A Question of Balance

Balance Sheets are the Rodney Dangerfield of finance – no respect. Everyone pays attention to income statements. Did earnings miss or beat expectations? Balance sheets, on the other hand, are rarely, if ever, discussed. The U.S., like corporations, sets a budget each year, but unlike corporations, there is often little regard for having expenditures be less then revenue. The reason is that the government has the ability to print money, if necessary. When spending exceeds revenue, deficits are produced and the difference is covered with the use of debt. When spending CONSISTENTLY exceeds revenue, the debt level CONSISTENTLY grows and as of September 2023, U.S. debt had grown to $33.17 trillion.

Some take comfort in the fact that debt, as a percent of GDP, is still (slightly) below the record set during WWII, but we take no solace in that analogy. The WWII debt runup was the result of war spending/borrowing. Once the war ended, spending declined substantially, allowing budget surpluses to follow. In addition, as the world’s only surviving industrial complex, economic growth after the war was very rapid as the rest of the world rebuilt. That combination made it fairly easy to reduce that large debt burden.

The situation today is vastly different. In the first place, we have been in a fairly constant state of ‘semi war’ since the invasion of Iraq in 2003 and there is no end in sight. Ukraine demands resources, as does the recent Middle East conflict between Israel and Hamas. In fact, rather than winding down, we might just be getting started. In the second place, we are no longer the center of world growth. Third quarter GDP grew at a robust 4.9%, but that was on the back of massive deficit spending, not organic growth. After WWII, the U.S. economy grew rapidly without fiscal stimulus (i.e., with budget surpluses). If you need deficit spending to produce 5% GDP growth and the cost of debt is 5%, you are simply spinning your wheels. You can’t borrow your way to prosperity that way. It is only possible if borrowing is put to a productive end that propels growth in excess of the rate paid on the debt. But war is not a productive end.

The result is that the U.S. has a rapidly accelerating balance sheet problem. Neither the Fed, nor Congress, nor the Executive branch appears to understand that debts need to be paid back – with interest. Here is where the U.S. stands (roughly):

      • $33 Trillion in Federal debt (i.e., U.S. Treasuries outstanding)
      • An average Interest rate of roughly 3%, or $1 trillion per year of interest cost
      • The Fiscal 2023 deficit (ended 9/30) was $1.7 trillion, an increase from $1.38 trillion in fiscal 2022.
      • The CBO (based on current conditions) projects that the deficit from 2024 through 2033 will average $2 trillion per year (i.e., net U.S. debt will increase by $2 trillion per year).

We haven’t done the math on this problem, but others have. This roughly 30-minute interview of Stanley Druckenmiller at the recent  JPMorgan/Robin Hood Conference is a must watch to understand the current balance sheet issue the U.S. faces.

What Were They Thinking?

Economics 101 teaches you that a properly managed economy should engage fiscal deficits (i.e. use government spending) to offset periods of slow, or negative, economic growth, but that is not what we have done. Following the Housing Crisis, fiscal stimulus was scarce, despite very slow economic growth. Years later, the Trump election started the fiscal gravy train as spending increased and taxes were reduced. The pandemic then produced a massive fiscal and monetary stimulus that is still working though the economy. We are currently in period of relatively strong economic growth accompanied by substantial fiscal stimulus in the form of the Inflation Reduction Act and other Biden Administration policies. As a result, the federal debt continues to grow very quickly. (See chart below.) It is highly unusual to see this level of fiscal stimulus in a period of relatively strong growth. Nonetheless, here it is.

Compounding the problem are entitlement programs (Social Security and Medicare), which are non-discretionary budget items, but are largely unfunded. For many years, many economists have worried about the longevity of Social Security and Medicare as the boomer generation not only ages, but lives longer than expected. Those concerns remain, but we have now layered on general fiscal irresponsibility into the equation as well.


The End Game

A trend of $2 trillion per year deficits as far as the eye can see is simply not sustainable. At some point, we can be sure it will end, we just can’t tell when that point arrives. Our analysis does not suggest that we have reached that limit, but the cranky bond market over the last several weeks (prior to this past week) makes it very clear that they are now carefully watching. The implication of this is that the bond market will likely remain more volatile than it has historically been. The market will not buy Treasury bonds in unlimited amounts and at some level, rates must rise to create more demand. In other words, the market will no longer view Treasury bonds as ‘risk free’.

The chart below shows the trend of net Treasury borrowing by quarter since 2000. (Net borrowing = total new debt, minus debt maturities.) There was an obvious large step up when the housing crisis hit and then borrowing stayed at lofty levels through the QE Era. The pandemic brought an astronomical spike in the second quarter of 2020, and since then it has gyrated wildly as fiscal stimulus came and went.

Now debt is so high that interest expense alone is eating a big hole in the budget, not to mention the cost of two proxy wars; Social Security; and Medicare. The nonpartisan Congressional Budget Office estimates that we are staring at $2 trillion gaps each year well into the future. That is roughly the same level as the ‘emergency’ measures taken during the housing crisis!.

The ending here is not yet set in stone, so for now, we wait. As Druckenmiller suggests in his interview, we need to be flexible is responding to this debt issue because our outlook is likely to change numerous times between now and when a decision ultimately needs to be made. This week alone, the mood has materially shifted, but don’t be fooled. This problem is not going away.

So why talk about this right now? The data this week was friendly and interest rates were down. Isn’t that what we want? Of course, the answer is yes, but even so, it does not change the long term debt outlook. The ‘big deal’ is that briefly, the bond market kicked back at the Fed and drove long term interest rates up for no obvious reason. That’s the part that bothers us. Nothing in the bond market happens for no reason, so the search is on for why this happened and the most logical explanation is that the bond market was simply getting worried about the debt outlook and tried to get some attention.

If the government does not act to end this run of debt, the bond market will eventually step in and stop it for them by refusing to buy bonds unless rates rise materially (i.e., it is no longer risk-free debt). So, the rational possibilities for the end game are as follows:

      • The Federal government learns to exercise fiscal restraint before the bond market shuts the borrowing door. That would imply very slow, or even negative GDP growth, brought on by changes to entitlement programs (primarily Social Security and Medicare) as well as overall reductions in government spending to achieve a balanced budget.
      • The bond market shuts the borrowing door and government responds with fiscal restraint. This is effectively the same outcome as above, but starting with a higher debt load, and therefore a deeper growth reduction.
      • The last option is that the Fed circumvents the bond market and renews Quantitative Easing. That simply means that the Fed buys the bonds that the bond market won’t buy (i.e., they are printing money). As we experienced post-pandemic, that tends to lead to much higher inflation. Only this time there is no realistic avenue for the Fed to regain control of inflation by raising interest rates.

How one would invest in these two basic scenarios are diametrically opposed to each other. Options 1 and 2 suggest a deflationary environment, so owning bonds would be the logical choice. Option 3 suggests inflation, which makes bonds 100% unappealing.

The debt the U.S. is accumulating represents a ticking bomb that will require some very hard decisions at some point in the future. One thing that we know for certain is that as the level of total debt grows faster, the fuse on this bomb gets shorter. The U.S. debt level is primed to go higher faster, which raises our level of concern. The U.S. needs to balance its short and long term priorities soon, or markets will force the issue upon us.


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By: Adam