Disclaimer: I am not a trained economist. The aim of the post is to start a conversation. If I am wrong about anything please let me know as I am trying to understand my blind spots. I have been interested in Macroeconomics, monetary and fiscal policy for the last few years. I have spent around 2000+ hours reading and listening about the topic. So I’m not an expert but have a good sense. I have moderate certainty about the maths behind the deficit calculations and will indicate where I feel less certain. I’ve chosen to analyze the US government budget here because it’s the most consequential and the data was easiest to find but the majority of governments around the world are in similar situations. This is also my first EA forum post so any feedback is appreciated.
Some parts of the posts were largely taken and paraphrased from the following articles, where I’ve updated some numbers. The authors of these deserve all the credit and I highly recommend reading them for a full understanding:
Acknowledgments: Thank you to two anonymous EAs for their comments and feedback.
Summary
In recent years, due to the 2008 Global Financial Crisis and COVID, the debt in major nations has increased to historically high levels that are demonstrably unsustainable. In this short post, I aim to demonstrate that with inflation at decade highs and interest rates at 15-20 year highs, we may have already entered a debt spiral.
The US government currently has $31.3 trillion of debt. The interest expense aloneon the debt is $482 billion per year (average 1.5% interest rates). As the debt is repriced at current interest rates (currently ~4%, but let’s take an average of 3%), the interest expense would increase by $500 billion per year to $1 Trillion per year. Additionally, the cost of living adjustments (COLA) to social security etc, combined with decreased tax receipts due to the recession, the annual deficit would organically increase at an unsustainable rate. This suggests the US government is already in a debt spiral, and the only way they can afford to finance the debt is to print money and essentially inflate the debt away.
It seems important for EAs to learn more about this not just to protect themselves against an inflationary decade (although we are currently in a short-term deflationary part of the cycle), but also so that we can consider the second-order consequences to this problem.
The US budget at a glance
In this section, I will show that when you take the tax revenue (the majority of the revenue to the government) and subtract it by JUST the mandatory and fixed items of spending alone, the US already lack the ability to cover their interest expenses. Lets start by taking a look at the The US debt clock so we can have an overview of the problem:
Screenshot of usdebtclock.org website as of 20th of Nov 2022
Pretty staggering.
The US gov tax revenue is $4.9T. According to the CBO (Congressional Budget Office), Mandatory spending will cost $3.7 trillion dollars in 2022. This includes all entitlements and expenditures that are signed into legislation and are considered absolute obligations, such as social security and medicare. Then we add in the estimated $800B of defense spending (which is contractual), and we get a total of $4.5T.
The problem is interest expense itself is currently costing $482 Billion dollars. So we have at least $82 Billion in deficit, which means we have to borrow even more money to pay back the extra interest expense that we can’t pay back. Note that this doesn’t even take into account some of the other discretionary spending as well as unfunded liabilities.
As James Lavish (ex-hedgefund manager who writes The Informationist newsletter) puts it:
Think of it like this: You run up the balance on a credit card. The monthly payments are more than you have after paying for mandatory things like mortgage, car loans, and food. So, you take out another credit card to pay for some of these things. But your credit score is worse and the interest rate on this new card is higher. So, now the monthly payments are even higher. And you have borrowed more. To make those payments, you have to open another credit card…and so on…you are trapped.
It’s no different for a country perpetually operating in a deficit.
more debt → higher interest rates → higher deficits → more debt
As it worsens, investors lose confidence in the country and demand higher rates for the country’s bonds, only worsening the situation.
As you may be aware, the federal reserve has been hiking interest rates at a historically fast pace in order to dampen demand and drive down inflation.
Interest rates for US government bonds since COVID. Colors represent different maturities.
As the government debt reaches maturity, it needs to roll over and be repriced at current interest rates of 4% (but let’s take an average of 3%) - think of this as your fixed-term interest rates on your mortgage running out so you need to renegotiate a new rate with the bank. If we reprice the current $31.3T of debt at 3% interest rates, the interest expense would increase by ~$500 billion per year to almost $1 Trillion per year—That will overtake military spending as the biggest single line item for spending.
Cost of living adjustments (COLA)
It gets worse (from a government debt perspective).
Because of the highest inflation in decades, there will be an upward cost of living adjustments made to spending from social security and other programs, and the CBO projects that this will be 6-9%.
Impacts of the upcoming recession
Although it hasn’t been officially declared, by many indicators and measures, we will be, if not already, entering a recession. During a recession like in 2008 and 2020, government tax revenues tend to fall by 8-10% compared to previous years because of lower capital gains and corporate tax (less earnings); and at the same time, entitlement spending also increases because of the eventual higher unemployment.
Even excluding these additional factors, assuming steady GDP growth and no recessions, you get this ugly chart from the CBO modeled using lower interest rates from earlier this year:
The projected deficit and total debt as a % of GDP. Source: CBO
If this was a company, it would be considered straight bankrupt.
Last thoughts
For decades we have been able to sustain higher national debt because interest rates kept falling, so the interest expense remained low.
Now with debt to GDP ratio at 135% and inflation finally running hot causing interest rates to go up, the debt monster may finally catch up to us. As Lyn Alden (macro investor) points out from a letter by Hirschmann Capital:
They found that over the past two centuries, 51 out of 52 countries that reached sovereign debt levels of 130% of GDP ended up “defaulting”, either through devaluation, inflation, restructuring, or outright nominal default, within a pretty wide spread of 0-15 years or so after that point.
