Introduction

The federal deficit reached $1 trillion in 2019, an increase from $585 billion in 2016 and $779 billion at the end of fiscal 2018, according to the Congressional Budget Office (CBO) in its Update to the Budget and Economic Outlook 2019 to 2029. The deficit is now equivalent to 4.4% of the U.S. annual economic output, as measured by its nominal GDP.

With the widening shortfall between annual federal tax revenues and government operating costs, the federal debt has climbed to $22.03 trillion as of June 30, 2019. The nonpartisan CBO estimates the $16 trillion in federal debt held by the public could rise from 79% of GDP in 2019 to about 95% by 2029. Further, the CBO forecasts the annual interest paid on Treasury securities will grow from 1.8% of GDP to 2.6% in that same period. 

Treasury securities are primarily marketable assets (that is, bills, notes and bonds), savings bonds, and special bonds issued to state and local governments.

Debt of this magnitude is unprecedented for the United States during a time of economic expansion. In fact, the aftermath of World War II in 1946 was the only period in history when public debt totaled more than 100% of GDP (108%), according to the Bureau of Economic Analysis. Robust demand for Treasury securities and the government’s ability to issue debt in its own currency have helped enable the federal debt to rise in the past decade with seemingly no near-term consequences. 

A steady but slow recovery from the 2008 great recession amid muted inflation has also been a factor in the Federal Reserve’s (Fed’s) decision to keep interest rates low, providing the government with cheap borrowing costs to help boost fiscal stimulus and implement tax reform in 2018.[1] As the deficit and debt burden grow, many investors are becoming uneasy there may be negative implications for the U.S. economy and financial markets.

Some economists and policy makers have expressed concern that persistent deficit spending could be detrimental to long-term GDP strength because it leads to higher interest rates and inflationary pressures. As borrowing intensifies, it crowds out public and private investment and increases the risk the United States could be caught fiscally unprepared in the event of an unexpected recession or international conflict.[2] In contrast, other economists have argued the risks are quite manageable in the near to midterm given the depth of the American economy, the consensus outlook for low real interest rates and stable growth over the coming decade, and a lack of empirical evidence that a large amount of debt in itself results in serious implications for an advanced nation, especially one with a strong central bank and control over its currency. Further, Congress has the full authority to make modifications to current law if necessary to put the country’s finances on a more sustainable long-term path. 

In this paper we discuss the mounting federal debt, the implications for the U.S. federal budget, and managing the interest expense burden. 

Trillion Dollar Federal Deficit

In its monthly budget review for August 2019, the CBO estimates the deficit will hit $1.2 trillion annually between 2025 and 2029. Despite the current economic expansion, the federal deficit has grown to $739 billion as of May 2019, partially due to fiscal spending efforts in 2018. The CBO calculates costs related to retirement and health benefits, the military, and interest added $208 billion in the month of May alone. Tax revenues meanwhile were similar to those in 2017, even with last year’s major tax reforms.

The federal deficit is projected to equal 4.4-4.8% of GDP over the next decade, well above the 2.9% average between 1969 and 2018. Excluding interest payments, the CBO, in its Update to the Budget and Economic Outlook 2019 to 2029 report, estimates the primary deficits could be 2.7% of GDP from 2020 to 2024 and 2.2% from 2025 and 2029, a good indication of the mounting interest burden. Deficits have traditionally been counter cyclical, thus the current trajectory is surprising to some given a backdrop of strong consumer sentiment and business activity and an unemployment rate of just 3.7% as of July 2019. 

According to the CBO, in 27 of the past 50 years the deficit was just 1.5% of GDP or even below when unemployment was under 6%. In its 2018 Financial Report of the United States Government, the Treasury Department anticipates the federal deficit rising to 2.9% of GDP in 2019 and accelerating to 4.1% in 2039 amid an uptick in demand for government benefits as the baby boom generation retires. It could progressively fall to 2.5% as demographics and revenues become more balanced. Tax collections are forecast to rise from 16.5% of GDP in 2019 to 17.4% in 2025 and reach 18.3% in 2029 after expiration of the 2017 tax reform provisions. Budget expenditures meanwhile could climb from 20.8% of GDP in 2019 to 22.3% in 2029.[3] Fiscal conditions have actually improved over the past decade, with the federal deficit declining steadily from 9.8% of GDP in 2009 to 6.7% of GDP in 2012 and then 3.8% in 2018). Taking a longer view perspective, it was over 4% of GDP at times in the 1980s and early 1990s.

