How much national debt is too much? Learn how the U.S. government’s borrowing habits could impact economic growth, from Bernstein economist Eric Winograd.
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Stacie Jacobsen: [00:00:00] Thanks for joining us today on The Pulse by Bernstein, where we bring you insights on the economy, global markets, and all the complexities of wealth [00:00:15] management. I'm your host, Stacie Jacobsen.
In absolute terms, the numbers are staggering. The U. S. national debt has surged to an unprecedented level of 34 trillion, and some projections expect it to [00:00:30] reach the 50 trillion range by 2033.
And the most recent fiscal year's deficit is running at 1. 7 trillion. These numbers may seem unexpectedly high, given that we're in a post COVID expansionary economy with low unemployment [00:00:45] and relatively strong economic data.
But the numbers themselves don't tell the whole story.
What about when we look at it relative to GDP? And what are the near term and long term consequences of running such a high deficit for both the economy and financial markets?
We're here [00:01:00] with Bernstein's chief economist, Eric Winograd, to put the deficit and debt in perspective.
Eric, thanks so much for joining us. Thanks for having me now. The deficit has remained unusually large given the post covid economic expansion So let's get to the why is the [00:01:15] deficit
Eric Winograd: so large and you're exactly right? The deficit has been unusually persistent given the magnitude of the economic That we've seen post pandemic.
And normally you would expect the, when the economy expands the way it has over the last few years that the deficit would start to fall a little [00:01:30] bit. And we really haven't seen that.
I mean, it's off of the very peak reached when the economy was contracting of course.
But it's still well above the pre pandemic norms, it's tracking at about 6 percent of GDP per year, which is unusually [00:01:45] large during an expansion, we normally look for it to be three and a half percent of GDP, something like that.
So it is unusually large. There's a handful of reasons for that. Some of them are temporary.
So for example, the, the deficit in 2023. [00:02:00] was unusually large, or at least so far in the reporting of it, it has been unusually large because the state of California offered a tax holiday to people who were impacted by natural disasters there in the first quarter.
So instead of filing taxes in April, they were able to defer until [00:02:15] October. And that meant that there was a large revenue shortfall that we expect will be made up in the fourth quarter.
And so, so that should come out in the wash, but underlying that, uh, there is still an unusually large deficit. And the reason is simply that that's what the [00:02:30] legislation in place today provides for.
You've had a combination of tax cuts and spending increases. And as long as that is the case, if you have more spending than you have revenue, you're going to have a large deficit.
And that's the [00:02:45] position we find ourselves in. Congress and neither the Biden nor the Trump administration has been able to work with Congress in a way that would reduce the deficit.
Stacie Jacobsen: Before we get too much further into the conversation, I would like to take a second to clarify two [00:03:00] terms that are often confused on this topic, and that is debt and deficit. So can you give us a quick definition for those two?
Eric Winograd: Sure. So the deficit is simply the difference between your revenue and your spending in any given year.
If you spend more than you bring in, you run a [00:03:15] deficit. So that that's the extra amount that you're spending relative to what you have earned. In the context of the United States or of a government, we tend to talk about that as a percentage of GDP. So the United States government is running a deficit of about 6 percent of [00:03:30] GDP.
Now, when you run a deficit, when you spend more than you bring in, the way that you are able to fund that spending is by borrowing, right? So the deficit adds to the debt in any given year. The debt is the amount of borrowing that has [00:03:45] accumulated the amount in this case of treasury securities that are outstanding that the government owes.
So the deficit accumulates and becomes the debt. So
Stacie Jacobsen: then when does a high deficit become a problem, and when does it impact the real [00:04:00] economy? So
Eric Winograd: a deficit, you know, there's no magic tipping point where you can say a deficit of 3 percent is okay, but a deficit of 3. 1 percent isn't, or a deficit of 6 percent is okay, but 7 percent isn't.
What we really look for over the long term in most [00:04:15] economies is a level of the deficit that would not result in a dramatic increase in the debt, right?
So you want to not have an accelerating It's a [00:04:30] little bit different in that the dollar is the reserve currency of the world. And so, uh, we have the ability to issue more debts and to run larger deficits at lower cost than other countries would, uh, because there is still this desire to hold dollars as a reserve [00:04:45] currency and to invest those dollars in treasuries.
