Not too long ago, the notion of the government spending over a trillion dollars was blasphemy. Yet today, we have become so accustomed to this type of spending that they barely raise eyebrows.
It’s almost impossible to contextualize numbers this large, but perhaps this example can help. If you had a job that paid $1 every second, you would earn $1 million by lunchtime on the 11th day, but it would take you 31,700 years to accumulate $1 trillion. These are numbers usually reserved to measure distances between stars, and now they happen with the push of a button.
To say that Uncle Sam is spending like a drunken sailor is an insult to drunken sailors. It’s also why Fitch downgraded its sovereign debt rating this week. But before we assess the near-term implications of so much spending and how long it will take to pay it all back, let’s first gain a clearer picture of how government debt works and its impact on the economy over time.
Size doesn’t matter
The first rule of debt analysis is that the total amount of debt, on its own, is meaningless. Some of the most successful companies in the world carry billions in debt and have operated for decades with little risk of default. That’s why debt must always be put into context using relative measures.
The problem is debt-to-GDP ratio has become that de facto measure. It compares the total debt for a country to its annual gross domestic product. Our debt-to-GDP ratio remained around 100% for most of the past decade and sits at 118% today.
Pundits like to stoke fears of runaway debt anytime this ratio exceeds 100%, as if it is some trigger for an economic death spiral. However, it offers little insight because debt is accumulated over several years, whereas GDP is a flow of economic activity measured annually. It would be like criticizing a homeowner for not being able to pay off a 30-year mortgage with a single year of income.
Several countries have debt-to-GDP ratios that exceed 100% and remain operational. The U.K. has been above 100% for 93 years, and Japan has had one of the highest in the world for decades (currently above 250%)1. On the other hand, Russia has one of the lowest despite a questionable outlook.
Affordability matters
The primary goal of debt analysis is to determine if the borrower can afford the debt. For example, if two neighbors have the same $1 million mortgage, but one makes $500,000 a year and the other $50,000, then the neighbor with the higher income should have an easier time making the payments.
Within this context, the U.S. can easily afford its debt. As of last year, interest as a percentage of GDP was 1.8%, or half of what it was back in the 1990s1. For scale, Italy and Portugal both exceed 5% but remain operational1. Hence, the U.S. would need to triple its interest while keeping GDP stagnant to come close to this level.
We can kick the can
The U.S. pays back billions in principal to retire old debt every year. The Treasury does this by issuing new debt to pay the old debt. This process is called “rolling” debt and is a common practice by governments and corporations.
Rolling debt can last as long as demand exists to buy the new debt. But if demand for U.S. debt vanishes for some reason, the government could just “print” new money to pay back the principal it owes. This practice is called “monetizing” debt, and although it would be widely unpopular with foreign debt holders, there is little they could do to stop it.
It also helps that the U.S. dollar is the world’s reserve currency. It’s used in around 80% of world trade and it took decades to attain this level of trust. It’s hard to imagine the U.S. could print enough to erode this confidence anytime soon.
Said another way, the U.S. can comfortably kick the can down the road for a lot longer than any realistic investment horizon.
China can’t foreclose
In 2010, a sensational television ad prophesized a day in the future when the U.S. would be at China’s mercy because they owned so much of our debt2. But the chart below shows that China only owns about 2.7%.
Source: U.S. Treasury |
In fact, add up all foreign ownership, and it’s barely 23%. That means the other 77% is owned by the U.S. government and domestic investors. So, when the U.S. pays interest, 77 cents of every dollar goes back to the government, American corporations and citizens.
But even if China owned 80% of our debt, it’s not collateralized like a mortgage. It’s only backed by the full faith of the U.S. Government. That’s just a promise to pay it back. Meaning, if the U.S. were to default for some reason, it’s not like China could sail a barge up the Jersey Shore and seize the Statue of Liberty. There is no foreclosure here like there is with a house.
Simply put, China or any other country’s share of U.S. debt gives them no power to shape our policies and way of life.
We need it
Let’s assume that the U.S. paid back all of its debt and eradicated the supply of Treasury bonds. While this may sound like a utopian paradise to some, Treasuries are the backbone of the bond market. The ramifications could be significant if there was no basis to price mortgages and car loans.
Furthermore, one person’s debt is another’s asset. Buying a house creates a liability for the homeowner, but it also creates a source of profit for the lender. What would retirees do if they lost access to risk-free investments that paid guaranteed income? How would it change a pension fund’s ability to meet liabilities 30 years from today if it did not have access to risk-free, long-term government debt?
Although hard to predict, it is conceivable that paying off all the debt could make the cure worse than the disease.
The bottom line
Imagine Elon Musk wakes up tomorrow, buys a $500,000 Lamborghini, and drives it into a lake. He has so much fun doing this that he decides to do it every day for the next 30 years. Would most people view this as stupid and wasteful? Probably, but a better question is whether he can afford to do so. The answer is an unequivocal “yes.”
His net worth is estimated at $240 billion1. Buy a $500,000 car each day for 30 years, and he would spend around $5.5 billion on fine Italian engineering. While that may seem staggering, it’s only 2.3% of his current net worth.
This is precisely how I view the fiscal insanity exhibited by both Democrats and Republicans since 2000. The amount of money both parties have set on fire is simply staggering, but the reality is that our country can afford to do it. We are not Greece or Argentina. It’s not even close.
Therefore, if you’re upset with all the spending (like me), channel that anger in ways that won’t risk your financial future. Get out and vote, protest, or run for office if you have the stomach for it (I don’t).
Lastly, let’s address the original question of when the U.S. will be debt free. The short answer is never. Governments don’t pay off debt, but strong economies can grow out of debt problems by increasing GDP faster than new debt creation. That’s how the U.S. solved its debt situation after World War II, and we’ll likely do the same again.
The bottom line is that U.S. government debt may be a fiscal time bomb, but it’s a problem for another day. Don’t let a risk that may take decades or longer to surface get factored into a financial plan built for the next few years.
Sources
1 The Federal Reserve
2 https://www.youtube.com/watch?v=TYKAbRK_wKA
3 Bloomberg. As of 8/3/2023
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.