Demands on the Budget

In the years since the great recession in 2009, there has been a decrease in the percentage of the budget allocated to nondefense discretionary programs (NDD), largely a consequence of swelling mandatory outlays for servicing the debt and promised entitlements benefits, as well as a drop in revenue from the 2017 tax cuts. Major benefit programs, such as Social Security, Medicare, and Medicaid (45%), led government expenses in 2018, with defense (15%) and interest (8%) close behind, according to data from USAspending.gov. The CBO expects interest to become the third biggest “program” by 2025, surpassing spending on the Department of Veterans Affairs, Department of Housing and Urban Development, the National Aeronautics and Space Administration, Department of Homeland Security, and the Department of Education.[4]

NDD programs are not mandated by law. These are domestic and international programs outside of national defense. Congress has the legal discretion to decide funding levels for these programs annually through the appropriations process. NDD spending is for health, transportation, education, and other programs.

Costly events like an international conflict, recession, or natural disaster have also played a role in shifting budget priorities. For example, Congress has spent nearly $2.1 trillion on defense since 2001 to fight the war on terror. The Peter G. Peterson Foundation estimates the United States represents one-third of total spending worldwide, more than China, Saudi Arabia, India, France, Russia, the United Kingdom, and Germany combined. Unlike discretionary items that must be approved each year through the appropriations process, entitlements and interest are mandated by government law unless Congress approves an amendment to the underlying legislation. Discretionary programs accounted for 31% of the budget in 2018, with 50% of that amount going to the military. The percentage for discretionary programs is expected to drop to 22% and to 5.0% of GDP from a 20-year average of 7.2% by 2029. Statutory limits on discretionary funding may also inhibit growth for the next few years. 

Composition of Mandatory Spending, 2018

View accessible version of this chart. 

In March 2019, the administration proposed a $4.75 trillion budget that would reduce NDD spending by 9%, including $1.1 trillion in cuts to education, housing, and the environment and a 5% increase to the military. The proposed budget calls for it to be balanced in 15 years rather than the Republican goal of 10, mainly due to the fiscal stimulus efforts of 2018 that will likely add about $1.9 trillion to the deficit through 2028.[4] Additionally, President Donald Trump’s Council of Economic Advisers has factored in what we view as an optimistic 10-year average real growth rate of 3.0%, with growth of 3.2% in 2019, 3.1% in 2020, and 3.0% in 2021. Many economists have questioned these rates given they have not exceeded 3% on a regular basis since the booming 1990s. In fact, the Federal Reserve Bank of St. Louis has noted that 2005 was the last full year GDP expanded 3%.

Federal Debt Levels

The United States has $22 trillion in federal debt as of June 2019, with $16 trillion owned by investors in the public bond market and $6 trillion held in separate nontraded government trusts, according to data from TreasuryDirect®. These trusts represent unfunded future liabilities on the balance sheet for payments to social security and health beneficiaries. Domestic creditors hold 60% of the public debt (the Fed holds one-third of that amount), and the remaining 40% is retained abroad.[5]

The Treasury’s room to borrow is not without restriction since Congress must approve a specific debt limit each year before any new securities can be issued. For example, in February 2018 the ceiling was set at $22 trillion and later reinstated at that level on March 2, 2019. Treasury Secretary Steven Mnuchin later asked for the budget caps to be lifted since the government was on track to run out of funding sources by the end of the summer. In the interim, he was relying on “extraordinary measures” to cover mandatory payments to bondholders and beneficiaries.[6] Given the severity of the situation, President Trump announced a bipartisan deal to suspend the U.S. debt ceiling and boost spending levels for two years, averting the risk that the government would default on its debt service payments.