So whatever the sustainable limit. might be for some other country, for the U. S. it is almost certainly higher than that. And of course, we can't know what it is ahead of time. Uh, there, there is no, as I said, [00:05:00] magic number that you can point to and say, this is too much.
Stacie Jacobsen: In your opinion, then, do we need to take any immediate action to reduce the deficit, at least on the short
Eric Winograd: term?
Certainly over the medium term, I think all economists and most policymakers on both sides of the aisle would agree [00:05:15] that it would be better to run. a lower deficit and that would keep the debt to GDP ratio.
And remember here, the debt is the accumulation of past deficits to keep that stable. Right now it's just over 100 percent of GDP.
So keeping that [00:05:30] stable would be a desirable outcome. The current level of deficits does not do that. It leads to an increase in the debt to GDP ratio over time. It's not sort of an exponential increase. But nonetheless, it would be better to run it at a, at a more [00:05:45] stable, sustainable level. Does that require immediate action?
Well, look, it doesn't require the sort of dramatic thing that would change the trajectory all at once. It does require though, some longterm thinking and some longterm planning around the tax code, around revenue streams that the [00:06:00] government collects. Around spending and the places that it spends its money, but you know, it doesn't require, you know You can't fix a long term deficit and debt issue with short term policy I think is the way to put it and Fed chair Powell says this a lot of the time, you know the [00:06:15] the Fed does not play a role in the deficit or the debt and so he says, you know, this is fiscal policy.
It's the role of Congress, but it would be better if to have this on a more sustainable trajectory,
Stacie Jacobsen: increasing taxes or revenue and cutting spending, which is often on entitlement [00:06:30] programs, certainly are solutions, neither of which are very popular, especially in an election year. So what is politically viable to tackle?
And how will election year politics influence or have an [00:06:45] impact on the deficit? So
Eric Winograd: unfortunately, I don't think there's anything that's politically viable. You're exactly right. There is no appetite on either side of the aisle to cut entitlement spending. Reducing social security or means testing social security or changing the date at which people are [00:07:00] eligible for social security appear to me, at least, to be dead on arrival politically.
There's no constituency arguing for that. Tax increases also are quite unpopular. And with Washington sort of gridlocked, there's no probability, I think, of any. [00:07:15] Real fiscal change over the course of the next year.
We certainly are not incorporating one in either direction into our, uh, into our forecast for this year for what it's worth, I think it's very difficult to see a political alignment that would lead to a significant [00:07:30] change in the trajectory of the deficit, even after the election next year, because as you say, you know, you either have to raise taxes.
Right, which is politically unpopular or you have to cut spending and the majority of government spending is either on defense or on [00:07:45] the social safety net. And that's not popular in either case.
Stacie Jacobsen: You mentioned those two, but you know, we are in a higher rate environment as well, and that does impact the debt service.
So how does the interest rate environment play into this?
Eric Winograd: Yeah, it makes it harder, [00:08:00] right? You're, you're right again, that rising interest rates make it more expensive for the government to service the debt that it has issued. Now that shouldn't be a cause for imminent alarm.
Remember that most of the debt has been issued years and years and years ago, and the [00:08:15] amount that the government pays on that is fixed, right?
So you don't reset the interest rate on. all of the outstanding debt when interest rates go up.
What it does mean though is that as debt matures and is rolled over, the new debt that you issue comes at a higher interest [00:08:30] expense. And so if you maintain interest rates at a higher level for a long period of time, it does become more expensive.
I think of that as a headwind to growth. You know, when the government borrows money, It can do a variety of different things with it. [00:08:45] Some of those have positive implications for economic growth.
Certainly infrastructure spending is one that would provide a boost to growth. Most of the social spending, to one degree or another, is positive for growth.
It allows households to consume, whether that is through food stamps and [00:09:00] social support programs or through programs designed to keep people healthy. Either way, those tend to promote positive growth. Debt service, by contrast, really doesn't.
That's just money that's being recycled into the hands of people who hold debt.
