Is the deficit threat being overhyped?

This accounting framework can help contextualize today’s fiscal deficit, which is equal to about 7.5% of GDP (in 2018–2019, it averaged 6.4% of GDP).

Let’s take the three balances one at a time.

The trade deficit is hindering, not helping

Over the last 30 years, America has run a persistent trade deficit, currently equal to 3.7% of GDP. (This shows up as an external sector surplus in Exhibit 1, since the accounting framework views the balance from the foreign sector’s perspective.) We’ll be using the terms “trade deficit” and “external sector surplus” interchangeably.¹

The trade deficit can be thought of as depressing aggregate demand in the United States (and demand is, of course, central to growth).² Moreover, the trade deficit is “structural,” as it is driven primarily by the U.S. dollar being the world’s reserve currency (more purchasers drives up its relative value), which makes U.S. exports less competitive than they otherwise would be. At the same time, Asian manufacturers, particularly in China, are highly competitive. The 2018–2019 U.S.-China trade war didn’t change this structural backdrop, and we’re skeptical that it will change under President-elect Trump’s second term.

This setup means that for the U.S. economy to continue to grow, demand needs to be stimulated elsewhere to offset the trade deficit’s persistent drag.³

A constrained private sector 

What do we mean by “demand needs to be stimulated elsewhere”? We mean by some combination of the domestic private sector and/or by the government running a deficit. We turn to those two balances next.

The private sector hasn’t shown much willingness recently to create new credit (credit is another form of the “money” the economy needs to create in order to continually grow). The regional banking scare in 2023 and the Federal Reserve’s tight monetary policy stance have led to stricter bank lending standards. As a result, private sector credit growth is depressed (Exhibit 2).

Under these conditions, the fiscal deficit has been a crucial ingredient in maintaining money growth and thereby support for aggregate demand. Indeed, the U.S. economy is on pace to achieve a solid outturn of roughly 2.5% GDP growth in 2024 (after 2.9% growth in 2023), which would likely have been implausible with a smaller fiscal deficit.

The risks of shrinking the fiscal deficit

To be sure, this logic—that the fiscal deficit is crucial for growth—could change. One way is if the Federal Reserve (Fed) pursued looser monetary policy. This could stimulate stronger private sector lending, relieving the fiscal deficit of carrying the burden. Looser Fed policy could even lead to a fiscal surplus, especially if private credit creation really boomed (and the private sector balance in Exhibit 1 moved into negative territory). But there are two practical complications:

Lending booms don’t have great track records 

The last two times the fiscal deficit was meaningfully reduced—the result of easy monetary policy and private credit creation—bubbles formed. One was during the late 1990s’ dot-com bubble. The other was the mid-2000s’ rise in private credit related to housing. Both bubbles subsequently popped, damaging the economy with the early-2000s’ “jobless recovery” and the devastating Great Recession following the 2008 global financial crisis.

Contrast that to fiscal spending: Ever since around 2013, a persistent and relatively stable fiscal deficit, along with private sector debt frugality, has coincided with a more steady and predictable business cycle.⁴

The point is, shrinking the fiscal deficit via easier monetary policy could result in a more volatile boom-bust business cycle. Is that really a wise path forward? We suspect the Fed understands this trade-off, and we expect policymakers to transition toward a more neutral monetary policy stance, rather than a stimulative one that could reignite the domestic private credit cycle.

U.S. national security is a priority

Another consideration is that today’s elevated fiscal deficit, in part, reflects the government’s willingness to spend more on industrial policies. It’s a strategic imperative to upgrade infrastructure, create supply chain resiliency by producing semiconductors domestically, and to accelerate the transition to renewable energy.⁵ The Republican sweep in recent U.S. elections may change the mix of priorities in the industrial policy agenda, but we don’t expect a U-turn.

Furthermore, the Fed must take the government’s industrial policy agenda as given. The Fed is an independent central bank whose goal is maximizing employment while maintaining price stability. The industrial policy agenda has undoubtedly changed the mix of what has driven growth in recent years—more the industrial sectors and less the rate-sensitive sectors such as housing.⁶

That shift simply reflects how a modern economy with an independent central bank operates: There is no free lunch.

