Fiscal Fix: Averting a US Debt Crisis

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Stacie Jacobsen: 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 management. I'm your host, Stacie Jacobsen.

In 1989, the US National Debt Clock was installed near Times Square, with numbers racing higher and higher in a digital display. At that time, the debt was only about 40 percent of US GDP, or a mere 2.7 trillion. Now, it's almost 10 times that amount, and registers at about 100 percent of US GDP. And according to the Congressional Budget Office, it's projected to reach 166 percent by 2020 in the next 30 years.

So how did we get here? Is a major or even minor debt crisis inevitable, or is there still time to prevent it? That's the topic we'll explore today with our guest, Chris Brigham. Chris is a Bernstein senior research analyst who recently coauthored an in-depth paper on the growing national debt and what we can do about it.

Chris, thanks so much for joining us today.

Chris Brigham: Thanks for having me, Stacie.

Stacie Jacobsen: All right. So just to get started, how did the US debt become almost 100 percent of GDP?

Chris Brigham: So, it's been a work in progress for a long time. It's been many decades in the making. It started to rise back from its post-World War II lows in the 60s and 70s and became hot but an issue in the 80s and 90s, at which point we dealt with it to some degree.

We had bipartisan support for budget policies under the Clinton administration that started to run budget surpluses. We started to get a handle on it and then following the .com bubble, and then particularly following the financial crisis and following the pandemic, we really spent a lot of money in deficit spending in each of those circumstances to bail ourselves out of the emergency.

And along the way in the interim years, we didn't exactly reverse that by running things tight. They actually did that in Europe. They had fiscal austerity in Europe, but we haven't done that in the U S which has allowed that to really balloon to about the same level as US GDP today. Okay.

Stacie Jacobsen: All right, Chris, one of the most frequently asked questions I hear these days is how risky is the national debt?

How risky is it?

Chris Brigham: So, the national debt is a major risk over the long term if we don't deal with it. We do currently have debt to GDP of close to 100 percent and that's projected to go up from here pretty much nonstop for the next 30 plus years. And unless policy changes. That likely will create some sort of a crunch at some point in time.

The difficulty is we don't know exactly what point in time that's going to be, or what the magnitude of that crunch would be. So eventually it becomes an issue. Right now, it's much less of a concern because there is still plenty of time and plenty of good solutions remain to deal with it now before it becomes a real problem later on.

Stacie Jacobsen: Okay. Let me ask you this because debt is often tied with US treasury. So, when you're talking about it from an investment standpoint, are there implications in holding us treasuries?

Chris Brigham: So, this is part of what makes it such a fascinating question is that you're talking about the risk of the debt. And at the end of the day, the national debt is the US treasury and the US treasury is the safest asset in the global financial system.

It underpins the entire rest of the financial system, and I would say that at present, it is still far and away that safest asset. So, I'd point out that the sell off that we had in global financial markets in early August, what asset did the best on that day? People flooded into US treasuries. It remains globally the safe financial asset.

So, in a time of crisis, even with all the risks that we're talking about today, that's the asset that global funds all flooded into. In a moment of crisis, and we've seen that time and time and time again. And unless something severely changes between now and the future point, we'd expect to see it continue to be that safe asset that everybody flocks to in a time of crisis again.

Stacie Jacobsen: You did say that you're not worried about an imminent debt crisis. Why not?

Chris Brigham: So, there's no red line with the national debt. It's not like, okay, we're at 100 percent debt to GDP today. And if we get to 110%, that's going to be an emergency. At the end of the day, the US issues its own currency, and we're the global reserve currency.

So, there's plenty of demand for our assets and for our debt. Plus, we still have plenty of time to deal with the issues at hand and actually find a workable solution in the long run. The challenge is that the longer that we kick the can, the higher the debt to GDP level gets, the harder it then becomes to solve later on, which is why it's probably better for politicians to think about solving it in the near term, as opposed to the later term, it's going to take some combination of economic growth, either from population growth or productivity growth from inflation, or most importantly, really fiscal policy changes.

And we don't need to have a crisis because of it. We just need to deal with it before we have a crisis.

Stacie Jacobsen: Now, it is an election year. People are more focused on the issues than they typically are. And as candidates are proposing their platforms, it's natural for people to wonder how everything will be paid for.

So, here's my question. Does the fact that it's an election year impact the outlook for the debt and the deficit?