While an upswing in debt is reasonable in certain fiscal situations, the risks multiply as debt becomes a greater percentage of GDP. In particular, a high debt burden may restrict a country’s capacity to effectively address an unexpected and costly shock to the economy. We are particularly concerned the debt is rising during a time of relative prosperity when the United States has traditionally taken advantage of robust tax revenues to accumulate budget surpluses. Some economists have called this flexibility to borrow for an emergency “fiscal space.”

During the great recession in 2009, the government was able to take advantage of borrowing to boost growth, with public debt subsequently climbing from 40% to 80% of GDP, according to data from the St. Louis Fed. In 2012 the International Monetary Fund (IMF) published research asserting that the key benefits of stimulus during a recession tend to be tempered when countries are overburdened with debt and that the recovery time is longer.[7] The CBO has said that “all else being equal...the larger a government’s debt, the greater the risk of a fiscal crisis.”[8]

Managing the Interest Burden

The Fed’s ability to manipulate interest rates is especially critical during a downturn. Cheap borrowing costs provide the government with more room to access liquidity in the bond market and increase spending. The IMF found a 1% bump in fiscal stimulus on average translates to a 16% greater chance a country will successfully exit a recession.[9] The Fed’s policy decisions help create an approximate floor for yields, pushing down shorter-maturity interest rates during a period of easing while having a lesser effect on longer maturities. If the economy were to falter in the near term, the Fed could have less ammunition to fight the next economic recession relative to previous business cycles.[10] The nominal federal funds rate is currently 1.75-2.00%, leaving the Fed little room to reduce rates, in our view. 

In contrast, the real rate was 2.75% at the end of the last tightening cycle in 2006 and 4.0% in 2000. We believe providing liquidity via buying more Treasuries may be politically challenging, given the Fed currently holds more than $2.2 trillion as of 2019 on its balance sheet compared to $770 billion in 2009. The Fed’s authority to set rates has tended to calm fears around growing debt, but a sharp slowdown may cause investors to reevaluate the risks. In February 2019, Fed Chair Jerome Powell commented that broader policy changes related to education, training, and social security are needed to support the economy, noting the Fed is limited in what it can do in the event of a financial downturn.[11]

Despite the CBO projection that interest expense will increase substantially over the coming decade, in part due to the outlook for rates to gradually move higher, borrowing costs are still historically inexpensive, with Treasury yields falling from 4% before the great recession to below 2% in 2019, according to the CBO.

In its Update to the Budget and Economic Outlook 2019 to 2029, the CBO notes interest on debt is forecast to average about 2.6% over the next decade, suggesting to us that investors aren’t too anxious about a financial crisis. Modest inflation and wage growth provides some cover for the Fed to keep rates low, while demand for Treasuries has been fairly consistent across the business cycles regardless of the country’s fiscal situation. In 2009 for instance, when stimulus resulted in a deficit of almost 10% of GDP, the yield on the 10-year Treasury remained below 4%. We believe this is a reflection of confidence in the country’s long-term solvency, with yields primarily influenced by perceptions of risk and, to a lesser degree, liquidity.

Research has shown that when GDP growth is greater than interest costs plus new deficits, financing a large amount of debt can be quite manageable over the long term. J. W. Mason, a Fellow at the Roosevelt Institute and noted researcher on the national debt, supports this theory, looking at the trend in interest costs and debt the past few decades. In the mid 1980s and 1990s, the country saw long-term rates rise above 4% as the economy boomed, with interest as a percentage of GDP reaching a peak of about 3.0% in 1990.

Federal Outlays: Interest as Percent of Gross Domestic Product, Percent of GDP, Annual, Not Seasonally Adjusted

View accessible version of this chart.

The costs seemed bearable, though, with President George H. Bush and President Bill Clinton making an effort to reduce primary deficits during a time of accelerating growth that regularly hit above 3%. This momentum culminated in the stock market bubble of the late 1990s and multiple surpluses as tax revenues benefited. With defense spending declining after the Cold War ended, the CBO forecasted the United States would reach a surplus of $5 trillion by 2009.

