The Days Ahead:

  • New home sales and durable goods.

This Week:

  • The growth of the U.S. deficit and debt.
  • A history of debt and whether there’s a right level for debt of it…
  • Turns out there isn’t.
  • Total debt-to-GDP is at post-World War II levels.
  • How did we get here?
  • The CBO projects deficits above 5% of GDP for the next 10 years.
  • Neither party has realistic plans to reduce debt levels.
  • We look at its impact on inflation, interest rates, and bond and stock markets.

How Important is the National Debt and Deficit1?

In 1989, Seymour Durst installed the first national debt clock in Times Square. It has started and stopped over the years, and relocated a few times but it’s still there and clicking away. The online version carries even more information, showing it takes about one minute to rack up the national debt by $2 million.

There’s scary stuff. Some of it seemed off. So, I sat there with a stopwatch counting the numbers and… it’s all off. Big surprise. Someone on the internet is wrong.

According to the clock, total federal, state and local government spending increases $1m every 25 seconds for a total of $10,700 billion. But total government spend in GDP is around $4,900 billion. It also shows corporate taxes growing at $1m every 4 minutes and 30 seconds, standing at $477 billion as a running total year to date. But last year’s total corporation tax receipts were $545 billion and are estimated at $612 billion for this year. The $477 billion is neither a mid-way point nor an estimate. It’s incorrect. Defense spending is shown at $900 billion, again year to date, and growing $1 million every 4 minutes and 28 seconds. But defense spending this year is capped at $844 billion.

The clock also includes reminders about the size and power of the U.S. economy. U.S. GDP is shown growing $1.0  million every minute. But that’s off. It’s more like $55 million every minute, 24 hours a day, seven days a week. It also shows U.S. debt held by foreign countries at $8,400 billion and growing $1 million every minute. But a quick check with the U.S. Treasury shows it at $8,000 billion and it has grown only by a total of 4.5% in four years. And while it shows debt climbing $2 million every minute, the real number is $1.6 million.

Finally, the clock uses the total debt of $34,800 billion (it’s $34,667 billion but we’ll not quibble over $150 billion) not the debt held by the public at $27,000 billion. The difference is total debt issuance less the $7,000 billion of debt held by government departments.

Economies Are Not Households

We’re not big fans of the “run the economy like a household” comparison but in this case we’ll make an exception. Assume wage earner Maureen owes $34,800 in mortgage, auto and credit card debt. Second sibling Kenny runs a hugely profitable Tik-Tok Birkenstock influencer channel in the basement and uses her profits to buy $7,800 of Maureen’s debt. The household owes $27,000. Net debt and gross debt are two separate items and its net debt that counts. In the case of the U.S., total net debt is $27,000 billion.

The debt clock is fun to look at. It uses inaccurate numbers, but in one way it’s right: debt is growing. It was $3,100 billion when Seymour built the clock and it’s now $34,800 billion.

Debt levels in the U.S. are at record highs, as are employment, wages, GDP, income and spending. But debt has grown faster than GDP.

Everyone’s Talking About the Debt Again

Over the next few months, we’ll hear a lot about budget deficits. What we won’t hear about are tax increases or budget cuts.

The 920-page report from the Heritage Foundation’s 2025 Mandate for Leadership, the closest thing we have to a Republican manifesto, doesn’t refer to the budget deficit directly. It does recommend 1) a reduction in crop insurance subsidies, saving $2 billion a year on $6,135 billion of expenditures, 2) that the Treasury should sell 50-year Treasury bonds to lock in low rates, 3) that all agencies should be good stewards of taxpayer money, 4) indexing capital gains and 5) a cull of the 95,000 wild horses living in the U.S. But that’s about all.

The Democratic party has tried to increase taxes, usually on the rich and corporations and with re-tread polices like carried interest. But neither side is going all out on a “reduce the budget deficit” platform.

We believe that deficits matter and they’re going to be a concern for voters. What follows is some background on deficits, their history, current predictions and their effect on the economy, markets, and investors.

Is There a Right Level for the Budget Deficit?

Probably not. It’s very much driven by the economic cycle and the need to stimulate or cut back demand. But in the last 30 years, we’ve seen two major efforts to establish a normal, non-inflationary deficit level.