Chris Brigham: So, looking at this election and what its impact could be on the debt and deficit situation, wouldn't really expect it to change too much, depending on who wins. If you look at what both sides have proposed and what they've done in the past, both sides are in favor of continued deficit spending.

In the first Trump administration, we had deficit-oriented policies, even outside of the pandemic. And then during the Biden administration, obviously we dealt with the pandemic and there were deficit policies in place because of that, but we're also currently running the largest deficit in the history of the country outside of either a recession or a war.

And when we look ahead, if they do anything at all, it would be to bring the deficit down a little bit from where it is currently. But both sides seem pretty intent on continuing to run deficits for the foreseeable future.

Stacie Jacobsen: So, Chris, the issue still does need to be addressed. What are some of the ways that we could potentially stabilize the debt, so we don't reach these crisis proportions?

Chris Brigham: We have three main options. There are a couple more, but they're less likely and less useful. So, it really comes down to grow out of it. Inflate our way out of it or deal with it on the taxes and spending. Those are the options of those three growing out of it as far away the one that's the best. And that would make everybody happiest.

The issue that we have is that population growth is weak. The native-born population is actually set to shrink. So, all of our actual population growth that we're baking in going forward is coming from immigration growth. That gives you about 0. 4 percentage points per year of growth. On top of that, there's this economic baseline expectation from conventional economists that will get about 1.4 percentage points per year of productivity growth, and that's a little bit lower than what we've done over, say the last decade, but that's what people had factored in over the next few decades.

Prior to the development of ChatGPT. What's interesting is that now we've seen what ChatGPT can do. Now we've started to factor in what does AI actually mean for productivity and for growth going forward.

And if that can boost GDP growth by even just say 0.4 percentage points per year, which is smallish relative to what we saw from the development of the PC or from the development of the internet. If it can do that, that's enough to bring that ending debt level down 30 years from now, from around 170 percent to around 120 percent.

So literally the 0.4 percentage points per year of GDP growth from AI or other productivity boosts could do a ton of the heavy lifting for us, but that remains to be seen. We're not counting on it. We're not going to underwrite that fully in our investments.

Stacie Jacobsen: And then the second one you said is inflate our way out of it.

Chris Brigham: Yeah, so then we could also try to inflate our way out of it. This is not a great option for many reasons, but this is the scenario that a lot of the doom mongering narratives out there really revolve around. The issue is that it's hard to do and it's probably not going to work. And so, for all the doom mongering, I don't think that that's actually the path that we're likely to take.

The real issues you run into, just mathematically, are that the future spending by the government Then has to deal with those higher prices. So that's one headwind to actually offsetting the existing debt stock with inflation is that you have this continued spending in the future, and you have that inflation hitting all of that.

The other issue is similar to that, which is that unless the Fed acts to in some way cap the interest rates in the economy, then bond investors are going to factor in that rising inflation in the future. And they're going to demand that in yields that they're asking for from treasury bonds, which means your interest rates go up.

And again, rising interest rates are the biggest cause of the growing deficits that we're seeing in the next 30 years in the Congressional Budget Office projections. So, you just turbocharge that problem if you send those yields rising because of inflation. The final thing is that the Fed could try to cap interest rates, but then the question is whether that happens moderately or aggressively, and ultimately, markets like independent central banks, so it's not clear that the Fed would do that because it may not be worth the backlash and the market reaction to doing that.

So, the consequences could be much worse than the cure if we try to inflate our way out of it, which I think is a real disincentive to people going that route.

Stacie Jacobsen: All right, Chris, and the third way is taxes and spending. So that would be increased taxes and reduced spending, neither of which are very popular.

Chris Brigham: Definitely. I think this has to be at the heart of any real long-term solution is dealing with the fiscal policy. And that's the key to a long-term solution. What makes it a challenge is that it's going to require compromise, which is about the dirtiest word that you can utter in Washington, D. C. these days.

And you can't get there with just tax hikes, and you can't get there with just spending cuts. When we tried to model about 4 trillion of tax hikes, or 4 trillion of spending cuts, and what that would do, that only brought the ending debt down to around 130 percent or 150 percent range, depending on exactly what assumptions you make there.

So, you need both halves to come together, which means there has to be compromise from both sides and for investors, you then need to think about, okay, one of the things that's likely to give here in D.C. is taxes. And so, if you are looking at stocks or even looking at bonds, you need to consider the fact that corporate tax rates may go up as part of the solution, and especially if you are a high income or a high net worth or ultra-high net worth investor, there's a really high probability that part of the solution is that your tax rates go up as well.

