By: Aaron Puthan
The budget deficit of the United States has ballooned to new levels, so what are its implications?
At first glance, it seems perplexing that U.S. government bond yields are trading near their lowest levels ever. After all, the U.S. federal deficit is projected to surpass $1 trillion this year, roughly double where it was a few years ago. And, projections abound that the deficit will continue to widen to scary levels in the coming years and decades if the U.S. doesn’t rein in its entitlement spending (i.e., on programs that are mandatory). Simply, the U.S. government continues to borrow more and more money. Usually, a less creditworthy borrower should not be able to borrow with a lower interest rate. So why can the U.S. government?
It’s all about supply and demand.
The key things to keep in mind when we talk about U.S. debt and deficits are that 1) the forces of supply and demand hold, just like for any other financial asset, and 2) it’s global supply and demand that matters, not just domestic. When thinking about debt and deficits in this way, it’s not that surprising that government bond yields are historically low.
On the global growth front, forecasts have been consistently revised downwards since the middle of last year due to lackluster global manufacturing demand and trade policy uncertainty. In a relative sense, U.S. growth has held up; nevertheless, the global picture is more important for how the U.S. government bond market behaves.
What about supply? While $1 trillion is a lot of money, in a global context, supply growth has actually been quite weak. This is a product of many years of budget austerity (i.e., trying to reduce government budget deficits), which was pursued most notably in Europe but also in Japan. We can see this trend in the chart below, which shows government bond supply growth for the U.S., Europe, and Japan (net of central bank purchases and maturing debt scaled as a percent of global GDP). So, even though the U.S. deficit could reach $1 trillion this year, the global supply of bonds hasn’t grown all that much.
What about entitlement spending and the longer-term projections?
While we don’t know where exactly the breaking point is for U.S. debt, all the available evidence from history and from other countries suggests the U.S. is not close to the point where debt and deficits are a problem. A ‘problem’ in the economic sense that they breach a point where they start to crowd out private sector economic activity.
It’s not actually, the debt or the deficit that is the constraint. Rather, it’s the interest burden relative to how much cash is coming in, just like it is a constraint for any company. The irony is that, as U.S. debt levels have risen, the federal government’s interest burden (relative to GDP) has fallen. In the 1990s, the interest burden was twice as high, but paradoxically, hardly anybody was worried back then about debt and deficits.
To take this logic further, the simplest way to assess whether a country’s debt is sustainable is to compare market interest rates to nominal GDP growth. Countries that get into trouble typically see a scenario where interest rates are rising and exceeding their cash flows. In other words, their interests costs are higher than their growth rates.
In the U.S., longer-term interest rates are well-below trend nominal GDP growth (to the tune of 2% points). Even in Japan, where the debt-to-GDP ratio is north of 230%, longer-term interest rates are healthily below trend nominal GDP growth. Put simply, growth is higher than interest costs. Even with Japan’s high debt levels, its interest burden seems sustainable.
Secret Sauce: reserve currency status
The U.S. and even Japan, still have room for more fiscal stimulus in part because their currencies have ‘reserve’ status. This essentially means that the global investor base sees U.S. dollar and Yen-denominated assets as safe and stable, especially during bouts of global market volatility and geopolitical uncertainty. This reserve status has been built up over many decades and is attributable to the hard-to-quantify things that make countries function well: a court system with robust checks and balances, legally defined property rights, the rule of law, etc.
Countries like Argentina and Turkey, which in recent years have run into problems regarding government debt and deficits, fall substantially behind the U.S. and Japan on these “soft power” characteristics. While it is impossible to perfectly quantify soft power, a useful ranking comes from the Global Competitiveness Index published by the World Economic Forum. The below chart shows how far ahead of the U.S. and Japan are compared to Turkey and Argentina when it comes to soft power and thereby, reserve currency status.
The U.S. and Japan have far more “soft power” than countries like Turkey and Argentina.
As investors have grown accustomed to a low interest rate environment, it’s easy to see why the amount of government debt might be worrisome. But, given global supply/demand dynamics, growth rates, and debt service costs, bond yields look more or less appropriate–even alongside seemingly high debt levels. So no, we shouldn’t worry too much about government debt. In fact, the U.S. and other developed countries have some capacity to borrow even more to stimulate economic growth.
Sources (APA Format):
Image Source: www.davegranlund.com
Davidson, K. (2019, September 12). U.S. Deficit Tops $1 Trillion in First 11 Months of Fiscal Year. Retrieved from https://www.wsj.com/articles/u-s-deficit-tops-1-trillion-in-first-11-months-of-fiscal-year-treasury-says-11568311201.
McGill, B. (2019, August 3). The National Debt, Visualized. Retrieved from https://www.wsj.com/graphics/us-national-debt-visualized/.
Schwab, K. (2019, August 14). The Global Competitiveness Report 2019. Retrieved from http://www3.weforum.org/docs/WEF_TheGlobalCompetitivenessReport2019.pdf.
Stein, J. (2019, June 25). Federal debt set to rise over the coming decades to highest levels since World War II, CBO says. Retrieved from https://www.washingtonpost.com/business/2019/06/25/federal-debt-set-rise-over-coming-decades-highest-levels-since-world-war-ii-cbo-says/.