to both domestic and international regulation.
The primary deficit
One clear way of measuring excessive government spending is by looking at the so-called primary deficit. This measure is traditionally defined as government revenues minus primary (non-interest) expenditures over a selected period expressed as a percentage of gross domestic product.
The last time the U.S. ran a budget surplus when yearly revenues exceeded expenditures was from 1995 to 2001. That coincided with the productivity gains during the last six years of the Clinton administration that carried over into the Bush administration.
After that, the primary deficit exploded during the extended financial crisis era and then into the pandemic.
While the primary deficit has moderated, it remained higher in 2022-24 than any year since 1983 during the era of double-dip recessions that brought the global economy to its knees.
The primary deficit becomes a concern when the financial markets are no longer willing to risk investment in a nation’s debt.
The result would most likely be a spike in interest rates, with the increased cost of financing the debt becoming a deterrent to investment and growth.
Deficit bias
There has been a sea change in the way governments view debt.
For instance, Japan has carried government debt of greater than 100% of its GDP for nearly 30 years. And while Japan’s economic growth has been moribund, Japan has a dominant role in sponsoring the U.S. accumulation of debt. As such, its currency has yet to come under attack, except for the surge in the dollar during the pandemic.
But Japan and the U.S. are not alone in accumulating debt. China’s debt, for example, is now reaching 100% of GDP.
As noted by the Bank for International Settlements, the prevailing political process in many countries leads to deficit bias, which has led to persistent deficits, especially during times of distress.
These shocks, like the pandemic, have been associated with deep recessions, coinciding with increased spending on services for ageing populations.
To that we would add the U.S. political reluctance to match spending with increased tax revenues, and the political unwillingness to accept that tax cuts in high-income economies have not been repaid by surges in economic growth.
Instead, potential GDP growth among the developed economies has been stuck at less than a 2% yearly rate.
Higher interest rates
Near-zero interest rates and the illusion of free money following the financial crisis gave policymakers the excuse for increased fiscal spending.
But the idea that the amount of U.S. debt is solely a function of the rate of interest is illusory.
For example, long-term interest rates began receding after 1980, just as deficit spending became prevalent. But even as interest rates dropped below 2%, interest payments continued to climb.
The recent spike in interest payments coincides with yields on 10-year Treasuries settling into a 4% to 5% range over the past two years.
The takeaway
So yes, monetary policy and the level of interest rates are a factor in servicing debt. And interest-rate payments have spiked to 4% of GDP this year.
But it is the level of debt and the mismatch between revenues and expenditures that should be the focus of correcting the fiscal imbalance.