Stacie Jacobsen: How would that play out?

Chris Brigham: So, one of the big levers that policymakers are going to have available to them to pull in order to deal with the debt situation is to raise taxes.

And if you think about. Who to raise taxes on or how to raise taxes. One of the more politically popular areas for that is to raise taxes on the wealthy. So, if you are an investor who is high income or high net worth, ultra-high net worth, you should probably be planning today on facing higher tax rates at any given level of wealth or income in the future than what you're dealing with today, because that's likely to form part of the long-term resolution of this.

So as investors try to process this and figure out how they should strategize, we'd really recommend that they have a conversation with their advisors about when do you want to take that income? How do you want to structure it? How do you want to shield it? What's the best formation of assets that'll treat you the best way as tax rates go up in the future.

Stacie Jacobsen: So, despite your use of the term doom mongering, when you're talking about inflation, your take on the current debt picture does make it more positive at the margins on stocks and maybe the inflation protection. But at the same time, what should investors be doing with their portfolio?

Chris Brigham: Anything at this point, we're not making any big asset allocation changes at this time.

As a result of this analysis, what we see is that different asset classes perform differently in each scenario that we talk about as a potential resolution to the issue, commodities muddle through. In most of those scenarios, but they don't really stand out in any of them nominal or real bonds do better or worse in certain scenarios, and stocks can do well pretty much across the board.

The best-case scenario is that we grow out of it, and that obviously would make everybody happy economically, but the market that would make us really happy because every single asset class performs well in that scenario, especially US Stocks, and especially if A.I. is part of the reason why we're able to grow out of it because the US Economy in the US Stock market is much more levered to the A.I. theme. Then other markets, but overall, there's enough difference between the performance of different asset classes in these scenarios, and we have too little visibility into which scenario will be the one that we ultimately go down and we think that really, it's going to take a combination of these scenarios, a combination of these solutions to deal with the debt situation.

We want to make sure that we're positioned to do well across the board with all these asset classes, with a solution, that's likely to span these different scenarios.

Stacie Jacobsen: All right, Chris, and earlier on in the conversation, you talked about the fact that the US dollar is the world's reserve currency, but many believe the debt crisis could endanger that status.

What are your thoughts?

Chris Brigham: So yes, and no, I would say, generally, and overwhelmingly, no. But at the same time, you can't count anything out fully. So, there is still some residual probability that it could be an issue. In general, the US does benefit from what people have deemed this exorbitant privilege where we are the world's reserve asset.

And as a result, global investors everywhere else demand our treasury bonds and dollar denominated assets, and that creates additional demand for US dollar based assets, and for the dollar itself and keeps our yields a little bit lower than they would be. Otherwise, what it would actually take to challenge that would be another asset emerging that people would like to own more than the dollar.

And that's where you really start to have problems seeing what that asset could be, because it's not likely to be the Pound. There would be some claim for it to be the Euro, but that would be difficult. People talk about the threat from China and whether it could be the Renminbi or the Yuan. And ultimately, the Chinese economy just isn't structured and doesn't seem like the government in China would want to structure their economy with such free capital movement and such demand for their currency to allow it to be part of the solution.

People talk about crypto assets like Bitcoin, but Bitcoin does not make a particularly good currency, let alone a really good reserve asset. That's a whole separate conversation, but we've run into this issue with any of the assets that we look at as potential alternatives, and that's why it's, it's still hard, no matter how challenging a situation the US finds itself.

Other countries are dealing with similar challenges, and we have tended to deal with those challenges slightly better and have that demand where it is hard to see other assets offsetting us as that reserve asset.

Stacie Jacobsen: All right, Chris, with that, do you have any final thoughts you'd like to leave our listeners with?

Chris Brigham: I think when it comes to the national debt, this topic is unlikely to go away anytime soon, and it's only going to grow as an issue until we deal with it. But that said, for anybody who's really worried, there is time to deal with it. And there are good solutions that remain to allow us to resolve it without a crisis.

Stacie Jacobsen: All right. And I think that's a great place to wrap. Thank you so much for joining us today.

Chris Brigham: Thank you again for having me, Stacie.

Stacie Jacobsen: For anyone who'd like to take a deeper dive in the issues we discussed today, I do recommend reading the white paper on the national debt that Chris and several colleagues recently published.

We'll link it in the show notes. And as always, thanks for listening. We'll be back in two weeks with another episode. I'm your host, Stacie Jacobsen, wishing you a great rest of the week.