A storm may be brewing off the coast. It is not a new concern for investors, but its intensity has grown. The US federal government owes more than $34 trillion—and counting. This level of debt has the potential to wreak havoc, even for the world’s largest economy. Government debt has grown in other parts of the globe as well, and debt held by consumers and businesses can also pose economic risks. With a tsunami of debt lurking in the distance, investors must take stock of the potential ramifications if it ever crashes onto the shore.
This episode of The Outthinking Investor addresses the economic challenges associated with an increasing debt burden, the impact on inflation, interest rates and financial markets, and fiscal policy prescriptions that could help bring the debt under control. Randal Quarles, former Vice Chair for Supervision at the Federal Reserve; Maya MacGuineas, President of the Committee for a Responsible Federal Budget; and Tom Porcelli, Chief US Economist for PGIM Fixed Income, join the podcast to give a unique perspective on the intersection of debt, fiscal policy and financial markets.
Episode Transcript
Tsunami. Even the sound of the word evokes a swell of energy. These great walls of water start deep in the ocean hundreds of miles from shore, usually triggered by an underwater earthquake. Tsunami waves are only a few feet high while they're traveling across deep water at hundreds of miles per hour. They rise suddenly and dramatically as they get close to shore. That's also when it can be too late for people to rush to safety. A tsunami may be brewing just off the coast of the United States. But this tsunami is not a wall of water. It's a wall of debt. The US federal government owes more than $34 trillion as of the start of 2024. The growing level of debt has the potential to cause destruction to even the largest economy of the world. While the ripples of debt started slowly many years ago, the wave appears to be cresting and leaving many to wonder if it's possible to reach higher ground. The financial devastation could extend for generations. Will policymakers heed the sirens of fiscal responsibility?
[ Music ]
>> To understand today's investment landscape, it's important to know how we got here. This is the Outthinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. In this episode, three experts share their views on government debt, focusing on the United States. Randy Quarles is chairman of the Cynosure Group. He was previously vice chair for supervision at the Federal Reserve and held positions at the US Treasury and Carlyle Group. Tom Porcelli is chief US economist at PGIM Fixed Income. Maya MacGuineas is president of the Committee for a Responsible Federal Budget, a nonpartisan and independent organization.
[ Music ]
The level of federal debt in the US seems to be an issue that leaves most people either deeply disturbed or unfazed. Maya MacGuineas explains why it's cause for alarm.
>> The national debt right now is at troubling levels no matter what metric you use to evaluate it. So debt as a share of GDP, which is probably the most reasonable and helpful metric, is approaching record levels at just below 100% of GDP. And that's debt held by the public. The record was set right after World War II at 106% of GDP. We are soon going to eclipse that. So we will be at the highest level of debt to GDP that we've ever been in this country, but the last time we were there was as a result of fighting a world war. This time, it's basically just a result of having not wanted to pay for many of the things that we do.
>> The near-historic federal debt level is an accumulation of deficits from years of not balancing the federal budget. Tom Porcelli recaps recent spending history and how that's affected America's debt.
>> In the year 2000, we sold a surplus. Now, in fairness, we only have a surplus for a few years, you know, and even prior to the surplus of the late '90s. Deficits got as deep as, what, 5% or so. This is all sort of -- you know, sort of in the post-war era. And they average probably closer to 2% or 3%. So we've really seen the deficit grow worse sort of year after year. So you get through the tech bubble of the late '90s, early 2000s, deficit grows. You get through the great financial crisis and all the fiscal that was associated with that, the deficit grows. And then, you know, we get to the pandemic and, you know, you have more fiscal stimulus that comes online. Some people will call these, you know, once every hundred-year events, but it just so happens that if that's true that these are once every hundred-year events, they just happen to happen in a 10-year window.
>> The cost of servicing the debt accrued over that time has gone up considerably, along with the rise in interest rates, and this massive cost to service the debt provides no real benefit.
>> For instance, right now, we spend more on interest payments than we do for all programs at the federal level investing in children. Within just a few years, we will spend more on interest payments than we will on national defense. That is a right flashing warning sign that we are on an unsustainable path. And clearly, it is unsustainable because the fastest-growing part of our budget is interest payments. And when you have a debt that's growing faster than your economy, obviously something will have to give.
>> Even more important and more worrisome than the current debt level and cost to finance it is the trajectory of the debt level. The slope of that trajectory looks like a tsunami wave in reverse.