Here’s the point: A campaign to reduce the fiscal deficit might result in looser monetary policy and, in turn, more housing activity, but that would come at the expense of the current upgrades to national security via renewed federal industrial policies.

Would that really be a good and prudent path, especially amid growing geopolitical tensions globally and a great power competition between the G7 and BRICS+?⁷

Is the sky the limit?

If you accept that the fiscal deficit is a crucial ingredient in growth and supports vital national security interests, a natural question arises: Are there any limits? Can the United States continue to run a fiscal deficit equal to 7.5% of GDP indefinitely?

One catalyst that could force the United States to sharply and abruptly shrink the fiscal deficit would be if definitive signs arose of what economists call “fiscal dominance.”

Fiscal dominance occurs when the public debt (and interest servicing costs) rise so high that they overwhelm the economy, such that the Fed can no longer manage inflation by manipulating interest rates.⁸

Yet we can say definitively that fiscal dominance hasn’t happened in recent years—and isn’t happening today. Yes, the Treasury’s interest payments have risen with Fed rate hikes.⁹ But that stimulative effect has not drowned out the restrictive impact of the Fed’s tight monetary policy stance in recent years.¹⁰

Interest expense is a crude metric

Core to the story of fiscal dominance is the cost of servicing the public debt. We would concede that gross U.S. government interest expense, as a share of GDP, is certainly on the high side—only surpassed by Brazil in Exhibit 3.¹¹

A crucial point of inquiry is whether government spending is contributing to growing the supply side of the economy so that it can accommodate higher levels of aggregate demand, which is crucial for keeping inflationary pressures contained. Net interest spending makes up about 10% of U.S. federal outlays. The other 90% contributes to the overall economy’s functioning, in particular the industrial policy spending. This will contribute to infrastructure upgrades and expanding aggregate supply.

Given this, and the poor relationship between debt service expenses and inflation, it’s just not clear how close to fiscal dominance the U.S. economy might be, even though the conventionally referenced debt-to-GDP ratio is on the high side, relative to history.¹²

The truth is that economists don’t know the limits of the U.S. fiscal deficit. They don’t know what total debt stock, or interest expense, would tip the economy into fiscal dominance. There’s a Nobel Prize waiting for someone who can figure this out.¹³

While not worthy of a Nobel, we have ways of seeing if the capital markets are trading as though U.S. fiscal dominance risks are high.

Do the markets show any evidence of fiscal danger?

What would it look like if the markets got spooked by the trajectory of the fiscal deficit? The United Kingdom’s mini budget crisis in the fall of 2022 was instructive.

What unfolded was the simultaneous decline in all U.K. assets: U.K. stocks, the GBP currency and U.K. gilts all sold off together when the U.K. government proposed a large fiscal expansionary bill.¹⁴

Exhibit 5 shows the percentage of trading days from 2022 to the present, in nine major economies, in which all domestic assets sold off simultaneously. Note the United States: It screens the lowest. 

The United Kingdom screens on the high side, though below Brazil.¹⁵

These analytical tools, which track assets’ simultaneous price movements, can serve as powerful signals to monitor, especially because an actual fiscal crisis likely wouldn’t be like a light switch that is suddenly turned on one day. Market trading risks, with respect to the deficit, would likely be visible for months, quarters or even years before a full-blown crisis erupted. 

That the United States is screening as well behaved on these metrics should be comforting to investors. In addition to these metrics, we are also tracking investor demand for U.S. Treasuries at new-issue auctions, which continues to look normal and unthreatening.¹⁶

One more topic that comes into play in discussions of the fiscal deficit is the rise in government spending on entitlement payments (Social Security, Medicare, Medicaid, etc.). Having treated that in depth before, readers interested in the subject are referred to our previous coverage.¹⁷

Innovation and household wealth are also crucial to monitor

As we’ve written before, a U.S. fiscal crisis would be the flip side of a poor productivity outcome at the macro level.¹⁸ However, to the contrary, the U.S. economy currently still appears to be pushing the frontiers of new technologies that can drive economic productivity higher. 

Deficit pessimism is equivalent to pessimism about the prospects of artificial intelligence (AI). The stock market is not currently pricing pessimism, given the high valuations of the companies at the forefront of the AI revolution.

