Before getting into the impacts of debt and a potential government shutdown, we’d first like to acknowledge that there is an obvious political element to this national conversation. However, as financial advisors, we’re not in the business of political commentary. Matthew and I and the rest of our team view our roles as neutral observers, tasked with the job of responding to the hand we’ve been dealt rather than commenting on what kind of hand it is. That being said, our aim here is to provide insight on what is and how that might affect our portfolios and our approach to investing. We hope you find that commentary valuable in light of our partnership with you and your financial legacy.
There has been much talk in the news recently of the potential for a government shutdown in the coming weeks if Congress fails to reach an agreement on the federal budget (though the topic seems a distant second to the news of Taylor Swift attending the Chiefs-Bears game on Sunday, but I digress). This debt ceiling dance has taken on a familiar tone, as the threat of a shutdown has become a more common event in recent years. One reason for this is an increasingly partisan government, a topic we’ll leave for someone else to explore. The focus of this article - a renewing deficit and growing debt - are longer trends worth exploring.
U.S. federal debt has increasingly grown over the past several decades, as illustrated in the following chart by the St. Louis Fed:
On its own, this chart may seem alarming. After all, if you came to our office and showed us a graph of your personal debt that looked like this, I feel confident a lengthy discussion would follow. However, you may also recall that when we talk about debt in the context of personal finances, the idea that debt can be valuable when it’s used to invest for growth also holds true at an institutional level. And in this case, it’s important to factor in the fact that over that same time frame, the U.S. Gross Domestic Product (GDP), which is the total value added of the goods and services produced by the U.S., also grew.1 With that in mind, we can also look at debt as a percentage of GDP, and we see a less steep but still growing line:
This trend is meaningful for a variety of reasons, the most overarching being that significant federal debt affects both the stability of a nation'’s economy and how both foreign and domestic investors view it. Similar to how carrying substantial personal debt can hinder your ability to borrow more, when countries have unhealthy balance sheets, investors may be less willing to invest with them, which can impact their ability to grow, ultimately hurting job prospects and wages. In some instances, this may lead to a broader crisis as seen in places like Venezuela in 2016 and Greece in 2009.
The U.S., however, is a unique case study because the U.S. dollar is not only the global reserve currency but, because of the historical stability of the U.S., treasuries are often considered a safe haven asset in times of trouble. Ironically, this means that when global financial instability occurs, even when the U.S. causes it, it often leads to an inflow of investment, which matters for several reasons. The first is that there is a lower likelihood of volatility because our currency is used globally. This is in part because of the size of our economy. Again, it’s helpful to think of this in terms of personal debt. Banks are willing to offer more debt to high earners because they have a lot of income to service their debt. In 2022, U.S. GDP was $25trn, followed by China at $18trn, and then Japan at $4trn. So, while the U.S. is carrying a lot of debt, it is also making a lot of money in a widely circulated currency, and some of that is a byproduct of spending, which one could argue was financed by the same debt under consideration.
The second reason the U.S.’s unique position is meaningful is that it means that there is and likely will remain significant demand for U.S. debt. One concern we often hear about the growing U.S. debt is that China is a significant holder of our debt, which could pose a geopolitical threat. However, there is a bit of hedge to this threat, in that it would be equally dangerous to China’s economy, if not more so, for them to try to dump U.S. treasuries. Doing so would require them to sell foreign reserves and either invest in an alternative reserve or convert dollars to yen.
Investing in an alternative reserve would be difficult. With maybe the exception of the European Central Bank, no other major national central bank could provide enough debt to come close to replacing China’s holding of U.S. debt. In the latter instance, converting a large quantity of U.S. dollars to Chinese yen would drive up the price of yen, causing the Chinese currency to appreciate and making China significantly less competitive as an exporter of goods – which would hurt China’s economy. Finally, there is a large market for U.S. treasuries, particularly in times of instability, and one could argue that such a large currency conversion may actually increase demand for U.S. treasuries. All that to say, the threat of China trying to weaponize U.S. debt is probably low, given the implications of how interconnected the global economy is.
