Will Rising Federal Debt Constrain The Next US President?

By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com

Political debate has roiled Washington in recent years, and it’s likely that the partisanship will intensify as the November election draws near. But one area where a consensus is building is the increasing concern that the rise in government debt (and its effects on the federal budget deficit) in recent years is worrisome and must be dealt with at some point in the near future.

“By 2034, the adjusted deficit equals 6.9 percent of GDP—significantly more than the 3.7 percent that deficits have averaged over the past 50 years,” advises the Congressional Budget Office (CBO), the nonpartisan agency that monitors the federal budget for the government. “Relative to the size of the economy, debt swells from 2024 to 2034 as increases in interest costs and mandatory spending outpace decreases in discretionary spending and growth in revenues,” CBO writes in its June update of its “Budget and Economic Outlook: 2024 to 2034.”

The pushback in some circles is that budget hawks have been warning of trouble for several decades but a tipping point that unleashes havoc for the economy and the financial markets has yet to arrive. But rather than using this history as an excuse to dismiss the current and expected state of fiscal affairs, it’s a reminder that estimating where and when the red line will arrive is a guessing game. The only thing that’s arguably beyond debate is that the red line is closer today than it has been in recent years.

Ignoring the risk is naïve, but panicking is premature. Instead, it’s prudent to understand this risk factor as a foundation for managing expectations and making informed decisions. Let’s start with a metric that’s become alarming for some analysts: US federal debt as a of percent of the economy (GDP). As the chart clearly shows, the debt burden has increased over the years, with a spike during 2020 when pandemic-related spending surged. The burden has eased in the last three years, but the current percentage – 122% as of 2024’s first quarter – remains far above the percentage that prevailed pre-pandemic.

One school of thought counters that the true burden for the government should be measured in terms of how interest payments compare with the economy. On that front the risk is lower – substantially so -- vs. the peak in the 1980s and early 1990s. Nonetheless, there’s been a sharp rise post-pandemic and government interest payments as a percentage of GDP have shot up to nearly 4% through the second quarter of 2024 – well above the roughly 2.5% mark that was typical for the previous two decades.

Although it’s obvious that the government’s fiscal situation has deteriorated, the debate is about when, how and if financial markets and the economy will suffer direct consequences of significance. Unfortunately, the answer’s not obvious if we’re trying to be relatively precise.

Deficit scolds have been warning for a generation-plus that disaster is near. This time could be different, of course, but some economists argue otherwise. One view is that budget risk can be managed through various measures, namely: reduced spending and/or higher taxes. For political reasons, neither of those options are palatable these days, especially with an election just a few months away. The next President and Congress, however, will be under increasing pressure to deal the growing fiscal threat.

In the meantime, it’s useful to look to the markets as a gauge of crowd sentiment. The US 10-year Treasury yield, in particular, can be used as an early-warning proxy. To the extent that investors, domestic and foreign, are worried about the US fiscal outlook, the sentiment shift will probably show up in the form of a rising 10-year yield. As with any country that’s perceived to harbor higher risk, investors typically demand compensation in the form of higher borrowing costs.

By that standard, there’s still room for debate. The 10-year yield has risen over the past two years, but moderately so relative to history. What’s more, one can argue that a fair amount of the yield increase since 2022 is due to tighter monetary policy rather than deficit concerns.

In any case, the trend so far in 2024 points to lower yields, in part because of expectations that the Federal Reserve will start cutting interest rates next month.

As useful as the 10-year yield will be for monitoring sentiment linked to fiscal risk, it’s still unclear what would constitute a clear warning that tolerance has faded if not collapsed in financial markets re: US debt. But this much seems likely: When and if a convincing market-based warning arrives, a persistent rise in the 10-year yield will be leading the attitude adjustment.

The recent fall of the 10-year yield from last October’s 5% to roughly 3.8% currently suggests that the crowd’s relatively calm. How long that will last is anyone’s guess, but when and if there’s a change there’s an obvious fiscal-risk barometer that will document the shifting outlook.