How to understand (and invest for) the threat of greater fiscal tradeoffs

The United States is on an unsustainable fiscal path that will likely require government action to avoid a crisis. We believe investors should keep an eye on this long-term issue and consider steps they might take to protect themselves.

Evidence of potential fiscal troubles has long been accumulating. Then, on August 1, the rating agency Fitch issued a wake-up call: It downgraded U.S. debt from AAA to AA+. 

As significant as that downgrade was, the markets seemed indifferent to it.¹ Their nonreaction was likely due to the fact that the deficit problem is too far into the future to price its tail risk efficiently. Also, previous doomsday predictions have been revised, leading many to treat such forecasts like the boy who cried wolf.

We believe the United States will not suffer a fiscal crisis. Still, taxpayers should beware: One of the key ways the government is likely to avoid this fate will be by raising taxes to increase revenues. Therefore, investors may want to consider making tax-efficient investing a priority in the coming decade.

While history has rarely seen a sovereign crisis in a developed country that issues its own currency, “rare” does not mean impossible. Last fall, the United Kingdom had what we view as a mini-debt crisis that led to unprecedented volatility for the currency of a G7 country: The pound depreciated by 10% in a few weeks. And in the 1920s, post–World War I France faced a full-fledged fiscal disaster, with the country’s solution forcing the French franc to depreciate by about 80% relative to the U.S. dollar.

The lesson from both these countries’ crises is this: Ultimately, the currency shoulders the burden of a fiscal crisis. We therefore suggest investors also consider adding real assets to their portfolios to hedge this long-term risk—just in case.

How do we reach these conclusions? Here’s our thinking.

CBO’s dire news re: the U.S.’s fiscal future

The Congressional Budget Office (CBO) startled many in June when it declared that U.S. government debt held by the public was on track to rise to its highest level ever: 116% of GDP in 2030.

Such a high would surpass the nation’s previous peak of 106% in 1946 following World War II.² It is also greater than the CBO previously had envisioned, stemming from the pandemic and its associated fiscal spending.

In principle, this shift to a higher debt level will have a cost associated to it. Indeed, the U.S. economy has already paid some of this cost in the form of higher inflation.³

It’s thought that the uncontrollable rise in the budget deficit will likely be the main culprit responsible for pushing government debt to new all-time highs. By the mid-2030s, all federal revenues will be required to fund mandatory government spending alone (i.e., to fund entitlement programs such as Medicare, Medicaid and Social Security, interest on debt plus other mandatory programs such as unemployment insurance and veterans’ benefits).⁴

At that point, there would be zero funds for such basic functions as defense, roadwork, the judiciary and so on—unless the federal government borrowed and went into even deeper debt. Such a spiral, if unchecked, would be dire. The CBO foresees that by the early 2050s, the overall U.S. fiscal deficit, if unaddressed, will grow to 10% of GDP.⁵

This projection is ominous and should be taken seriously. However, we are skeptical about its exactitude, given that prior CBO projections have proven overly pessimistic. For example, in 2009, the CBO thought healthcare spending would surge; instead, it flatlined.

Indeed, in 2009,⁶ the CBO stated that 2024 was the year when mandatory government spending would outstrip total U.S. revenues.⁷ But then improvements in healthcare spending (on Medicare and Medicaid) led the CBO to push back this deadline by a full decade—to 2034.

The CBO said its dramatically revised projections for healthcare spending⁸ were due not principally to legislative reforms, but rather as a result of other developments, both positive and negative. 

The positive developments included the following: Generic drugs have slowed drug price inflation; care practitioners have improved some disease management; cost-saving technologies were implemented, particularly to treat cardiovascular diseases. Together, such factors helped healthcare inflation to fall below overall U.S. inflation in the 2010s.

However, a negative development also has decreased government spending on healthcare relative to the prior projections (i.e., Americans’ increased rate of morbidity).

Life expectancy took a huge hit during the pandemic, resetting back to late 1990s levels. Yet even before the pandemic, U.S. life expectancy was deteriorating relative to all other advanced economies,⁹ which means less expense pressure on Medicare and Medicaid.

What would U.S. debt crisis look like?