First, the original Maastricht Treaty of 1993 set out common policies for the then 12 members of the European Union (EU). As membership grew to the current 27, more rules were passed on economic coordination and the formation of the euro. Countries with hard currencies and low inflation like Germany, Austria, and the Netherlands were wary of joining countries with a history of devaluation and looser fiscal rules, notably Italy, and Spain.

Everyone wanted closer economic cooperation for the 20 national currencies that were to merge into the euro. In later negotiations, notably the Stability and Growth Pact  (SGP) of 1999, countries agreed to inflation levels, and spending, notably with Article 126. This stated that budget deficits should not exceed 3% of GDP and total debt not exceed 60% of GDP. The idea was “one currency, one economic unit, so one set of rules.”

There were some fierce punishments for those countries that broke the SGP rules. The European Commission (EC) handed out Excessive Deficit Procedure (EDPs) penalties including payment of a 0.2% of GDP fine to the ECB, a required cut of 20% in the deficit and a bunch of “corrective actions” to be submitted to the EC.

Since 2005, all 27 EU countries have exceeded the limits. The last report showed debt to GDP ranged from 24% for Estonia to 201% for Greece. The big four of Germany, France, Italy and Spain averaged 115%. Some 25 states failed the deficit criterion and 11 the debt criterion. What’s happening to them? Nothing. Governments provided guides on how to close the gaps but the conclusion was that most countries:

“Did not respect the debt reduction benchmark…and compliance with the debt reduction benchmark is not warranted under the prevailing economic conditions.”

Oof. I mean, what are you going to do? Fine every country in the EU? The targets aren’t about to be written off the statutes but right now it suits everyone to ignore them.

But Why the 3% and 60% Rule?

Embarrassingly, the 3% deficit number was made up by two low-rank officials in the French Ministry of Finance in 1981. They, in turn, came up with the number because the then Minister of Finance, Laurent Fabius, needed a limit to play off the wishes of competing cabinet ministers. There was no economic rationale for the number, as the inventors later told journalists. The 60% number was also made up. It happened to be the average debt ratio for the 12 EU countries at the time of the SGP in 1999.

Nor was there any relationship between the two numbers. If a country ran a deficit of more than 3% it was in trouble with the EU. If it ran a surplus, but had 61% debt level, it was in trouble. If it had debt of 61% and paid  a 1% rate on the debt, it was in trouble. If it had debt of 55% and paid 10% interest, it was not in trouble. Both numbers were hard caps. There was no way to use an average over a cycle.

Such inflexibility meant the first break in the rules happened almost immediately when Germany faced stagnation over 13 quarters from 2001 to 2005. Every other country followed over the next 24 years.

The 3% and 60% rules broke down badly during the financial crisis. Italy, Ireland, Greece and Portugal came under severe stress as debt ratios climbed from around 80% to well over 120%. The solutions, prompted from ECB President Mario Draghi’s 2012 “whatever it takes” stance, included buying government debt to reduce the cost of borrowing, various loan and bailout packages, credit extensions and crippling unnecessary austerity. It came at a cost. Between 2011 and 2023, GDP per capita fell between 25% for Italy and Portugal and 45% for Greece.

Greece was badly hit. It saw its debt-to-GDP ratio rise from 109% in 2008 to a peak of 201% in 2020. At the same time, its deficit went from 15% in 2009 to a surplus of 1.1% in 2020. The ECB’s bond buying lowered its debt interest from 20% to 0.6%. Today it borrows at rates 1% above Germany and 1% below the U.S.

Figure1 Greece GDP Graph
Source: FactSet, 06/11/2024

But while the deficit was solved, it came at a terrible price. The Greek economy fell 40% from peak to trough and remains no larger than it was in 2000. It also lost 6% of its population to emigration and will likely lose another 11% in the next 20 years.

Today the EU carries an average debt level of 88% and deficit of 3.6%. Eleven states have deficits of over 3% and 13 have debt levels of over 60%. Romania is currently under review for having an 8% deficit even though its debt ratio is around 55%.

The EU is doing fine. Unemployment is at an all-time low, and inflation at 2.6%, about in line with a 20-year average. Perhaps letting the 3% and 60% targets go was the best idea.

It’s clear that the 3% and 60% rates failed in the EU, had no economic legitimacy now or when devised and utterly failed to prevent the catastrophe of the decade long euro crisis from 2010 on.

If the 3%/60% Rule Didn’t Work, What Else Was Tried?