Where the rubber ultimately meets the road is household wealth. An economy—such as that of the United States—that continues to innovate and push productivity forward is an economy that is becoming wealthier and wealthier over time. A key answerable question, therefore, would be: Is U.S. government debt rising faster than the country’s overall household wealth? 

It turns out the answer is no.¹⁹

Indeed, Exhibit 7 shows that the ratio of total U.S. government debt to the total net worth of U.S. households has been falling over the last 10 years and is currently at about 20%.²⁰ It is often said that the pandemic resulted in an explosion of government debt. More appropriately, the narrative should be that the pandemic resulted in an explosion in household wealth: Since 2019, while U.S. government debt has increased by about USD 7 trillion, it has been dwarfed by the simultaneous increase in U.S. household net worth, by USD 35 trillion.

The public debt could become a greater issue of concern if this higher wealth weren’t filtering back to the government in the form of higher tax revenue. It’s debatable whether that is the case today.²¹ Monitoring the translation of greater wealth into tax revenue is an important ongoing exercise for budget analysts. 

Investment implications

We think the issue of the deficit becomes less scary once it is appropriately recontextualized.

We began with a fundamental macroeconomic accounting framework, examined history, the global context, the absence of market alarm signals and other encouraging metrics.

We do not think deficit concerns warrant large-scale changes to multi-asset portfolios. Yet ongoing concerns about the deficit are likely to contribute to greater volatility in the U.S. Treasury market—or, at the least, to alter the risk-reward profile of investing in longer-dated U.S. Treasury securities or securities with a comparable duration.

Given these considerations, within fixed income portfolios, our managers have been focused on efficiently maximizing income while being cognizant of the risks associated with extending duration, all while acknowledging that fixed income remains our preferred option to buffer against potential recession risks.

¹Technically, the external surplus is the net lending/borrowing position of the external sector, excluding capital transfer payments to the rest of the world made by U.S. domestic sectors. This encompasses the U.S. trade deficit, and also America’s income balance (from salaries and from investment assets) with respect to the rest of the world, and includes the tax balance as well (the net of taxes paid to the United States from overseas and tax payments made by U.S. domestic sectors to the rest of the world).

²A large portion of the money sent abroad due to the trade deficit gets “recycled” back into USD assets, but this recycling is mostly saved in financial assets rather than spent in the real economy.

³The trade deficit has not been the only structural drag on U.S. aggregate demand in recent decades. Another relevant factor is the rise in income and wealth inequality. The Gini ratio measuring the income distribution of all households in the United States rose from 0.40 at the start of the 1980s to 0.49 as of 2023, according to census data (0.5 is considered a severe income gap).

⁴Except for the COVID-driven recession and inflationary recovery, of course, which was an exogenous shock.

⁵We first wrote about renewed U.S. industrial policy, and the drivers of it, more than a year ago: Joe Seydl, “The Opportunity in renewed U.S. industrial policy,” J.P. Morgan Private Bank, January 1, 2023. https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/the-opportunity-in-renewed-us-industrial-policy

⁶Said differently, without the U.S. government’s pivot toward industrial policy, interest rates would likely be lower than where they currently are, and housing activity would likely be stronger.

⁷The Group of 7 is an intergovernmental forum of Canada, France, Germany, Italy, Japan, the United Kingdom, the United States (and an eighth member, the European Union). The BRICs+ are Brazil, Russia, India, China (BRIC) plus South Africa, Iran, Egypt, Ethiopia and the United Arab Emirates (UAE). We have previously written about the G7-BRICS+ growing geopolitical power competition. Joe Seydl, “How do geopolitical shocks impact markets?” J.P. Morgan Private Bank, May 24, 2024. https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/how-do-geopolitical-shocks-impact-markets

⁸Under fiscal dominance, as the Fed raises interest rates to reduce inflation, inflation would get a counterproductive stimulative effect from the higher debt service payments. After all, more than 75% of U.S. Treasury debt is held by domestic residents and institutions.

⁹The U.S. Treasury’s interest payments more than doubled, from around USD 400 billion in early 2022 to nearly USD 900 billion today; 12-month rolling sum.