Because the US central bank has the ability to create new dollars out of thin air, the US government will almost never hard default on the debt (less certain). In the future, I will write another post about how I expect the US government will pay back this debt, but the short answer here is: The only choice is to let inflation run hot, higher than the stated 2% target, in the hopes to raise GDP and monetize the debt. In other words, use cheaper dollars to pay off old debts. Still only a short-term solution, though, as investors will eventually demand higher Treasury rates in order to be compensated for being paid back in cheaper dollars. It is likely that the federal reserve will have to do some form of quantitative easing again to keep interest rates low. As a result, EAs should learn more about the effects of inflation, and take steps to protect their own purchasing power via investments.
Is the US government insolvent?
Disclaimer: I am not a trained economist. The aim of the post is to start a conversation. If I am wrong about anything please let me know as I am trying to understand my blind spots. I have been interested in Macroeconomics, monetary and fiscal policy for the last few years. I have spent around 2000+ hours reading and listening about the topic. So I’m not an expert but have a good sense. I have moderate certainty about the maths behind the deficit calculations and will indicate where I feel less certain. I’ve chosen to analyze the US government budget here because it’s the most consequential and the data was easiest to find but the majority of governments around the world are in similar situations. This is also my first EA forum post so any feedback is appreciated.
Some parts of the posts were largely taken and paraphrased from the following articles, where I’ve updated some numbers. The authors of these deserve all the credit and I highly recommend reading them for a full understanding:
“Fixing” the debt problem
What’s a Debt Spiral, and is the US already in one?
The Long-term Fiscal Spiral
Acknowledgments: Thank you to two anonymous EAs for their comments and feedback.
Summary
In recent years, due to the 2008 Global Financial Crisis and COVID, the debt in major nations has increased to historically high levels that are demonstrably unsustainable. In this short post, I aim to demonstrate that with inflation at decade highs and interest rates at 15-20 year highs, we may have already entered a debt spiral.
The US government currently has $31.3 trillion of debt. The interest expense alone on the debt is $482 billion per year (average 1.5% interest rates). As the debt is repriced at current interest rates (currently ~4%, but let’s take an average of 3%), the interest expense would increase by $500 billion per year to $1 Trillion per year. Additionally, the cost of living adjustments (COLA) to social security etc, combined with decreased tax receipts due to the recession, the annual deficit would organically increase at an unsustainable rate. This suggests the US government is already in a debt spiral, and the only way they can afford to finance the debt is to print money and essentially inflate the debt away.
It seems important for EAs to learn more about this not just to protect themselves against an inflationary decade (although we are currently in a short-term deflationary part of the cycle), but also so that we can consider the second-order consequences to this problem.
The US budget at a glance
In this section, I will show that when you take the tax revenue (the majority of the revenue to the government) and subtract it by JUST the mandatory and fixed items of spending alone, the US already lack the ability to cover their interest expenses. Lets start by taking a look at the The US debt clock so we can have an overview of the problem:
Pretty staggering.
The US gov tax revenue is $4.9T. According to the CBO (Congressional Budget Office), Mandatory spending will cost $3.7 trillion dollars in 2022. This includes all entitlements and expenditures that are signed into legislation and are considered absolute obligations, such as social security and medicare. Then we add in the estimated $800B of defense spending (which is contractual), and we get a total of $4.5T.
$4.9T revenue - $3.7T entitlements - $800B defense = $400B leftover for interest expense.
The problem is interest expense itself is currently costing $482 Billion dollars. So we have at least $82 Billion in deficit, which means we have to borrow even more money to pay back the extra interest expense that we can’t pay back. Note that this doesn’t even take into account some of the other discretionary spending as well as unfunded liabilities.
As James Lavish (ex-hedgefund manager who writes The Informationist newsletter) puts it:
This is also known as the dreaded debt spiral:
But interest rates have gone up a lot...
As you may be aware, the federal reserve has been hiking interest rates at a historically fast pace in order to dampen demand and drive down inflation.
As the government debt reaches maturity, it needs to roll over and be repriced at current interest rates of 4% (but let’s take an average of 3%) - think of this as your fixed-term interest rates on your mortgage running out so you need to renegotiate a new rate with the bank. If we reprice the current $31.3T of debt at 3% interest rates, the interest expense would increase by ~$500 billion per year to almost $1 Trillion per year—That will overtake military spending as the biggest single line item for spending.
Cost of living adjustments (COLA)
It gets worse (from a government debt perspective).
Because of the highest inflation in decades, there will be an upward cost of living adjustments made to spending from social security and other programs, and the CBO projects that this will be 6-9%.
Impacts of the upcoming recession
Although it hasn’t been officially declared, by many indicators and measures, we will be, if not already, entering a recession. During a recession like in 2008 and 2020, government tax revenues tend to fall by 8-10% compared to previous years because of lower capital gains and corporate tax (less earnings); and at the same time, entitlement spending also increases because of the eventual higher unemployment.
Even excluding these additional factors, assuming steady GDP growth and no recessions, you get this ugly chart from the CBO modeled using lower interest rates from earlier this year:
If this was a company, it would be considered straight bankrupt.
Last thoughts
For decades we have been able to sustain higher national debt because interest rates kept falling, so the interest expense remained low.
Now with debt to GDP ratio at 135% and inflation finally running hot causing interest rates to go up, the debt monster may finally catch up to us. As Lyn Alden (macro investor) points out from a letter by Hirschmann Capital:
Because the US central bank has the ability to create new dollars out of thin air, the US government will almost never hard default on the debt (less certain). In the future, I will write another post about how I expect the US government will pay back this debt, but the short answer here is: The only choice is to let inflation run hot, higher than the stated 2% target, in the hopes to raise GDP and monetize the debt. In other words, use cheaper dollars to pay off old debts. Still only a short-term solution, though, as investors will eventually demand higher Treasury rates in order to be compensated for being paid back in cheaper dollars. It is likely that the federal reserve will have to do some form of quantitative easing again to keep interest rates low. As a result, EAs should learn more about the effects of inflation, and take steps to protect their own purchasing power via investments.