The second attempt to establish guides and ceilings on national debt came in an acclaimed book called “This Time is Different” by Reinhart and Rogoff (Rogoff) in 2009. The book trawled through an impressive eight centuries of sovereign defaults, currency crashes, banking crises, leverage, and debt. It was an impressive study finding, for example that sovereign debt crises had been a rite of passage for almost every country. France defaulted 13 times before its last in 1812. Spain defaulted nine times in the 19th century. From 1800 to 1900 there were 83 sovereign defaults. From 1900 to 2008, there were 147 defaults of which 72 were from 1975 to 2008.

Only 16 countries have not defaulted since 1800 and only six have never defaulted: Australia, New Zealand, Canada, Thailand, Denmark and the U.S. In 1940, 35% of countries were in default. Rogoff found that some countries defaulted with debt ratios as low as 21%, like Turkey in 1978 or Mexico at 26% in 1995 and some defaulted with debt well over 100%, such as Jordan, Costa Rica and Egypt between 1981 and 1989. The common denominator was that countries with external debt more than 45% of GDP were in trouble and 80% of all defaults from 1970 to 2008 were with countries that exceeded that level.

These were countries that borrowed in a foreign currency and so were particularly exposed to foreign exchange swings. In 1994 for example, Mexico issued a $25 billion dollar-linked short-term bond at a time when GDP was $500 billion. But the peso declined by 47% in three months. GDP fell 32% to $380 billion and suddenly those short-term notes alone were equivalent to nearly 10% of GDP and external debt totaled 70%.

It’s Much Safer to Borrow in Your Own Currency

The 45% threshold seems to work for countries borrowing in foreign currencies. But what about those that only borrowed in their own currency?

For the nine countries that defaulted in the 20th century and only borrowed in their own currency, the debt ratio ranged from 10% (Philippines in 1984) to 266%, (Japan in 1945). In every case, inflation was never less than 25% and ranged up to 3,000% for Argentina in 1989. Of the nine countries, only four were emerging economies and three are in the G7.

The Rogoff study’s final answers to the questions “at what level of debt do countries get into trouble” was 45%. For those borrowing in their own currency it was 90%.

The first group includes mostly emerging markets economies and the authors found growth fell by about half once countries breached the 45% level.

The second group, mostly advanced economies, saw growth fall by about 1% once they breached the critical 90% level. From 1790 to 2009 growth fell from 3% to 1.7% once debt rose above that level. In the post-war period, growth fell from 3.0% to -0.1%. They also warned that it was not a linear relationship, meaning debt looked benign up until the point it wasn’t. Perception can change quickly, forcing governments into hard choices on austerity, inflation or default.

We got a new rule: don’t let debt exceed 90% of GDP. It quickly became the target for austerity programs in the U.S. and EU.

The Excel Error Heard Around the World

The 90% rule didn’t last long. Another paper in 2013, found errors in the Rogoff study Excel data and showed the growth drop off was not from 3.0% to -0.1% but 3.0% to 2.2%. A big difference. What’s more the authors found the growth didn’t shift downward quickly but eased down. They did find that countries with debt above 120% saw growth fall from 3.0% to 1.6%.

They also found, as did Rogoff, there was no link between debt and inflation.

All Interesting But Is There a “Right” Debt Level?

No. We dove into the past here because the optimal level of debt or deficit to GDP is elusive. Zero debt obviously makes no sense. Governments don’t receive tax revenues exactly when bills are due so need to borrow. Large capital projects also need money that may not be available in year one. Borrowing works if you’re building out an economy for transport, housing, or supply chains or for setting up a school system. And debt makes sense if there’s a recession and the government can stabilize demand by borrowing against future tax revenues.

But at some point, a high level of debt starts to worry the public, politicians, borrowers and savers. What if the government reneges on its debt? What if the interest burden grows so high there’s no room for other government expenditures? What if the government “inflates” the debt away by letting inflation rise? What if the government’s borrowing crowds out the private sector? And what happens if the government can’t sell debt at any rate because no one trusts the system? If zero percent isn’t correct, is the 60% determined by the Maastricht Treaty? Or the 90% from the Rogoff study? Or the 120% from recent studies? Or is there another number we don’t know about?

Let’s look at U.S. deficits and debt for some answers.

