By Howard Schneider
WASHINGTON, Aug 25 (Reuters) – U.S. debt hasn’t been further downgraded, breakeven rates on inflation-protected bonds haven’t spiked, and the cost of insuring against a federal default hasn’t skyrocketed, signs that most investors still see U.S. bonds as a largely risk-free bet even if they have been demanding higher interest rates.
That’s the good news.
Not so great is that developments in recent weeks have put U.S. federal debts and deficits in the broader context of an emerging era of higher global interest rates, stiffer competition for the next dollar of lending, and global geopolitical and demographic headwinds that other countries are also confronting. There may not be a crisis tomorrow, but the idea of a cliff somewhere in the future seems more tangible, a point implicit in Treasury Secretary Scott Bessent’s sudden openness to active intervention to try to cap yields on long-term bonds.
Here are some reasons why this moment seems different:
ECONOMIC GROWTH HAS FALLEN BEHIND BORROWING
From World War Two until the late 2010s, U.S. debt dynamics were helped by the fact that the economy in general grew faster than federal debt, which helped keep borrowing contained relative to the size of the nation’s output of goods and services. That relationship began to shift due to the spending used to counter the 2007-2009 financial crisis and the COVID-19 pandemic roughly a decade later. The sweeping tax cuts pushed by President Donald Trump and passed by the Republican-controlled Congress in his first and second terms in the White House exacerbated the deficits, adding to the total debt pile.
DEFICITS ARE AT RECESSION LEVELS
One typical use of a government’s financial power is to support the population and economy in the event of a crisis. Deficits expand during recessions as unemployment payments and other “stabilizers” rise. The cash funneled to households helps boost demand and shorten the downturn. During the COVID-19 pandemic, in particular, payments to households hit historic levels, and the economy rebounded quickly and defied fears of a lingering collapse.
But deficits, the gap between government spending and tax revenue, have remained near such recession levels even as the economy grew. Part of that is due to Trump’s tax cuts, but it is also tied to the now hard-wired growth in spending on an aging population, and the recent reversal of tariffs that forced the administration to begin sending checks back to importers. Though the U.S. crossed the headline-making $40 trillion debt milestone last week, arguably it’s the higher year-to-year annual deficit, now close to 6% of gross domestic product, that presents the bigger threat to debt sustainability. Economists generally think of the 3% level as manageable.
IS $40 TRILLION TOO MUCH?
About $8 trillion of the total outstanding debt is money the government owes itself, representing, for example, money “borrowed” from various trust funds, including the Social Security program for retirees and the disabled. Though still a U.S. government obligation, it holds a different status than the $32 trillion owed to public creditors, including individuals, foreign governments and the Federal Reserve.
Those public debts now amount to roughly 100% of annual GDP. Other nations, notably Japan, have lived with far higher debt-to-GDP ratios. As the issuer of the world’s main reserve currency, the U.S. has certain advantages in that regard, and as long as the country is seen as stable, rule-bound, and in line with the rule of law, that “exorbitant privilege” will help keep its debts funded.
But no one can know for certain where the tipping point is in terms of market perceptions of what’s sustainable.
A given debt-to-GDP ratio isn’t necessarily good or bad on its own. Countries can underborrow and underinvest, crimping their economic potential, just as they can overspend. But corporate credit spreads and other premiums factoring into bond prices have suggested the U.S. advantage over competing debtors has narrowed.
SOME OF THE TRENDS ARE NOT GREAT
Broader economic trends can help distinguish sustainable from unsustainable debt. Olivier Blanchard, the former chief economist of the International Monetary Fund, has argued that as long as a government can borrow at an interest rate below the pace of economic growth, debts could be sustainably recycled.
That simple rule of thumb proved influential during the COVID-19 crisis, laying a foundation for the massive borrowing triggered by the pandemic. It also rang true when global interest rates seemed structurally low.
Rates now seem structurally higher, and for the U.S. borrowing costs are no longer anchored comfortably below the rate of economic growth.
One measure — interest payments as a percent of GDP — tells the tale. Unlike overall debt-to-GDP, interest payments show the flow of national income needed to service national debt, similar to a household looking at what share of its paychecks goes to service the mortgage.
Between high deficits, growing debt, and higher interest rates, the share of GDP going to pay interest has doubled to around 3%.
WHY IT MAY NOT GET BETTER
Trump and Bessent have promised what amounts to a costless fix to the country’s debt challenges through faster economic growth.
That bet isn’t a sure thing. Events can intervene, and an unexpected shock followed by a recession would force the U.S. to seek the fiscal capacity to borrow more to support the economy. The pace and sources of growth can also matter. Presumably the two are talking about inflation-adjusted or “real” growth, not trimming the relative debt load by deflating it with cheaper dollars. It means growth must be within the constraints of the economy’s capacity to produce goods and services without boosting prices.
Current estimates of the non-inflationary rate of growth are generally around or slightly below 2%, well below what would be needed to curb the relative debt load even if the administration trims the annual deficit to 3%.
Artificial intelligence might help boost productive capacity, but the timeline for that jump is uncertain. The tax implications are also unknown for a technology that could undermine employment, resulting in lower income tax receipts even as it boosts stock prices and corporate profits, now taxed less aggressively after the Trump tax cuts.
And, in the meantime, AI is supercharging the demand for credit, putting the hyperscalers in competition with the U.S. for the pool of global savings and helping sustain higher interest rates.
(Reporting by Howard Schneider; editing by Dan Burns and Paul Simao)
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