The amount owed recently eclipsed the size of the economy, you might have heard. That happened once before, during World War II, when the primary driver was temporary, and kind of a biggie: converting the world’s largest economy into a global war machine deployed across two oceans to help free humanity from fascism. We’ll top that peak soon, probably by the end of the decade, only now the money is spent mostly on autopilot old-age programs and compounding interest.
Interest almost single-handedly explains why massive and growing deficits, or amounts added to the debt each year, are the new normal. This year’s deficit is pegged at $2 trillion, or 6% of the economy, an unprecedented high during a peacetime economic expansion. The interest bill is likely to be $1.1 trillion, or more than half of the deficit. A decade from now, it will be $2.1 trillion, or 69% of the deficit, which will itself have risen to 7% of the economy. That projection comes from the Congressional Budget Office, and it is almost certainly too optimistic, because Treasury bond yields recently jumped above levels the CBO used in its math.
Voters have heard similar warnings for more than 30 years, and the math grows ever worse while the consequences never seem to arrive. But look around. The 30-year mortgage rate has jumped a point in a year, to 7.2%, paralyzing buyers and sellers. It might be only the beginning. Inflation, recently 3.7%, hasn’t been below the Federal Reserve’s 2% target for more than five years. For the past two years, the Fed had been lowering its core federal-funds target rate, but in September it shifted to a quarter-point hike, to 4%. Torsten Sløk, chief economist at Apollo Global Management, recently calculated that the Fed would have to keep hiking all the way to 6.75% by the end of next year to bring inflation down to its target. Get ready for 10% mortgages, or else a lot more growth in the cost of living.
Watch out for wilder stock swings, too. Investors in recent decades have gotten used to speedy rescues from market downturns in the form of slashed interest rates and lavish government spending. But what if high inflation and a cranky bond market don’t allow for these interventions? Deutsche Bank macro strategist Henry Allen calls it the end of the safety net. “People should prepare for a world in which volatility of the kind we haven’t seen in many years is kind of normalized again,” he says.
Your reporter writes a debt scolding once or twice a decade. He has taken pains over the years to express equal disdain for both political parties, neither of which has wrapped itself in fiscal glory. If the Democratic takeover says anything about the nation’s budgetary mood, it might have little to do with Democrats. In what has somehow become a forgotten footnote to this election, a sitting president offered $5,000 checks as a perk if his party won, but voters went in a different direction. They probably didn’t take the offer seriously. Or maybe they’re just tired of debt-funded gimmicks.
Let’s turn now to possible paths from here. What does it mean to inflate the debt away, and is that feasible? Is a grand political bargain out of the question? What’s Japanification, and what role might bond vigilantes play? Could an artificial-intelligence growth miracle bring the debt back in line? Read on for thoughts on each of these, and how investors should prepare.
The ‘Inflate It Away’ Fantasy
In a recent Deutsche Bank survey that asked how the U.S. will ultimately deal with its debt, respondents overwhelmingly chose political cowardice. That is, they favored paths that don’t require Congress to act. The top prediction is that America will run inflation hot, which we’ll look at now. A close second was that it will muddle through indefinitely, which we’ll come to.By 1946, America and its allies had prevailed in war, but U.S. debt was left at 106% of GDP—still the record, for a little while longer. The government then allowed most prices to soar, which flattered economic growth, and by 1960, debt was back to 60% of a much higher GDP. Easy peasy? Let’s dig deeper.
The Fed, which back then worked for the Treasury, had capped bond yields starting in 1942, just after Japan attacked Pearl Harbor. The short stuff paid 0.375%, and the long, 2.5%. Patriotic savers, flush from wartime rationing, had lined up for 10-year war bonds, while institutions bought 20- and 25-year paper. As soldiers returned to factories, inflation roared, hitting 8%, then 14%, then 8% over three years ended in 1948. Unrest boiled over. In 1946 alone, more than four million workers walked off their jobs during nearly 5,000 strikes. President Harry Truman at one point threatened to draft railroad workers into the military to force them back to work.
Inflation is a kitchen table issue, and an electoral one. The 1946 midterms were called the Beefsteak Election. To appease angry workers, Truman kept many wartime price caps in place, including for beef. Ranchers, rather than sell at losses, put their cattle out to pasture. Pork ran short, too. Big city butcher shops hung cardboard signs, “No Meat Today.” High-end restaurants paid dearly for black market cuts, while ordinary families ate macaroni and beans. Hospitals appealed for emergency meat allotments to feed the anemic, and at least two resorted to serving horse. Truman briefly considered sending the military to seize pasturing cattle. Weeks before the midterms, he lifted price controls on meat. Republicans nonetheless swept Truman’s Democrats from control in the House and Senate.
Caps on yields remained in place for years. Return on investment for those 10-year war bonds was, well, freedom from tyranny on one hand. But on the other hand, it was negative 20% to 30% after inflation.
Could the same playbook work today, minus maybe the missing beef? Unlikely. After WW II, military spending plummeted from about 40% of GDP to under 5%, but today, there’s no end in sight to government spending, because most of it is for Social Security, Medicare, Medicaid, and interest. And let’s not get hung up on “waste, fraud, and abuse,” that half-century chestnut of American political rhetoric. There is squander in the spending, to be sure, much of it concentrated in Medicare and Medicaid. But the nonpartisan Government Accountability Office estimates all “improper payments,” including fraud and errors, at $175 billion to $235 billion a year. That amount should burn voters’ biscuits, but we’ll need to capture 10 times as much yearly savings just to keep from sinking deeper into the debt hole.
Last year, recall, Elon Musk raised his hand to slash government spending via a move-fast, break-things squad named for a parody crypto coin, the Department of Government Efficiency, or DOGE. Musk started with a $2 trillion savings goal, but eventually lowered it to $150 billion. When DOGE closed in July, it claimed $215 billion in cuts, but auditors failed to verify anything remotely close. According to BAD-FAIL, or the Barron’s Analysis of DOGE Finding Absolutely Itty-Bitty Largess, it had no chance, because it took military spending and entitlements off the table to start, and targeted civilian discretionary agencies, which are less than 15% of spending, with brash firings of federal workers, who are less than 5% of spending. We’re all for government efficiency, but you simply can’t fix the math we’re talking about by storming the Department of Peanuts and canning everyone.
Back to the inflate-it-away fantasy. If deficits are 6% of the economy and rising, and you wish to rerun the post–WW II playbook, you need to run inflation significantly higher than 6%, which isn’t going to be popular. Then, you somehow need to convince bond investors that you’re not actually doing the thing that you’re definitely doing, or else they’ll send long yields soaring, while the Fed, which today no longer works for the Treasury and is legally obligated to fight inflation, jacks up short yields. And we’re not talking about war bonds anymore. The adjusted weighted duration on America’s debt today is just 4.5 years, according to Kent Smetters, director of the Penn Wharton Budget Model. We doubt you’d like the rates come refinancing time.
The Tech Miracle vs. the Grand Bargain
There is a budgeting model called the debt sustainability hypothesis, or the Blanchard free lunch, named for a former chief economist of the International Monetary Fund, who wrote a 2019 paper on the matter but today no longer likes the idea. So long as the average government borrowing cost is lower than the nominal economic growth rate, or r < g on the chalkboard, governments can watch their debt/GDP levels shrink without the unpleasant work of spending less than they take in. If you’ve ever heard that debt-fueled stimulus will pay for itself with higher growth and tax receipts, those notions are almost twin siblings, like Tweedledum and Tweedledummer....
