Something's Gotta Give
There is pain involved.
We’ve witnessed a lot of volatility and a few weeks of really crappy returns in U.S. stock markets. Much of the sell-off has been due to fears of an impending recession (I will write more on this on in a subsequent post, coming soon!). Some of the market bounces higher stem from news that a government shutdown has been avoided and postponed.
I really don’t find this kicking-the-can-down-the-road great news.
Obviously, we are enduring all sorts of intense policy announcements that drive markets and emotions short term. In the meantime, however, we have an underlying “huuuuge” problem that could eventually cause a major ruckus in the medium term. At a minimum, if we don’t see policy action that convincingly puts the US on a better path, we will see more volatility and more swings in financial markets ahead.
The U.S. government debt has been growing fast with no correction in sight.
Take a gander at this lovely chart, produced by none other than the U.S. Treasury in its annual report issued recently.
Source: Financial Report of the US Government, Fiscal Year 2024, page 15. See https://www.fiscal.treasury.gov/files/reports-statements/financial-report/2024/01-16-2025-FR-(Final).pdf
The U.S. Treasury states unequivocally:
“The current fiscal path is unsustainable…the projections demonstrate that policy changes need to be enacted to achieve a sustainable fiscal policy.”
Something’s gotta give, or our debt is going to blow up.
Take a close look. The left-hand side shows the ratio of debt held by the public as a percentage of GDP. It measures how big the debt is relative to the size of the economy. At 100%, it’s akin to earning $150,000 a year while having $150,000 racked up on your credit card. If you don’t charge more to your credit card AND if you pay ZERO in interest, the balance won’t grow. If you don’t pay it down, or if you’re charged a normal rate of interest, or if you charge more stuff to your credit card, this will balance will grow and grow. If you want to make a big dent in the credit card balance, you’ll have to go on a tight budget. No more eating out, no Amazon shopping, no trips, move to a cheaper apartment, sell your car, buy ramen noodles.
Any way you look at it, 100% debt ratios don’t seem sustainable, and cutting them on a tight budget is no fun.
When I analyzed and invested in developing countries for a living, our team started to get worried when a country’s debt ratio surpassed 60%. Many of these situations did spiral into full-blown crises. Big, stable countries can get away with much higher debt loads without a problem—under certain circumstances. For example, if they have massive savings that can fund the debt (like Japan, that owns its own debt), if they have the world’s reserve currency, follow prudent fiscal spending, and enjoy stable, predictable policies with strong institutions (like the USA, historically). These countries can typically borrow more to finance their spending and have plenty of time to pay the debt down when economic times improve.
However, no matter who you are, if you spend too much and have a huge interest bill, you can’t keep borrowing more indefinitely.
For countries that lack offsetting caveats, a debt crisis ensues (Greece, Argentina, Thailand, Mexico, etc.). Every single one of these debt crises resulted in significant recessions and deep financial pain for their citizens.
With that context in mind, here’s what the U.S. situation looks like historically:
Source: Congressional Budget Office
The good news? We’ve had similar sky-high 100% debt ratios once before—just after World War II—and we proved that we could reverse the trend.
The bad news? It will likely hurt. Cutting budget deficits is painful, and someone—if not everyone—will feel it.
The sooner change is enacted, the smaller the shock to the country. However, no politician wants to inflict pain, as that almost guarantees losing power (for themselves and their party).
Where might we feel the pain? Let’s look at the numbers behind what the government currently spends, so we can see what levers the President and Congress can control in the near term and long term.
Short version: There is nothing the government can cut that won’t be politically difficult, the economy will feel some pain, and many people will be angry.
Typically, economists look at government budgets in terms of Mandatory, Discretionary, and Interest payments. They are exactly what they sound like. This chart from the Peterson Foundation shows us a snapshot of the current situation.
Only 28% of the money the government spends is discretionary! The bulk of it is coded into permanent law.
Social Security, Medicare, and Medicaid account for nearly 75% of mandatory spending. Net interest is 11%—and it’s projected to increase even if interest rates drop, since the debt pile remains high and growing.
In every country I’ve covered during my career, reforming Social Security and Medicare-like programs only happens when the government faces a debt crisis—it’s practically political suicide. Changing these laws typically happens when there is no other choice. Let’s set that aside for now because I really don’t see Trump and gang signing up for this. (I should remind us that current projections suggest 2035/2036 as the time period where the taxes paid in for these programs fall short of what is paid out, EEK).
That leaves us with the Discretionary Category and Net Interest.
Net interest isn’t a lever that is directly controllable; it’s tied to total debt and interest rates. What can we do to reduce total debt, and therefore the bill? And, will we do it?
Restructure debt – Restructuring debt is like trying to find a different payment plan for your bills when you can’t afford your next payment. It usually is BAD news for everyone, especially your credit score. This is a no go for the U.S. of A. Trust me, if the U.S. government attempts to wipe out its debt in any form, it would be a disaster. Think of the fallout if you defaulted on your mortgage or credit card. Now multiply that by the U.S. government defaulting on global obligations. Yikes.
Run fiscal surpluses – A surplus mean we spend less than we earn. In the last 50 years, the U.S. has run a surplus exactly four times – four little blips above zero in the chart below. It’s possible to achieve this, but not easy, and unless the country is growing like crazy, it is painful. Revenues have to be much larger than spending.
If “they” touch nothing else, they are left with the categories of Discretionary spending (defense related and non-defense related) to fix the situation.
Can we cut Defense? With China, the Middle East, and Russia brewing as hotspots of conflict? Maybe. But is that a risk worth taking? I’m sure we can all argue this many ways.
That leaves us with the 15% in the Non-Defense Discretionary category. What, you may be thinking, do we spend that money on? Our friends at the Congressional Budget Office have this cool infographic for the most recent fiscal year budget:
Each of those numbers/areas seem chump change relative to the size of the budget. But cutting $50 million in each of them will be felt by the people on the ground, no doubt. I love National Parks, I do not want anything cut out of my beloved outdoors. My sister-in-law’s job relies on the funding of the Department of Education. I believe strongly that as a rich society, we should help both domestic and foreign people who are so underprivileged, just because of where they were born. I will be upset, if and when these areas are cut.
But wait, spending isn’t everything! Remember, Trump hopes to CUT taxes (which is often great for the economy), which leads to LESS revenue, which makes these fiscal numbers get worse, and the need to cut even more from Discretionary. I think that he is hoping that DOGE will find big savings, that government waste can be culled in a big way, and that he can get other countries to pay us directly for Military Might. I don’t think this will be enough. I’m pretty sure of it, actually.
Discretionary is not the big spender in the room, it’s actually the Mandatory that is the problem. We have tons of older people who will put heavy demands on the system as they age. We need to raise taxes to pay for these programs or cut benefits (and that only happens to future generations, not current old folks). Both types of measures will sadly hit the younger generations.
Pain is coming, no matter what. Most deficit reducing policies slow the economy, which in turn drops government revenue. Layoffs suck. Getting less from the government sucks. Real people feel real pain.
A debt crisis would suck more.
I’d rather we take some bitter medicine now, get better faster, and then enjoy growth instead of collapse.