This doesn’t necessarily mean debt is a good thing, but it offers some perspective. So, is significant federal debt a bad thing? Maybe. And maybe not. Like so many other financial matters, perspective matters. For one, significance is a relative term and it’s worth noting that the U.S. is not the only country to carry significant debt, in fact, both Japan and Italy have fiscal debt that exceeds the U.S.’s as a percent of their GDP. At the same time, if the world believes that our debt has become too high or we default on our debt, there would be major economic consequences.
Returning to our personal debt analogy, financial health and stability matter. So long as I’m working and making payments on my debt, my bank is happy to loan to me. After all, the bank makes money off of the interest on my debt, and lenders enjoy making money. However, if I start to miss my loan payments and begin giving the impression that I may not be able to repay my debt anymore, the bank may begin to worry about its loan to me. It may start asking me to pay more on any additional debt that I need, or it may stop lending to me in the future.
On a global scale, this is compounded by the interwovenness of the financial markets. Markets don’t like uncertainty, which is why they become more volatile when talks of failing to reach an agreement on servicing our debt occur. Furthermore, a government shutdown, while likely short-term, will affect our economy. Government entities employ a lot of people, and having them stop working will have an impact on GDP, albeit likely a short-term one.
What can we conclude from all this? For us, it’s helpful to separate the conversation into short-term and long-term implications. As I just mentioned, the short-term implication is market volatility arising from uncertainty. A government shutdown will hurt GDP because fewer people will be working and spending, and the sum of our economy is really just all the transactions between buyers and sellers of goods and services added together. While these are topics for another time, the current market volatility we're seeing is also a byproduct of the ongoing UAW strikes, and the recent tone coming from the Federal Reserve that rates may need to be left higher for longer. Altogether, we expect some choppy market movement likely through the end of the year. However, we believe Congress will eventually come to some kind of agreement, even if it is short-term.
In the longer run, the growing federal deficit could pose a very real threat to the U.S. economy if it balloons to a point where U.S. debt comes to be viewed as a riskier investment. It also reduces our ability to utilize debt to respond to potential crises in the future. When times are good, it’s smart to have some margin so that when times are tough, there’s room to respond. Carrying a large debt load leaves the government with less optionality for responding to future pandemics, conflicts, or recessions.
Of course, we will continue to reiterate that we don’t know what the future holds. When it comes to economics and the financial markets, so many factors are at play that could influence the federal debt burden - trade balances, foreign relations, interest rates, inflation, exchange rates... I could probably write a book about how nuanced this topic is (and I’m sure someone has). Nevertheless, it’s definitely something that the markets will continue to factor in and something that we want to be mindful of in our portfolio construction. At the moment, we believe the risk of the current debt level is low, and the effects of a government shutdown would likely be temporary. They’re also mitigated somewhat by globalization and how interdependent the world’s economies are. For now, we continue to monitor the news as it unfolds and remain defensive and diversified to weather whatever storms the future holds. As always, if you’d like to discuss your specific investments, please don’t hesitate to reach out.
Council of Economic Advisers (US), Gross Federal Debt [FYGFD], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FYGFD, September 25, 2023.
U.S. Office of Management and Budget and Federal Reserve Bank of St. Louis, Federal Debt: Total Public Debt as Percent of Gross Domestic Product [GFDEGDQ188S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GFDEGDQ188S, September 25, 2023.
“Central Government Debt Percent of GDP.” IMF. Accessed September 25, 2023. https://www.imf.org/external/datamapper/CG_DEBT_GDP@GDD/CHN/FRA/DEU/ITA/JPN/GBR/USA.
Cheatham, Amelia, Diana Roy, and Rocio Labrador. “Venezuela: The Rise and Fall of a Petrostate.” Council on Foreign Relations, March 10, 2023. https://www.cfr.org/backgrounder/venezuela-crisis.
“Greece’s Debt Crisis.” Council on Foreign Relations. Accessed September 25, 2023. https://www.cfr.org/timeline/greeces-debt-crisis-timeline.
Silver, Caleb. “The Top 25 Economies in the World.” Investopedia, September 20, 2023. https://www.investopedia.com/insights/worlds-top-economies/.