The World We Have Now

This is where we are now:

Figure2 Deficit Since 1942 Graph
Source: FactSet, 05/30/2024

The above chart shows the amount of U.S. public debt outstanding as a percentage of GDP, using the $27,000 billion of public debt rather than the $34,800 of total debt. The difference between the two is held by intragovernmental agencies and does not need public financing. You’ll hear both numbers kicked around as well as a debt-to-GDP ratio of 95% for public debt and 121% for total debt. But the lower numbers are  correct way to look at the debt.

The current 95% debt-to-GDP ratio is equal to the post-World War II level. That was a time when the U.S. had just finished financing a global war and implemented European reconstruction through the Marshall Plan, which alone cost 5% of GDP.

Since the 2017 tax cuts, government revenues rose 40%, expenditures by 63% and GDP by 46%. Personal taxes are up around 47% and corporate taxes are up 20%.

Simply, the government spends more money than it takes in. Whether the government spends too much or doesn’t tax enough is irrelevant. The deficit, however, is a hard fact.

How Did We Get There?

As Ernest Hemmingway put it: “Two ways. Gradually, then suddenly.” Here’s the gradual part:

Figure3 Revenues and Outlays Graph
Source: FactSet, 06/12/2024

The chart shows federal revenues and expenses going back to 1982. There was a brief time in the late 1990s when revenues exceeded outlays but then a recession started in March 2001, unemployment rose by 1.4% to 5.8%, 2 million people lost their jobs and tax receipts dropped $307 billion or 11% of GDP. The reason tax receipts fell so much more than the economy was because of the 2001 and 2003 tax cuts which took income tax from an average of 38% to 35% and cost 2% of GDP. The brief period of budget surplus was over.

Over 42-years outlays are up 5.5% a year and revenues up 4.9%. That doesn’t sound too bad but for the magic of compounding. Here’s the history of revenues and outlays since 1980.

Figure4 Tax Revenues Table
Source: FactSet

One can question whether the imbalance was uncontrolled spending or too many tax cuts, but the result is the same. Over the entire period, revenues oscillated from 16% to 18% of GDP and outlays from 16% to 29%. This is captured in the chart below with the blue line showing outlays as a percent of GDP and the green line receipts as a percentage of GDP.

Figure5 Government Receipts and Expenses GDP Graph
Source: FactSet, 06/17/2024

The down arrows indicate times of tax cuts and the up arrows are tax increases, or in most cases, letting recent tax cuts expire. This current gap between revenues and outlays is around 6%. It’s clear tax cuts reduce revenues but less clear that the tax cuts subsequently increase revenue through additional economic activity. The debate that tax cuts pay for themselves continues. But we do know that tax revenues were flat from 2001 to 2005 and down from 2017 to 2020.

What Did We Spend It All On?

The “Big 4”: defense, health, Social Security and debt interest. In 1982, they totaled 83% of all outlays. Today they’re 74%. That’s surprising because social security is often held up as a major budget drain. But throughout the period, social security receipts were always more than expenditures and remain so today. The problem was the general increase in all categories of spending. Even health expenditures fell from 35% of all outlays in 1983 to 22% today.

That’s the “gradual” part. A steady increase in spending while revenues remain flat.

The “Sudden” Part Started Two Years Ago

The green line in the chart below shows government outlays, excluding debt, dropping from 2021 to 2024, mostly because of the end of large Covid-19 stimulus packages. But interest payments, in blue, turned sharply upwards. In the last two years, average monthly debt interest climbed 32% to $90 billion.

Figure6 Govt. Outlays Interest and Everything Else Graph
Source: FactSet, 06/17/2024

The reason for the increase is that the Fed started raising rates from 0.25% in early 2022 to 5.25% in July 2023. The average interest rate on government debt rose from 1.5% in 2022 to 4% in 2024. Debt costs will continue to grow as the U.S. Treasury replaces debt issued from 2010 to 2022 at an average level of 2% with bonds, bills and notes that now cost 4.5%. The Congressional Budget Office (CBO) sees interest payment climbing from $659 billion in 2023 to $1,628 billion in 2034, a 150% increase. Discretionary spending, which is spending on all items except the “mandatory” Medicare, Social Security, and veterans’ benefits, will rise 21%. Mandatory spending will rise 50%.

Debt Is Now Expensive

Interest increases generated another point that can come as a shock. Interest payments on the national debt, in the blue line below, exceed defense spending (the green line).