>> You think about the deficit right now, it's about 6% of GDP. And you think about where this is going. And this is a complicating factor. No one does it better than the Congressional Budget Office in terms of making forecasts of fiscal. I think their official number's out to 2033. It's -- deficits force as far as the forecast horizon looks and it deteriorates, right? So if you're at, you know, roughly 5% or 6%, today, you know, out into the middle of the 2030s, it gets to between 7% and 8%. That's where we are from a deficit perspective. It's complicated and it's going to grow more complicated. Part of the challenge is the fact that we're an aging population. And that's an incredibly complicating factor. Because as the population ages, it means that there's even more spending that has to take place.
>> Certainly, the US isn't the only country to be grappling with an aging population and increasing debt. According to Randy Quarles, the current level of debt is in line with other developed countries.
>> Our debt to GDP ratio is as high as it has ever been historically, really, and it is high compared to most countries in the world. All of the advanced financial economies now, though, have quite high levels of debt to GDP. Ours is not out of line, it's probably middle-ish of the pack for European countries, you know, and the United States countries that we would consider our peers. Japan famously has a materially higher debt-to-GDP ratio than the United States, but France and Italy and Spain have higher debt-to-GDP ratios. That's not intended to be comforting or complacent at all, but just to say that it's not as though we're significantly out of the pack of countries that we would consider similarly financially sophisticated and rich.
>> But if the economy continues to grow and the government continues to service the debt without problems, what's the fuss? Do we really need to obsess over the potential for collateral damage ahead.
>> One of the biggest challenges, of course, is that people don't feel this in their daily lives. We worry about job security, saving for retirement, affording college, the affordability of health care, all of these things, but the national debt really underlies each and every one of those issues. So the way I think about the problems presented by the large national debt are, one, economic, if we're borrowing too much, there is crowding out, even when there's low interest rates. And it means that our economic growth, our standard of living, our job prospects for the future are all lower than they otherwise would have been. The second issue on top of economic concerns is that you want to be able to borrow as defense, when you're hit with an emergency, when you're hit with a recession, when you're hit with a huge one-time cost that you want to spread out over time. But if you are borrowing for normal daily spending, you don't have the fiscal space to borrow when you most need it. It's clear that fiscal threats are no longer just economic. Our spending and national security is all certainly going to go up as a share of GDP. And there are going to be a lot of emergencies around the world where the short-term expenses are probably critically important long-term investments. But if we're constrained because our debt is too high and our interest payments are growing part of the budget, we may fail to make those necessary investments. The same could be said for climate. The same could be said for investment in human capital, as the growing competition around the world continues to affect younger and future generations.
>> And as Tom Porcelli noted earlier, there was increasing risk related to our aging population.
>> We have a social contract that is basically created for last century, not this century. The risks are all for senior citizens, retirement programs, Social Security, healthcare programs, Medicare. This was created when seniors were the poorest cohort in the country. Today, those over 65 are the richest cohort. The poorest is children under 18. But we still have a social contract that is geared towards seniors. And we, still at the federal level, spend $6 for someone over 65 for everyone we spend on people under 18.
>> But as any politician or any parent can tell you, no one wants to give up something they feel entitled to. President George H.W. Bush famously took an extraordinary policy position in an attempt to get a handle on the country's debt.
>> He lost his presidency by negotiating the budget deal that for a modest tax increase got the Congress to agree on the so-called PAYGO rules that if anyone in Congress wanted to propose a expenditure increase, they had to propose a tax increase that would pay for it and they had to be passed together. If anybody in Congress wanted to propose a tax cut, they had to propose an expenditure cut to go with it and they had to be passed together. And the economy grew significantly in part because of the fiscal discipline that was imposed by the PAYGO rules.
>> The increasing federal debt, a portion of which is theoretically owned by each person in the country, is just one side of the debt picture. Increasing consumer debt is also a growing concern. Credit card balances in the US have gone up 40% in the past two years alone. More than half of Americans live paycheck to paycheck and over 1/3 have more credit card debt than they have emergency savings.
>> The systemic risk in the economy is affected both by levels of consumer debt and federal debt. They don't necessarily interact directly, but high levels of debt across the economy can create risks for stress in the financial system, perhaps ultimately instability in the financial system. And the source of that would be somewhat different if the original source is coming from the consumer side as opposed to the federal government side. But you're obviously -- by increasing both types of debt, you're increasing the risk of some financial instability in the future. So the two don't necessarily interact, but I think they have to be thought of together because the overall level of debt in the economy is relevant both to financial stability and to the ultimate strength of the economy.
>> From a bond market perspective, increasing debt naturally means an increase in the supply of treasury bonds. Is that necessarily a bad thing for bondholders?
