Introduction: What is a “Debt Ceiling”?
In early June, Congress passed a bill to suspend the US government debt ceiling through the end of 2024. The debt ceiling is the maximum level of government bonds that Congress has authorized the US Treasury to issue. This latest deal suspended the debt ceiling limit of $31.4 trillion, meaning the government can continue to operate and fund operations with debt above that threshold without defaulting. Unless the US reduces its debt, come 2025 Congress will either need to further suspend the debt ceiling or increase it, otherwise the US will default.
A default by the US government on its debt obligations would be catastrophic for the economy. Lenders would dump US bonds, while any new borrowing would come at much higher interest rates. The interest rate on national debt sets the baseline for interest rates on just about everything else, including for things like cars, houses, and small business loans. In short, growth would seize up and the US would be in for a protracted recession or depression.
Some people argue that the US national debt has ballooned out of control, and Congress should take steps to reduce it. Is this true? Let’s take a deeper look.
Servicing the National Debt
The US has the largest debt of any country at over $32T. However, unlike many smaller countries, the US issues debt in its own currency (US dollars), over which it has full control. This is important because, if needed, the US can print more US dollars to pay down the debt. As long as Congress is willing to continually raise or suspend the debt ceiling, then the US will not default on its debt as it can issue new debt to pay off any maturing debt. There is ongoing debate as to whether the debt needs to, or will ever, be fully repaid. Putting that aside, there is consensus that the US must service its debt payments or default. The amount of stress that the government debt has on an economy is a function of 1) how big the debt is relative to the size of the economy (i.e., the debt-to-GDP ratio); 2) how much it costs to service the debt (i.e., the real interest rate on the debt); and 3) whether a country is adding or subtracting to the amount owed by virtue of running a budget surplus or deficit.
Interest Rate and the Debt
Over the past 50 years, the national debt has increased as a percentage of GDP. In the 1970s and early 1980s it hovered around 35%, whereas now it has ballooned to a high of ~135%.
Chart 1: US Debt as a Percentage of GDP
Despite these increasing debt levels relative to GDP over this period, US debt servicing costs have remained stable thanks to the countervailing force of declining real interest rates.
Chart 2: Real interest rates have been on the decline for 40+ years
Most economists agree that low real interest rates over this period have been a result of structurally low global investment demand and high savings rates. As the US prints new debt, it becomes more and more dependent on perpetually low real interest rates to service the debt. Whether real interest rates will see a sustained increase in the future is a point of disagreement and debate amongst economists, but as you can see above, interest rates began to tick up in 2022.
The average nominal interest rate today on US debt is 2.3%, which is an increase from 1.4% at end of 2021. By some estimates, the government will need to refinance 30% of all its outstanding debt over the next year. This will lead to higher debt servicing costs because interest rates are higher today than the rate on the debt that is maturing.
GDP, Budget Deficits, and the Debt
From 2008 to 2022, the US had a nominal GDP growth rate of 3.9%. If the US can manage to sustain GDP growth in the 3%+ range (c’mon A.I.), it has a fighting chance of naturally reducing its relative debt level assuming interest rates fall back into the Fed’s target rate of ~2%. This also assumes we don’t add any new debt to the existing pile. In other words, the government needs to run a balanced budget or surplus, something it has not done in most recent years. Of the $32T in total public debt, the US added about $6T during the COVID pandemic to keep the economy afloat. Even during the recent “good” years prior to the COVID pandemic (2018 and 2019), the US ran large budget deficits that required additional borrowing, due largely to the tax cuts implemented during the Trump presidency.
If the government continues to run large deficits, then the debt will likely continue to grow regardless of whether interest rates fall back into the Fed’s target range. On the other hand, higher than expected GDP growth can absorb much of the debt servicing costs by creating naturally higher government receipts. To paraphrase Warren Buffet, don’t underestimate the US economy.
The Bottom Line
Over the past several decades, U.S. national debt has grown on both an absolute basis and relative to output (GDP). So, is the national debt too high and does Congress need to rein it back in?
A rising debt level is not necessarily problematic when it causes the supply of goods and services to rise in tandem with the demand it creates. When that happens, the debt is considered self-liquidating, with debt rising no faster than the real debt-servicing capacity of the economy. The problem is more concerning when debt rises faster than the country’s real debt-servicing capacity. This occurs when debt boosts the demand for goods and services without directly or indirectly causing an equivalent rise in the production of goods and services. It can also occur when the real interest rate on the debt spikes or when the federal government runs large deficits. These are key risk factors to keep an eye on. In such cases, a variety of issues can result including slow economic growth, distortion of economic activity, and political crises.
There have been numerous sovereign defaults and debt crises throughout history, but they tend to happen with small countries that take on debt in a currency they don’t control (and therefore cannot print their way out of it). As the world’s largest producer and controller of the world’s reserve currency, the US does not fit the profile of prior sovereign debt defaults. That being said, it seems prudent to not let the debt continue to grow relative to GDP. Debt-to-GDP ratio is a useful metric for measuring the stability and health of a nation’s economy. Nobody knows for sure at what level relative debt becomes “too much” but I would prefer not to find out.