One might argue that the United States already experiences a debt crisis of sorts: Congress’s annual showdowns over lifting the debt ceiling and adopting a budget have repeatedly damaged confidence that lawmakers can resolve fiscal issues—all of which played a role in Fitch’s decision to make the downgrade.

However, a true debt crisis for a country like the United States would mean:

1. Tax revenue could no longer finance the fiscal deficit, or at least keep it from spiraling higher
2. Investor demand for Treasury securities would deteriorate dramatically
3. The Treasury would be forced to ask the central bank to finance the deficit directly, in a way that supersedes the central bank’s inflation objectives

This scenario is not playing out now—nor is it likely in the future—for a number of reasons. 

For one: The debt-carrying capacity can be mind-bogglingly high for countries such as the United States that issue nearly all sovereign debt in domestic currency, in this case the USD, which is also a global reserve currency.¹⁰ For example, a debt crisis still hasn’t arisen in Japan (which issues its debt essentially entirely in yen)—even though that country’s sovereign debt-GDP ratio is currently at 228%, more than twice of the United States.¹¹

Indeed, the United States and Japan can never technically default, as they can always print domestic currency to pay their debts. Little wonder then that the capital markets allow them to sustain higher equilibrium levels of debt¹² than countries such as Argentina and Turkey, which each have issued more than 60% of their government debts in a foreign currency.

Still, the United States could quasi-default. The government could be forced to borrow money from the central bank to fund public spending, causing a dramatic depreciation of the dollar and/or spiraling inflation.

Instead, today’s Federal Reserve has been doing the exact opposite to counter the country’s recent high inflation. The Fed has been reducing the size of its balance sheet.

It is historically very rare for a government to borrow money from its central bank to finance public spending (debt monetization). But it can—and has happened. The last time it occurred for a member of today’s G7 nations was 100 years ago: in France during the 1920s.¹³

WWI left France with high legacy debts and little domestic capacity to raise tax revenues. When Germany refused to pay war reparations, France borrowed directly from its central bank to finance its post-war reconstruction.

French inflation soared, and the value of the French franc plummeted (by close to 80% versus the USD). France decided to monetize its debt (rather than endure fiscal austerity). The fallout wasn’t pretty; fixed income investors suffered mightily.

Yet historians today are still debating how negative France’s choice ultimately was to the country’s real economy.¹⁴

More recently, we believe the United Kingdom experienced a mini debt crisis during just one month in 2022: The pound sterling fell by about 10% against the dollar—an extreme move for a G7 currency.¹⁵

However, this currency depreciation was a response to proposed tax cuts and increased spending, at a time of minimal fiscal space in the United Kingdom. The moves in Gilt yields and the currency reversed when the plans were abandoned.

France’s and the United Kingdom’s experiences illustrate that when fiscal pressures intensify, the currency can serve as the relief valve.

Tough battles ahead over taxes and spending

The U.S. democratic process will decide what budgetary changes will be made to improve the nation’s fiscal sustainability. We make no recommendations and have no preferences. We can, though, observe facts that will underlie discussions about how to stave off a potential quasi-default.

First, it is unlikely the problem will be solved by potential savings from increased means-testing for entitlement programs. For example, according to a CBO study in December 2022, means-testing that reduces benefits only for top-quintile earners would reduce Social Security outlays by a total of $40 billion by 2032.¹⁶ However, $40 billion is miniscule compared to total Social Security expenditures of $2.27 trillion by 2032, in the CBO baseline projection. And there is a firm bipartisan consensus against more sizable cuts to these programs.¹⁷

Also: It’s not obvious that the U.S. government has a spending problem in its other mandatory categories (unemployment compensation, the nutrition assistance programs, veterans’ benefits, etc.). This component of spending surged during the pandemic. However, it is expected to drop back to its historical average (relative to GDP) over the next decade.

Investors: Watch debt payments versus growth

What should investors be looking for, and how might they consider hedging the long-term risk of possibly deteriorating U.S. fiscal dynamics?

Keep an eye on R-G: The sovereign debt-to-GDP ratio cannot spiral as long as the interest rate on newly issued debt (R) is below the economy’s structural growth rate (G).¹⁹ Generally speaking, R has been below G for at least the last 20 years.²⁰

However, the CBO is assuming that over the long run, G will fall below R on a sustained basis—sending interest costs spiraling. The agency’s long-term projections show interest costs rising to 6% of GDP by 2050 (double the 3% highs recorded in the 1990s).