Mr. Mason points out that the 1980s and 1990s were a unique period in U.S. history, with the country soon returning to a deficit following the stock market and financial downturns of the early 2000s.[12] The 10-year Treasury yield subsequently settled in the 2–4% range for more than a decade. A ramp-up in debt, spending, and accommodating monetary policies helped support two economic recoveries, with interest costs dropping back down to the long-term average of 1.5% of GDP by 2005, according to the Federal Reserve Bank of St. Louis.

If rates were to defy expectations, the interest burden could become unsustainable, but it would likely be accompanied by a more positive outlook for GDP, negating some of the additional costs. The real interest rate on 10-year Treasuries is currently 0.8%, much less than the most cautious forecasts for real GDP growth, with the CBO calling for 2.3% in 2019 and an average of 1.7–1.8% through 2029 as participation in the labor force slows. The Fed projects 2.1% in 2019, 2.0% in 2020, and 1.8% in 2021, while the PNC Economics team forecasts 2.6% in 2019 and 1.8% in 2020, as of July 2019.

Conclusion

We are aware of the potential risks the mounting deficit and debt levels pose to the financial markets and investors. We believe a moderate amount of debt is desirable because it affords the government greater latitude to invest in the country’s growth or to support the economy during a sharp downturn. The U.S. Department of the Treasury, in its annual performance plan and report, said serious policy reforms will likely be necessary given the forecast for a worsening fiscal shortfall over the next couple of decades.

10-year Projected Debt and 10-year Interest Rate, 2000-18

View accessible version of this chart.

Nonetheless, the United States oversees the largest, most liquid, and secure capital markets in the world, keeping the risks relatively contained, in our opinion, for holders of American debt. Global demand for Treasuries remains robust, with the 10-year Treasury yield settling under 2% as of September 2019. This suggests to us that investors aren’t overly anxious about the state of the government’s finances.

We will continue to closely monitor the debt issue and communicate any new developments that may shift our long-term view, but we see no reason to raise the alarm quite yet. Further, as with any potential risk in which the outcome is unclear, it is difficult to make prudent portfolio adjustments without increasing the likelihood of underperformance.

What Is the Federal Deficit?

The federal deficit can be defined as the shortfall between total budget expenditures (outlays) and tax collections (revenues) in a given year, while the primary deficit is the federal deficit minus annual interest expense. As a ratio relative to GDP, the primary deficit number is useful for gauging the long-term sustainability of the country’s finances by isolating the costs of servicing current debt. The primary deficit spending projections, along with those for interest rates and growth, determine the outlook for the debt-to-GDP ratio.

The Treasury Department relies primarily on income taxes from individuals and corporations to cover the cost of government operations, with the remaining source of funds garnered through the issuance of Treasury bills, notes, and bonds in the public bond market. The federal government, unlike most states, is not required to balance the budget each year, and so has temporarily run up deficits in the past to shore up the economy or finance military operations.

 

TEXT VERSION OF CHARTS

Composition of Mandatory Spending, 2018

Discretionary Mandatory  
31% Social Security 24%
  Medicare 14%
  Medicaid 9%
  Interest 8%
  Income Security 7%
  Other 7%

 

Federal Outlays: Interest as Percent of Gross Domestic Product, Percent of GDP, Annual, Not Seasonally Adjusted

Frequency: Annual Observation Date Percent
1/1/1945 1.36487
1/1/1950 1.60493
1/1/1955 1.13989
1/1/1960 1.28083
1/1/1965 1.15737
1/1/1970 1.33979
1/1/1975 1.37954
1/1/1980 1.83855
1/1/1985 2.98407
1/1/1990 3.09144
1/1/1995 3.0385
1/1/2000 2.17461
1/1/2005 1.4113
1/1/2010 1.30865
1/1/2015 1.2246
1/1/2018 1.57906


10-Year Projected Debt and 10-Year Interest Rate, 2000-18

  2000 2018
Debt to GDP ratio projected for 10 years later
43% 105%
Real interest rate on 10-year government bonds
6% 0.8%