Figure7 Interest Pmts and Defense Graph
Source: FactSet, 06/17/2024

The last and only time this happened was from 1994 to 2001 with the Cold War peace dividend when real defense spending fell 29% from 1988 to 1999. That quickly disappeared in 2001 as higher defense spending resumed. Low rates from 2010 to 2022 made debt look cheap and plentiful. But the sudden change in 2022 was a surprise. Interest payments are now the third largest line item of government expenditures and will remain so until 2034.

In the last two years, interest costs soared, and mandatory spending continued to grow with inflation and the burden of an older workforce. Taxes remained flat, while GDP grew 13%.

The problem of debt and deficits suddenly became a lot bigger.

Can Budget Deficits Hurt Us? The German and Japanese Experience

Again, there’s no simple answer so let’s look at two case studies. First, here’s Germany, which is a good example of a country that avoids debt and deficits as much as it can. The chart shows the country’s budget deficit and inflation.

Figure8 German Budget and Inflation Graph
Source: FactSet, 06/17/2024

Germany increased deficits at the time of unification in 1995, during the GFC in 2010 and in the Covid-19 era of 2020. Throughout the period, the debt-to-GDP ratio ranged from 50% to 81% and is now 67%. Germany showed consistent debt discipline for 40 years, but it did little to bring down inflation, which averaged 1.9%. Indeed, inflation rose during the six-year budget surplus years from 2012 to 2019.

Low debt did not help growth, which averaged 1.3% from 2000-2024. EU GDP grew 32% from 2000 to 2023 while Germany grew 25%. It has also underperformed the EU bloc six out of the last seven years.

Japan famously increased its debt-to-GDP ratio from 80% in 1994 to 220% in 2024 (the blue line in the chart below), way beyond even the revised Rogoff levels of 120%.

It also used the Bank of Japan to buy up government debt to the point where it now holds 53% of all government debt. In the U.S., the Fed owns around 17%, down from a peak of 24%. That used to be a text book case for rampant inflation but as the chart shows inflation in Japan, (green line), averaged 0.4% for 30 years and only broke above 2% when the government imposed occasional sales tax increases.

Figure9 Japan Budget and Inflation Graph
Source: FactSet, 06/17/2024

Growth in Japan was a problem. GDP grew only grew 0.8% over the period and nominal GDP fell, partly because of the 1990 post-bubble crash and very unfavorable demographics: the over-65 age group grew from 8% to 28% of the population.

Japan currently pays around 0.8% on its $8,927 billion of government debt. At near zero rates, the burden of debt was manageable. Interest payments were only 7% of all government expenditure, compared to the U.S. at 16%. That will start to climb as rates slowly increase in Japan and it’s one reason the government intends to bring the budget into primary balance (i.e. a budget surplus before interest payments) by 2030.

We might add a third case. China’s debt-to-GDP grew from 120% in 2000 to nearly 300% in 2024. China structures its debt at the national level but also approves and guarantees debt issued from the provinces, municipalities, and local cities. China’s economy averaged growth of 12% over that period although it’s since slowed to around 4.4% in the last five years. We wouldn’t push the comparison too far because China exerts tremendous centralized power. It also saves around 40% of GDP. But again, the debt to GDP ratio by itself is not an indicator of growth, interest rates, or inflation.

Two Paths, Same Results

Japan and Germany took two different approaches to debt. One avoided deficits and debt at all costs, the other ran up both to kick-start a once mighty economy. In both cases, rates, growth and inflation remained low. Both found plenty of buyers for their debt. Both had idiosyncratic problems: Japan with an aging workforce and Germany with the costs of unification, a high dependency on imported energy and a very cyclical economy. In hindsight, Germany could have taken on more debt and Japan could have started the economic and businesses reforms sooner. In neither case can we point to debt as the problem.

And the U.S. Experience?

We’ve shown the effect of deficits in Germany and Japan. We’ve looked at country debt levels ranging from 21% to 200% some of which ended up in near default (Greece), some of which barely changed anything (Germany and Japan) and some of which turbo charged growth (China).

Let’s look at the U.S. and review debt and its effect on rates, inflation, bonds and the S&P 500.

In the chart below, we show the deficit in blue bars both historically and out to 2034 as estimated by the CBO. They’ve been doing this since 1974 and they make it clear that estimates assume no change in laws, spending and taxes. Sometimes their estimates are accurate. In 1982, the estimated budget deficit for 1986 was 4.3% and it turned out to be 4.8%. Sometimes they are less accurate. In 1996, the CBO estimated a 2000 deficit of 1.5% which ended as a surplus of 2.3%.  