In terms of the short term, we believe the rise in interest costs over the last year should be seen as a one-time reset to a higher level (relative to GDP) because of a shift in Treasury bill issuance.²¹ After this reset is complete, the rise in interest costs should become more gradual (especially if, as markets currently expect, the Fed ends up cutting its policy rate in 2024).

To be sure (and pivoting back to the long-term discussion), over the past year, the market-traded real 10-year interest rate has picked up meaningfully, to about 2%. This is getting close to consensus estimates for longer-term economic growth in the United States.

But no one knows exactly what is now causing today’s longer-term real interest rates to rise.

According to J.P. Morgan Corporate Investment Bank Research, one catalyst could be a pickup in expected productivity growth as corporations adopt new artificial intelligence (AI) technologies.²² This gets at a crucial insight: An economy’s fiscal sustainability is intimately tied to its long-run rate of productivity growth. If productivity growth picks up in the coming years due to AI (and especially if AI technology contributes to a further bending of the cost curve in the healthcare sector), then the CBO’s baseline outlook could become more favorable to debt sustainability.

Alternatively, this year’s rise in real interest rates could signal more intense tradeoffs are coming. Budget and policy analysts are highly uncertain about the cost of the Inflation Reduction Act (the historic climate related legislation passed in 2022). It could be more than double what the CBO currently assumes.²³ If so, prospects for U.S. fiscal sustainability may actually be more dire.

How to hedge the long-term risk?

Consider tax-efficiency and real assets as hedges against a potentially dicey fiscal outlook over the next decade.

Because the federal government is likely to try to raise the tax share of GDP, investors may want to pay a lot of attention to tax efficiency and should consider tax-loss harvesting strategies. Also, as we noted in a previous article, separately managed accounts (SMAs) can offer advantages over exchange-traded funds (ETFs) due to their flexibility in terms of potential tax savings, benefits when it comes to tax-aware transitions and tax-efficient gifting.

And in case all else fails (U.S. economic growth fails to pull us out of the hole, political gridlock prevents necessary changes to taxes and government spending, recently passed legislation ends up being more costly than assumed), then it’s not too far-fetched that the United States might experience an event that is qualitatively similar to France’s in the 1920s.

Hence, we also recommend that investors who like to be very prepared consider adding real assets to their portfolios, given the historically tight inverse relationship between the U.S. dollar and a diversified portfolio of real assets.

¹The dollar was stable throughout the downgrade and Credit Default Swap markets, while they reacted to Congress’s fierce debates over the debt ceiling in the spring, generally did not increase the price of U.S. sovereign risk premia after the Fitch downgrade at the end of the summer.

²The CBO is a non-partisan agency in the U.S. government that provides budget and economic information to Congress. Twice a year, it provides long-term budget projections that set the baseline for expectations about government debt, deficits, economic growth and interest rates.

³If one looks at the high-frequency (monthly) data on the government debt-GDP ratio, the ratio peaked in April 2020 at 102.1% (from 81.3% in January 2020) and then fell to 93% by March 2023, in part because of the inflation surge that began in 2021.

⁴United States Office of Management and Budget, Congressional Budget Office, Haver Analytics. Data as of August 1, 2023.

⁵United States Office of Management and Budget, Congressional Budget Office, Haver Analytics. Data as of August 1, 2023.

⁶2009 was the first year the CBO started providing longer-term budgetary projections.

⁷Then, the CBO was projecting healthcare spending at 12.2% of GDP in 2050. Now, the CBO projects healthcare will be just 7% of GDP in 2050.

⁸“Re: CBO’s Projections of Federal Health Care Spending,” Letter to Sheldon Whitehouse from Phillip L. Swagel, CBO Director, March 17, 2023.

⁹Deteriorating U.S. life expectancy is not due to low life expectancy in old age, but rather to Americans being more likely to die before old age (with “old age” defined as age 70 or greater). This crisis in life expectancy stems from a range of lifestyle and diet-related factors, including a high prevalence of obesity-related diseases (diabetes, cardiovascular disease, etc.), elevated drug and alcohol consumption, high suicide rates and high murder rates. See John Burn-Murdoch, “Why are Americans dying so young?” Financial Times, March 31, 2023.