>> Yields don't have to rise as much as you might say. When the US was first downgraded by S&P a number of years ago, I think everyone thought that this would usher in higher yields. I remember at that time thinking that doesn't have to play out that way. And so what happened? Well, there was a flight to safety. When you're the world's reserve currency, I saying -- you know, it doesn't necessarily work in the sort of the way that you might think of it from a -- from an academic sense. I think that's an important idea. When I worked at the Federal Reserve a number of years ago, you know, one of the things that we were always sort of thinking about and talking about was sort of a fair value model and 10-year yields. And if you, you know, went back 20 or 25 years ago, what's interesting is, you know, a fair value model 20 or 25 years ago, you know, most of the inputs into the model would have probably been mostly domestic in orientation. Fast forward certainly to today, the model would be sort of a hodgepodge of both foreign and domestic economic variables embedded in that. And I think it's always a really useful reminder to think of that because you can make forecasting guilds as complicated as you want. When I think about 10s, tenure yields, or, you know, you could use any term across the term structure, I think a really foundational way of thinking about this is if you want to forecast 10s, think about what you think stead funds will average over the next 10 years. That is the starting point for that conversation. And when I think about that, when I think about funds over the next 10 years, to me, 4% seems right-ish.
>> There were some known risks that come with the increasing debt, such as the crowding out of other investments that need funding. Even in a financial system as large and advanced as that of the US, higher debt could dampen the economy.
>> I think we're seeing it as well begin to play out in investor confidence. If you believe that a government's policies are unsustainable and obviously increasing our debt at the level of its increasing is unsustainable over some length of time, then you're going to have increased volatility in the markets as investors reevaluate their portfolios in light of that risk assessment.
>> Beyond these kinds of known and unknown market dynamics, there are also operational risks to large and swift increases in the debt.
>> I do think that there is an issue about the mechanics of the treasury market that's kind of mundane and -- I mean, it's plumbing as opposed to strategy. But the intermediaries in the treasury market have created private sector infrastructure that could handle a treasury market of a certain size. And I think we've seen a couple of times over the course of the last few years that that infrastructure is not yet large enough or robust enough given what the size of the treasury market is now to provide that intermediation even in times of fairly mild stress and certainly not in times of severe stress. So there was the incident in September of 2019 when the Fed's balance sheet shrinking policy, which was moving incrementally and slowly towards a smaller balance sheet, hit a particular moment where there was this immediate disruption in the repo market for treasuries. And the Fed had to increase its balance sheet again rather quickly because the private sector market wasn't able to intermediate it and, of course, in March of 2020, only six months later, the onset of the COVID event and the administrative closing of a lot of the global economy, which led to an extreme demand for selling treasuries and not enough buyers on the other side. But again, that private sector infrastructure couldn't provide the swing for that demand by purchasing and holding the treasuries for which there was an immediate demand on the other side and the expectation that ultimately would happen and the Fed had to step in and start buying $120 billion of treasuries and asset-backed securities a month just so that the market would clear. So there's some thinking that has to be done around market structure as opposed to fundamental market demand around treasuries given how large the treasury market has become in a relatively short period of time. The private sector market infrastructure hasn't grown as rapidly in order to provide that intermediation.
>> Market events don't happen in a vacuum and investment decisions are relative. Randy Quarles saw this play out back in the early 2000s when, at the US Treasury, he chaired a committee that reviewed foreign investments into the US that had the potential for national security implications. At the time, an international company called the Dubai Ports World was looking to purchase a US-based firm that operated many ports on the Eastern Seaboard. This was a big deal in the works and it fell apart, essentially, a victim of Washington politics.
>> I went around to all of the central banks and finance ministries in the Gulf saying, "Look, I'm very sorry about this, we had approved the investment, this wasn't the government, it was a political -- politics are very difficult to control. And we really do want your money." The message of the Gulf had been, "Well, maybe if these people don't want our money, maybe they don't want our money. And we're just going to stop buying treasury securities." And I said, "No, no, no, we do want you to continue buying treasury securities." And the most local of these central bank governors had been the Central Bank governor of the UAE based in Abu Dhabi. And so he was the last port of call on this trip that I was making. And he met me on the steps of the Central Bank and there -- had the press there and denounced me and the United States as we stood there on the press, and nobody stepped inside his office. And I said that, "I'm very sorry about this whole situation. As you know, we approved the investment." And he said, "Oh, I just have to say that for public consumption." I said, "What are my options?" And he said, "I -- You know, of course, I'm going to continue to buy treasury securities, so I could buy euros, I suppose." And then what would I do with euros? Invest them in Italy? In the current world, the demand for treasury securities will remain high because what's the alternative? You're going to buy Chinese debt or you're going to buy European debt? Certain amount, yes, but that's not going to significantly impair demand for US treasuries.