We think of the CBO not as a forecasting tool but as an extrapolation of what will happen assuming no changes to any fiscal policy. In other words, it’s a base line.

Figure10 Deficits and Treasuries Graph
Source: FactSet, 06/17/2024

In the next 10 years, the CBO sees GDP growing by 48% to $41,398 billion, revenues up 60%, expenditures up 94%, and interest payments up 150%. It also sees discretionary spending increasing by 26%  and mandatory spending (Social Security, Medicare, veterans benefits etc.) up 50%.

On the revenue side it also assumes a drop in corporate taxes from $525 billion to $507 billion. Those are not inflation-adjusted numbers. They drop from 1.8% of GDP to 1.2% mainly because of 1) a 2022 ruling that allows companies to deduct 100% of expenses of new investments 2) the end of a one-time tax on foreign profits and 3) companies paying more in foreign income tax and claim tax credits. It’s complicated but, as we noted, the CBO goes with what’s on the statute books.

The green line shows the 10-year Treasury rate. In theory, the higher the deficit, the higher the interest rate at which the government borrows. But the relationship is complicated. Sometimes rates climb when the deficit is flat, as in the 1950s, and sometimes rates fall when the deficit increases as in 1982, 2001-2003 and 2008-2012. From 1986 to 2019, the average deficit barely changed but rates fell from 9% to 2%.

The deficit and interest rate relationship looks more complicated than just two variables at work.

What About Deficits and Inflation?

In the chart below, we’ve used the same deficit chart but overlaid it with annual inflation. In theory, higher deficits mean more spending. In the absence of improvements in things like productivity, it pushes up prices. The CBO thinks as much and publishes various rules of thumb to gauge the effects on the deficit and inflation. The rule of thumb is that a 0.1% increase in inflation pushes up the deficit by $307 billion over 10 years.

Figure11 Deficits and Treasuries and Inflation
Source: FactSet, 06/17/2024

But that rule of thumb doesn’t appear in the chart. We saw low deficits in the 1950s along with inflation ranging from 1% to 7%. In the early 1970s we saw shrinking deficits with escalating inflation. In the 1980s we saw the opposite, with higher deficits and lower inflation. From 2010 to 2012, deficits tripled but inflation fell. In the last 10 years we’ve seen deficits as low as 2.4% of GDP to as high as 15%. During that time inflation was steady between 2.0% to 2.5% but shot up in the post-Covid-19 reopening. Again, there doesn’t seem to be a strong relationship between the two.

What About Deficits and Bonds?

This is a variation of the deficits and rates question. Below we show the debt level, in blue, overlaid with the 10-year Treasury in green.

Figure12 US Govmt Debt as % of GDP
Source: FactSet, 06/17/2024

The relationship is, again, very unreliable. The debt ratio fell steadily in the 1950s and 1960s yet bond yields increased from 2% to 7%. The peak rate of 16% on the 10-year Treasury in 1981 coincided with the lowest debt-to-GDP ratio in 82 years. Recently the debt ratio climbed from 35% in 2007 to 95% now but rates are unchanged.

What About Deficits and Stocks?

Finally, let’s look at the S&P 500. Here we show the annual change in the S&P 500 in the blue bars with the deficit as a percent of GDP in the green line.

Figure13 Deficit and SPX
Source: FactSet, 06/18/2024

We’ll keep this simple; there is no correlation between deficits and stocks. At times of surplus, in the late 1990s, markets had some of their best and worst years. At times of worsening deficits, in the early 1980s, markets rose sharply. At other times of worsening deficits, as in 2009, markets collapsed. In times of improving deficits, as from 1985-1988 or 1994-1998 or 2020-2021, markets performed well. In other times of improving deficits, markets fell, as in 1994, 2006, and 2022.

It’s all over the place, which comes back to the lesson that deficits by themselves don’t matter too much. But when combined with other data and variables, they matter very much.

This All Sounds Too Easy. When Do Deficits Matter?

We have two examples when they matter. One from two years ago and one going on now.

In 2022, Liz Truss, the hapless U.K. Prime Minister that week, and her Chancellor of the Exchequer, Kwasi Kwarteng, announced “The Growth Plan 2022.” It was a huge unfunded tax giveaway, lowering corporate tax from 25% to 19%, eliminating a house transfer tax, and cutting the top rate of tax from 45% to 40%.