And so the [00:09:15] more debt service costs that you bear, the less likely it is that government spending will make a positive contribution to growth. So I think of the debt burden that we face right now as a headwind to future growth. And it's one of the few reasons that we expect [00:09:30] growth to be slower. Over the next decade, the next couple of decades than it has been looking back 5, 10, 20 years.
Stacie Jacobsen: All right, Eric. So fiscal policy really is a long term thing, but how is that impacting the financial markets in the short term? Yeah,
Eric Winograd: it is a long term thing and it [00:09:45] changes slowly, but it can have impacts on financial markets over shorter time horizons. If you think back to late last year in October, interest rates went up very sharply for no apparent reason.
There wasn't a change in the inflation environment or a change in the monetary policy environment. [00:10:00] Generally, what most people attributed that move to was increased concern about fiscal deficits.
You know, we did see the data start to roll in for the second quarter. Uh, in terms of government spending and revenue, and it caused some concern and it pushed interest rates sharply higher because [00:10:15] investors became concerned that there would be fewer buyers for the increased supply of debt.
Now, that was short lived and interest rates now are back to where they were before that happened or even a little bit lower.
So, you know, we didn't see a sustained [00:10:30] impact from fiscal policy as a result of that. And I think it's a good reminder that. And while it's very easy to be concerned about fiscal policy, it doesn't typically drive markets in the near term, particularly not in the U.
S. But it also is a reminder that these things can happen unpredictably. At [00:10:45] various times over the next few years, it's entirely likely that there will be concern about debt and deficits and that it will push interest rates higher.
It's just that that does not define the market most of the time. We have cyclical variables like inflation and monetary policy that [00:11:00] tend to predominate over shorter periods of time.
Stacie Jacobsen: Okay, well then with that said, let's look outside of the US as we're not the only ones running an abnormally large deficit. What's going on globally?
Eric Winograd: So there are other places where fiscal policy is a concern. China is one [00:11:15] of them, but China is a place where fiscal policy will become an increasing source of concern.
You know, we talked earlier about there being no magic tipping points in terms of debt to GDP or whatever. Uh, Japan has run debt to GDP well over 200 and approaching 300 [00:11:30] percent for a long time and yet has the lowest interest rates in the world. So it is an example of what we were discussing in terms of the lack of sort of these tipping points.
But as Japan's economy normalizes that there's some scope for change in fiscal policy there that could be interesting as [00:11:45] well. Europe actually looks a little bit better and remember that Europe, the euro area in particular, is constrained by a series of fiscal rules that were part and parcel of the creation of the euro area that limits Massive deficits.
And certainly during the pandemic. Many sovereigns [00:12:00] found and were given exemptions and found exceptions to try to support their economy through such a difficult time. But their fiscal position actually looks a little bit better coming out than the U. S. is does largely because it looks like some of those rules are going to be reapplied and [00:12:15] imposed in a, in a stricter fashion going forward.
Stacie Jacobsen: So what does all of this mean for the dollar? You had mentioned earlier on about the, you know, the dollar being the reserve currency of choice. There's some concern that having such a large deficit may impact that. So what are your thoughts?
Eric Winograd: You're right [00:12:30] that the dollar and its role as the global reserve currency has been a hot topic.
Not just. In this environment, but at various times over the past, uh, few years, and even going back a little bit longer than that, we actually recorded a podcast about that last year as part of what we call the disruptor series, where [00:12:45] we talked about the role of the dollar and how it might change in large part because of concern around fiscal policy and around debts.
And you can access that through wherever you access Alliance Bernstein podcasts. Uh, but the basic gist of it is that you know, the [00:13:00] dollar.
Wayne in popularity, but it's very difficult to see an alternative and it's all well and good to say that we're concerned about the, the dollars reserve currency status, or we're concerned about the policies that underlie that.
But it is very challenging to find something else that [00:13:15] meets the needs of the holders of large amounts of currency reserves around the world. There aren't very many other currencies, if any at all that are as liquid as the dollar that are. trade at 24 hours a day, where the exchange rate is freely determined by the market rather than heavily [00:13:30] influenced by policy makers.