¹⁰Since the Fed began hiking, core U.S. inflation has fallen from 5.5% year-over-year in Q1 2022 to 2.7% in Q3 2024 (and even lower, if we consider 3-month or 6-month inflation, 2.35% and 2.30%, respectively). Meanwhile, the labor market has slackened to a degree that slack is now modestly higher than just prior to the pandemic, in our view. We point readers to a new metric for labor market slack produced by the New York Fed: the Heise-Pearce-Weber (HPW) Tightness Index, which is constructed from data on quits and vacancies per job seeker. Sebastian Heise, Jeremy Pearce and Jacob P. Weber, “A New Indicator of Labor Market Tightness for Predicting Wage Inflation,” Federal Reserve Bank of New York, October 9, 2024. https://libertystreeteconomics.newyorkfed.org/2024/10/a-new-indicator-of-labor-market-tightness-for-predicting-wage-inflation/

¹¹It should be noted though that net U.S. interest payments (which nets out U.S. Treasury debt owned by U.S. governmental entities) are lower, at 2.4% of GDP. Gross is shown in Exhibit 3 to make an appropriate cross-country comparison.

¹² The total public debt-GDP ratio for the United State is 120%, but this overstates due to a large portion of the debt held by U.S. governmental entities. Total privately held Treasury debt-GDP is 80%. From 1990 to 2019, this metric averaged 44%.

¹³ And good luck: The last time two influential Harvard economists claimed to discover the limits of fiscal spending and debt, their analysis was rebuked and found to be flawed from Excel spreadsheet errors. Ruth Alexander, “Reinhart, Rogoff … and Herndon: The student who caught out the profs,” BBC News, April 20, 2013. https://www.bbc.com/news/magazine-22223190

¹⁴ The market moves eventually reversed when the Truss government backed away from the fiscal expansion, and the whole debacle contributed to former Prime Minister Liz Truss losing her job and breaking the record for the shortest-serving prime minister in British history.

¹⁵ The Brazilian real is not a reserve currency, and the country has struggled with investor concerns regarding the size of the public debt for many years. Brazil’s outsized deficit (7% of GDP in 2024) primarily stems from increased bureaucratic structures, personnel expenses and public machine maintenance costs, as opposed to productive infrastructure development.

¹⁶ “The Deep Dive: What to expect when you’re expecting a fiscal meltdown?” J.P. Morgan Private Bank, October 2024.

¹⁷ Joe Seydl, “How to understand (and invest for) the threat of greater fiscal trade-offs,” J.P. Morgan Private Bank, October 9, 2023. https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/how-to-understand-and-invest-for-the-threat-of-greater-fiscal-tradeoffs

¹⁸ Joe Seydl, October 9, 2023.

¹⁹ It is very odd that the government debt-to-GDP ratio has become the conventional metric that analysts examine in the context of debt sustainability because it’s an apples-to-oranges ratio (i.e., comparing a stock to a flow). It’s a common finding in macroeconomics that the wealth-to-GDP ratio has been rising in recent decades for the largest economies around the world. Given this, it’s not surprising that the debt-to-GDP ratio would be rising over time, reinforcing the need to examine a better stock-to-stock ratio, such as the ratio of government debt to household net worth. See Exhibit 4 in Lola Woetzel, Jan Mischke, Anu Madgavkar et al., “The rise and rise of the global balance sheet: How productively are we using our wealth? McKinsey Global Institute, November 15, 2021. https://www.mckinsey.com/industries/financial-services/our-insights/the-rise-and-rise-of-the-global-balance-sheet-how-productively-are-we-using-our-wealth

²⁰ While government debt is not directly “backed” by household wealth in a legal sense, there is an implicit connection because governments rely on their economies—and thus their citizens—to generate the resources needed to manage and repay the debt. 

²¹ Federal tax revenues relative to GDP have been falling over time (from 17.8% from 1980 to 2007 to 16.5% from 2008 to 2023), but much of that decline appears to be driven by the 2008 global financial crisis, and the slow and prolonged recovery following it. It remains to be seen how much tax revenue can be generated in a stronger cyclical economy, such as what has been achieved in recent years.