The trouble was that debt had already risen from 83% of GDP in 2016 to 98% in 2022. The new plan added £160 billion to total debt of £2,500 billion or another 6%. The bond market reacted very quickly, taking the 10-Year Gilt from 2.8% to 4.3% in less than a month. The Bank of England stepped in, the Prime Minister fired her chancellor and left office two weeks later. Her entire premiership lasted 45 days. The bond markets had spoken. Yields quickly headed down to 3.1%.

In France, we’ve recently seen the spread between French and German bond yields widen from 0.45% to 0.75% in less than a week. The reason is that French President Emmanuel Macron called a parliamentary election where he is likely to lose his majority either to the right Rassemblement National (RN) party or the left Nouveau Front Populaire (NFP) alliance. One has promised tax cuts on energy, fuel and pensions and the other a big increase in public sector wages.

France already runs a 4% deficit with debt at 112%. While the market was fine with that three weeks ago, a sudden possibility of unfunded, increased spending and tax cuts resulted in a quick reaction from the bond and equity markets. Debt didn’t matter until, suddenly, it did. The market took fright at populist policies and sold bonds and stocks quickly.

Again, the lesson is that debt and deficits can run high while markets remain calm. But a sudden, rash level change in fiscal policy can lead to a quick market reaction.  

Putting It All Together: Deficits and Markets for 2024

We’re sympathetic to concerns about U.S. debt. It’s not improving and there’s much talk about further tax cuts, renewing cuts beyond their expiration date, higher than expected health spending, and interest payments. The latest CBO report sees a deficit between 5.5% to 7.1% for the next 10 years with interest payments accounting for about half the number.

In 2025 we’ll see a resumption of the debt ceiling debate, and a likely repeat of a last-minute deal that keeps everyone on edge. We may even see Moody’s join Standard and Poor’s and Fitch and downgrade its current Aaa credit rating on U.S. debt.

But we also see strong demand for U.S. treasuries. The bid to cover ratio for recent Treasury bond auctions, a reliable guide to demand for new debt, is around 2.9 times, well above its 42-year average of 2.2 times. We also haven’t seen any sign of crowding out of other borrowers. The spread between U.S. corporate and Treasury debt is 145 basis points (bps), well below its 20-year average of 250 bps. Households aren’t borrowing heavily and have increased their holdings of Treasury debt by five times since 2021 to $2,416 billion in 2024. They now own 8.8% of all U.S. public debt up from 2% in 2022. When rates were high in the late 1990s, households held around 22% of all debt.

Foreign demand for Treasuries remains high and growing and stands at 31% of all debt. There’s no sign any borrower wants to reduce U.S. dollar holdings.

We would also note that the relationship between deficits, rates, growth and bond and stock markets is tenuous. Other factors like productivity, wages, size of the labor force, and central bank and government policy introduce far too many variables to link deficits with only bad outcomes.

On the other hand, it won’t take much to cause the bond market to kick back quickly if it sees poor tax planning, a debt ceiling misstep, a recession, bank bailout or some unforeseen shock. It’s possible that future U.S. administrations could face a bond crisis as the UK did in 2022 and France is now.

What level of debt is too much? We don’t know.

We’d like to see Congress address the budget issues. No one is discussing both the revenue and the expense side at the same time and we see no agreement on a common solution.

We’re neither deficit hawks or doves. Deficits can help or damage an economy depending on numerous factors. Markets can thrive both in low and high deficit periods.

We Also Believe Deficits Should Not Interrupt a Solid Long-Term Financial Plan

Your Cerity Partners’ financial advisor will know your situation and has already considered these issues in your investment strategy.

The next few months may be fraught. No one is addressing the deficit issue, and it looms large as a market risk. We constantly monitor markets for all issues, including debt and deficits. We currently don’t see any reason that it should derail long-term investment strategies and plans. But we’re paying attention to it – all the time.

Subscribe here to receive weekly updates.

Art of the Week: Andre Derain (1880-1954)

  1. What are deficits? Deficits are the annual shortfall of government revenues and expenses. They’re expressed mostly as a percent of GDP but also in nominal (i.e.current) dollars. They’re also called fiscal or government deficits.

    Primary deficits are the shortfall of government revenue and all expenses except interest payments. The idea behind is to see how government spending is doing before debt interest payments.
    Debt, government debt or total debt is the amount of total government debt outstanding, expressed as a percent of GDP or in dollars. ↩︎

Please read important disclosures here.