Is a Default on U.S. Debt Possible?
President Biden is pushing hard for his $1.9 trillion Covid Relief package. Republicans are balking at the size, having already offered up trillions in previous packages. All this spending has again raised the question of when our nation’s debt will become too high? When will it start creating serious economic harm?
As of January 22, 2021, according to Investopedia, the national debt stood at $27.8 trillion and growing. Does its size matter? I contend that yes, it does, but no one seems able to articulate the precise level when it becomes an obvious problem.
The alarm bell is often rung. Over the years, many politicians have used the national debt size to accuse opponents of reckless spending and mortgaging our children’s futures. However, once in power, neither political party has done much to cut the spending that grows our nation’s debt.
Part of the problem is that most Americans don’t understand what the debt is, why they should be concerned or, for that matter, the difference between deficits and the nation’s debt. For that reason, when elections are held, talk of deficits and debts takes a back-seat to other, more pressing issues. Issues that people can understand.
Budgetary deficits and national debt are quite simple to understand. Each year, the U.S. Treasury collects money from taxes. Those cash receipts always fall far short of the amount the government spends. That creates a budgetary deficit. To cover the short-fall and pay expenses, the government sells bonds to investors. Investors exchange cash for a promise to receive interest and return the cash sometime in the future. This exchange gives the government the cash it needs now but adds to our nation’s debt.
Our government is continuously in the market selling bonds to investors.
Our rising national debt is the result of persistent annual budget deficits. These deficits are made worse when Congress undertakes large stimulus programs like those seen in 2008, this past year, and the one being debated now.
So why don’t politicians just cut current spending? I would point to the fact that most of the power and influence vested in being an elected official rests in the ability to appropriate money. People and organizations find value in lobbying politicians because they can get money. Should politicians ever start cutting spending, they’d be diminishing their importance. Neither party seems interested in doing that!
But the problem we face has moved beyond how reasonable, or irresponsible individual politicians may be. Most of the money spent each year is no longer open for debate.
A large percentage of Washington’s annual budget is spent on automatic transfer programs like Social Security and Medicare. To have a meaningful impact on our deficits, Congress would have to address spending on these programs.
Cutting either program will never happen as the mere suggestion of touching them is considered the surest way to lose political office.
For those reasons, meaningful spending cuts will never happen; it appears the spending problem will only worsen.
That has many looking at the revenue side of the equation. Why not just raise taxes to shrink the deficit?
This idea only gains traction because few genuinely understand the numbers. Raising taxes will not solve the problem; it will not work. Our deficits have reached a level where imposing even a 100% tax on the “rich” would fail to eliminate the deficit. In fact, not only would deficits remain, but higher tax rates would slow economic growth, making the situation even worse.
The only solution to our deficit and debt problems starts with accelerating economic growth. Washington’s current spending level can only be supported by an economy larger than the one we have today. But any reasonable observer would conclude that even faster economic growth will fail to solve the problem. The solution would require both a larger economy and fiscal discipline in Washington.
Is anyone ready to bet that will ever happen?
In short, we might as well be resigned to the fact that neither spending cuts nor increased tax revenues will ever solve our debt problem.
This brings us back to the original question. Does the size of our nation’s debt matter? I answered yes, but many would disagree with me.
Those who do not see a problem point out that the mechanisms that finance our deficits are working just fine. Each time the Treasury holds a bond auction, all the bonds are purchased by investors. In fact, the demand for the bonds typically exceeds what is being sold.
It’s not wholly unreasonable to contend that so long as we can sell bonds, we can continue to fund our deficits and grow the nation’s debt.
This analysis fails to provide a guide to when the financing may start to be at risk.
Greece’s financial crisis 10-years ago is a case in point. The crisis was triggered when the Greek government went to the market to sell bonds but failed to attract buyers. Investors lost confidence in the Greek government’s ability to repay their debt, and the bond auction failed. The market for Greek bonds evaporated, and with it, the Greek government's ability to pay its bills.
It’s important to internalize that all it took for Greece’s deficit financing to end was a failed bond auction.
Greece was saved, but only by the willingness (although begrudgingly) of the Germans to stand behind them. The market would buy bonds to fund Greece’s deficit only if they had more robust backing for the bonds.
If a similar event occurred with the U.S. Treasury’s auction of bonds, the impact would be felt worldwide. No country has the money to prop up the U.S. Treasury. Checks to pay for our government’s expenses would stop or be issued with a diminished dollar.
I think it’s improbable the end of the U.S. government’s deficit spending and growing debt will result from a failed auction. If it came to that, the result would be catastrophic.
Other market mechanisms will set in motion the end of deficit financing and debt growth in the U.S. A combination of rising interest rates, inflation, and a falling dollar will be the signals that end our nation’s ability to deficit finance its spending. None of these mechanisms are pressuring current spending, but there are signs that investors are becoming concerned.
The rise of cryptocurrencies like Bitcoin is clearly a signal that investors are concerned about the dollar's future. Cryptocurrencies are attractive because their supply is limited. This is thought to protect investors from the effects of inflation and the falling value of currencies that can be printed in unlimited quantities by governments.
Our nation will eventually be diminished by persistent deficit financing and increasing debt, but I cannot quantify the level where it presents an immediate risk. However, it’s essential to understand that investors in U.S. Treasury bonds face no risk of default. The danger they face is being repaid with a currency whose value has fallen.
It does not appear that we are on the precipice of a problem, but that does not mean we should not be concerned. Since there seems to be no viable solution to Washington’s spending habits, we will someday discover the limits of our deficit spending as things sit today. No one will want to be around when that happens.
I reject all arguments that contend the deficits and debt do not matter. They do matter, and we should all advocate policy that limits the growth of both.
The current issue we face is managing fixed-income portfolios in light of low interest rates. Since we use individual bonds in our client’s portfolios, we can customize each bond portfolio to the client’s specific requirements. As important, we can construct a portfolio that is positioned to quickly respond when interest rates start to rise.
By comparison, bond funds do not offer that same flexibility. We have discussed this in previous Nicollet Navigator articles and will continue to pound the table on that front as loudly as possible. Should the value of the dollar slide while interest rates power higher, those owning bond funds could find themselves suffering *not* unforeseen consequences.
If you would like to discuss the merits of owning individual bonds in your portfolio, please schedule an appointment to chat with me personally. I look forward to hearing from you.