And it can be spent everywhere. So, you know, it's very tempting to say that the dollar's reserve currency status should weaken. It's very hard to find a plausible alternative. And that does give the U S the ability to run the sorts of [00:13:45] policies that other countries might not be able to get away with.
Stacie Jacobsen: Eric, the combination of an abnormally large deficit and an election year may feel like the financial markets are in for increased volatility in 2024. But from a historical perspective, what has the [00:14:00] actual impact been of these two events on the markets?
Eric Winograd: So election years always have the potential to be volatile.
And what I would say is the following. While there will be volatility this year, I think it's unlikely to be related to fiscal policy because it is very [00:14:15] unlikely that there will be a dramatic change in fiscal policy ahead of the election. Some sort of dramatic change in fiscal policy would require unified control.
Of both branches of government, and we simply don't have that at this point. And it, it's very difficult to see a sort of [00:14:30] dramatic fiscal change. The one exception, of course, is the need to continue on the current trajectory and by passing continuing resolutions and, and funding bills that keeps the government open.
An obvious way that you could get volatility is if we have government shutdowns. Uh, it's an issue we [00:14:45] talked about in the fourth. Quarter of last year that was delayed, but not canceled. And as we record the area, it is once again, front of mind for a lot of people. And I expect that we will continue to worry about that for the next few weeks, if not even longer.
So that to me is the most likely [00:15:00] cause of volatility, at least as related to the deficit. There are of course, plenty of other things that we expect to cause volatility along the way. And I should also add the, while there may be volatility. Let's not forget that the Federal Reserve has pivoted and has told us that rate cuts [00:15:15] are more likely than rate hikes at this stage.
We're forecasting rate cuts over the course of this year, starting in the second quarter. That provides some cushion for financial markets and some comfort that if things do start to deteriorate economically or in the markets, the Fed could step [00:15:30] in and ease the pain. And that's new. The Fed has been raising rates for two years and now that they appear to be done with that, That should smooth out some of the bumps in the road, at least to a degree.
Stacie Jacobsen: So for investors, we'll say that, you know, markets really do come in bursts when you look at the [00:15:45] last two months of 2023, I think it's fair to say that that was entirely unexpected to have the magnitude of return that we saw, and especially in a diversified portfolio. So when you look at the overall allocation of, let's say, a 60 [00:16:00] percent investment to the S& P 500 and 40 percent to the U.
S. Ag, that was one of the best two months period that we've seen in a very
Eric Winograd: long time. I think it illustrates a point that we made earlier, which is that. Monetary policy and cyclical forces tend [00:16:15] to predominate over structural ones. There was no change in the deficit. There was no change in the debt load that would have led to that sort of thing.
What did change is that the Fed more or less validated the idea that there were done raising rates. And that matters. It matters a lot to financial [00:16:30] markets. It mattered to fixed income markets in particular. Yields moved significantly lower. Again, despite the debt still being high and deficits still being large, there was plenty of demand for bonds and for treasury assets in particular once the Fed told us that the likely [00:16:45] path for interest rates is down.
And the active interest rates going down provided a real boost to risk markets and the equity market in general. We, as I said, expect The Fed to continue cutting rates this year, and we expect interest rates to continue to fall. Our [00:17:00] forecast for the 10 year Treasury at the end of this year is 3. 25%, almost a full percentage point lower than where we are today.
Generally speaking, when interest rates fall, particularly if the economy holds up, as we expect that it will, Uh, that's a [00:17:15] pretty good environment for risk taking. There will be volatility, no question, but having the Fed behind you instead of, you know, fighting against you, right? Having the idea that the Fed can stand in to minimize economic downturns is a source of comfort for investors.
And we [00:17:30] saw a large part of that play out in the, in the fourth quarter of last year. All right.
Stacie Jacobsen: And with that, I think that's a great place to wrap this conversation. Eric, thanks so much for joining us.
Eric Winograd: My pleasure. Thanks for having me.
Stacie Jacobsen: Thanks to everyone for giving us a listen. If you enjoyed this episode, please subscribe to the Pulse [00:17:45] by Bernstein on your favorite podcast platform.
I'm your host, Stacie Jacobsen, wishing you a great rest of the week.