>> What we don't know is, at what point do inflation plus interest rate expectations and changes impact the economy? While stock markets are said to take the stairs up and the elevator down, interest rates seem to have taken the elevator up, but could also end up taking the stairs down.
>> I believe and the Fed is certainly signaling that this level of interest rates will obtain for another year. And I don't think that we're going back to the level of interest rates that we had pre-COVID, even after this inflationary episode is contained. So that pressure will continue to apply. And I think we'll see in the non-bank sector a lot of noise and some significant failures of institutions because of this dynamic that has obtained every time that there's been a substantial inflation and a Fed response, I don't think that it's going to rise to the level of systemic instability in the way that we saw during the great financial crisis, but it will certainly create some drama.
>> Inflation and higher interest rates haven't made much of a dent on demand. But the relationship between federal debt and inflation may be closer than we realize.
>> I would, just as a side note, point out that some of the things where the costs are growing the most, housing, education, health care, it is not surprising that those are actually the three areas that the federal government subsidizes the most through the tax code in a way that I would argue is incredibly inefficient and doesn't make those things more affordable. It actually drives up the costs. So we have very backward policies that make all of the out-of-reach costs of education, health care, and housing worse, not better.
>> At the end of the day, a key question on investors' minds is the risk of a recession, which could be impacted by the debt level, but could also dramatically affect the debt level.
>> One of the questions that, you know, the market keeps on asking itself is if a recession is going to happen, you know, sooner than later. At PGIM Fixed Income, you know, we do think that the odds of recession are elevated over the next 12 months, just to frame that a little bit if the steady state for a recession is 10%. Meaning, you know, in any given year, the odds of recession are about 10%, we have a 25% probability of recession in the coming year. So we're two and a half X what is steady state. So we recognize that there's real risk to recession in the coming year. What's interesting about that, and if you looked at the CBO baseline, deficits has a percent of GDP go to about 8%, which is a deterioration from where we are now. Today, we're around 5%, 6%. But the CBO doesn't have a recession built into that forecast. Think about what has happened over sort of the last few recessions. The fiscal authorities always step in. That has been the reaction function. You have a recession, fiscal policy comes in and tries to help. That, to me, is the biggest challenge to the CBO's estimate of the deficit. And again, I want to be clear, they're not forecasting that, I'm simply saying while I think the CBO estimate is a very good starting point for the conversation and I don't think anyone does it better than them, to be honest, but there's no recession in there. So you're at 8% over the next decade without recession. You put a recession into that scenario and the deterioration will happen again, and likely in earnest. I think recognizing that the likelihood of having a recession over the next decade is very elevated, then, yes, I think that the deficit problem, particularly given the fact that we don't even have recovery in the deficit built in in the next decade, I think will just continue to remain a challenge.
>> A much bigger risk is the potential for an actual debt default. In 2011, the debt ceiling crisis triggered standard and poors to downgrade the US credit rating for the first time ever. Significant volatility was seen in the fixed income and equity markets. The cost of debt that consumers held went up on many things, from credit cards to car loans to mortgages. But back in 2011, the country avoided default. We don't know the potential impact of an actual default and how global macroeconomic and geopolitical factors might affect it positively or negatively. With so much at stake, is it reasonable to think the US or other developed countries will ever get the debt back in line?
>> It's not rocket science. Our borrowing, our interest payments, our debt trajectory are so large that in order to deal with them, every single thing has to be on the table. You can't do this without raising taxes. You can't do this without reducing spending. You can't do this without fixing entitlements. And you can't do this without trying to grow the economy. Just to stabilize the debt where it is today would take savings of about $7 trillion. To balance the budget would be more than twice that much. The last time we did that was never. We've never saved as much money in a budget deals that would require to balance the budget right now. Rather than shooting for unachievable goals, we should try to make as much progress as is politically possible and realize we're going to have to make incremental improvements. The only answer I really think is wrong is pretending that it's OK to borrow indefinitely or to borrow as much as we are or not pay for anything. But there are perfectly legitimate different preferences and values and policy choices in this discussion. I would just like it if we could get back into the parameters of how would you pay for that. How would you reduce the debt?
>> Good food for thought, especially as we enter the election cycle in the US and other countries. Perhaps it's not a coincidence that November 5th, World Tsunami Awareness Day, is the same day as the next general election in the United States. Will candidates be sounding any warning sirens? Or will the massive wave of federal debt just roll off? Thanks to our experts, Randy Quarles, Maya MacGuineas, and Tom Porcelli for their insights on the current and projected federal debt. The Outthinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review.