¹⁰Economists generally agree that because the USD is a global reserve currency, the United States’ debt carrying capacity is higher relative to other countries, though there no precise formula to quantify how much higher.

¹¹This is the Bank for International Settlements’ 2022 estimate of the debt-GDP ratio for Japan. The BIS attempts to remove inter-governmental debt issuance so as to avoid double counting. Including inter-governmental debt issuance, Japan’s debt-GDP was 259% in 2022.

¹²Emerging market sovereigns are typically stuck between a rock and a hard place when it comes to debt issuance. They don’t typically wish to issue a large fraction of debt in a foreign currency, but they usually must in order to raise capital for development.

¹³International Monetary Fund. Data as of August 15, 2023.

¹⁴Interestingly, France’s debt-GDP ratio then was approximately what Japan’s is today. For a full history of the monetary developments and crisis France faced in the 1920s, see: Ralph Worthen Tryon, “The French Franc in the 1920’s,” Massachusetts Institute of Technology, August 27, 1979. The debate among historians examines the different choices France and the United Kingdom made: France in the 1920s chose to de-peg from the gold standard and monetize the government’s deficit, but the United Kingdom chose fiscal austerity and a commitment to the gold standard. Fixed income investors not surprisingly suffered more dearly in France than in the United Kingdom. However, real GDP per capita growth in France exceeded that in the United Kingdom by 47% points through this period (1919–1926), according to the Maddison Project Database.

¹⁵Bloomberg Finance L.P. Data as of September 22, 2023.

¹⁶Reduce Social Security Benefits for High Earners,” The Congressional Budget Office, December 7, 2022.

 ¹⁷See, for example: “Few Americans support cuts to most government programs, including Medicaid,” Pew Research Center, May 26, 2017; “Public Wants Changes in Entitlements, Not Changes in Benefits,” Pew Research Center, July 7, 2011; “How Americans evaluate Social Security, Medicare, and six other entitlement programs,” YouGov, February 8, 2023.

¹⁸“What options would increase federal revenues?” Tax Policy Center Briefing Book, May 2020.

¹⁹In a given year, the percentage point change in the debt-GDP ratio is equal to the primary deficit (i.e., the deficit excluding interest rate payments) plus R-G multiplied by the debt to GDP ratio. It can thus be seen that if R is less than G, the debt ratio cannot rise in a multiplicative manner; if R is less than G, a widening in the primary deficit (say, due to an exogenous shock like a pandemic) will cause the debt-GDP ratio to rise, but it will rise concavely, not convexly, ultimately settling at a higher but stable level in equilibrium.

²⁰We say “at least” because this comparison between R and G, in principle, should be done in real terms, and since a liquid market for Treasury Inflation Protected securities didn’t exist much longer than 20 years ago, we restrict the comparison to starting in 2003.

²¹Putting aside the Treasury bill issuance volatility associated to the debt ceiling, the Treasury has been making a conscious effort to raise the bill share of outstanding debt to a strategic level of 15–20%, per recommendations made by the Treasury Borrowing Advisory Committee back in 2020. From 2012 to 2019, the bill share averaged under 10%, as back then the Treasury was extending the average maturity of its debt amid low interest rates. As of August of this year, the bill share finally crossed back above 15% (the first time since the mid-1990s, outside of extraordinary periods such as the acute phase of the pandemic or the Global Financial Crisis). The upshot is that the rise in interest costs since the start of 2022 (from $600 billion annualized to $850 billion annualized as of August) should be seen as a one-time reset to a higher level relative to GDP, rather than the beginning of an interest cost spiral. This is, at least, regarding the short run outlook for interest costs; over the long run, interest costs could spiral, but that would be due to the R-G dynamics that we discussed.

²²Michael Feroili, “Post-pandemic productivity improves,” J.P. Morgan Corporate Investment Bank Global Research, August 9, 2023.

²³Neil R. Mehrotra and Sanjay Patnaik, “How much will the climate provisions in the IRA cost, and what will they achieve?” The Brookings Institute, April 27, 2023.