How America's Debt Spiral Could Spark The Next Crisis

Our fiscal situation is a 350-pound, two-pack-a-day smoker on the ICU table. The U.S. federal budget is on an unsustainable path. We're gonna be broke really quickly unless we get serious about dealing with our spending issues. There's no shortage of voices sounding the alarm about the national debt. America's borrowing levels are currently the same size as the entire economy and are expected to skyrocket from here. That's because the U.S. spends way more than it brings in and then borrows to cover that deficit. There's plenty of debate on how to close that gap. Raise taxes, cut spending, a combination of both, no doubt. Any solution demands hard choices. But what are the actual consequences if the deficit gets out of control? I often liken this to the invisible dog fence where you really don't want to hit it, but you won't know until you do. And it seems like the U.S. is almost intent on finding out where that tipping point is. Here, we'll explore not how to fix the deficit, but to figure out what could happen if we don't. We'll focus on three key areas, the potential market fallout, economic ripple effects and international implications. Even though debt has been central to America since 1776, we haven't yet seen a tipping point. For much of the nation's history, the U.S. tried to balance the budget. That changed toward the end of the 20th century. 1991, 1990 were periods when there was a lot of uncertainty about our economy. I remember I was at that time co-senior partner of Goldman Sachs, and a lot of our clients were very uncertain what was going to happen. And deficits played a big role in that. This is Robert Rubin. He advised Bill Clinton on his presidential campaign, the transition, and later joined the administration. He ultimately served as the 70th Treasury Secretary. I'll never forget, we had a meeting of the economic team, and at some point he looked at us and he said, this is a threshold issue. It's going to be difficult politically, but this is what we have to do. And that is indeed what we did. Tonight at midnight, America puts an end to three decades of deficits and launches a new era of balanced budgets and surpluses. It was the first time since 1969, but the surplus was short-lived. Since then, the U.S. has had several rounds of tax cuts, multiple expensive wars, a financial crisis and a pandemic, all contributing to an historic fiscal hole. It's very, very roughly about one-third from tax cuts, one-third from spending increases, and one-third from emergencies. Those emergencies were the right time to borrow, the other two, not so much. Kent Smetter's team at Wharton creates models that show how policy changes impact the federal budget. What does the model tell you in real time about the current state of our deficit? Fiscal policy is not sustainable. The economy essentially blows up. There's so much debt under current law that fixed income markets, bond markets will collapse. Smetter's model shows that collapse could happen within 20 years. If Congress really doesn't get its act together and try to figure out some grand bargain that solves this problem, then there's only one mathematical way of getting out of this, and that is for some type of default to happen. A default is when a borrower can't make payments on a debt, but that's unlikely to happen to America because we have ways to get around it. The United States can pay any debt it has because we can always print money to do that. If you print bonds in your own currency, what happens to the currency is going to be a question because you don't default. We just cranked up the printing press. That now means there are more dollars in the economy that are chasing the same amount of goods and services. That's where inflation comes from, and that's what we've seen throughout history of other countries that have struggled with high debt. What do you think the likelihood is that the U.S. does experience a crisis related to its deficit or debt levels? I think that there's more than a 50 percent chance that in three years, give or take a year or two, that we will experience a trauma if we don't deal with this well. Ray Dalio has been a global macro investor for 50 years, known for starting Bridgewater Associates. He's been concerned about government debt levels since the 2008 financial crisis. I think of myself being very much like a doctor. I watch the plaque build up in the system. I always said it was unhealthy, but I've not said before that the supply-demand picture is a very serious picture as it is now. That's because Dalio has studied how countries go broke and says his research across centuries found that there are cycles that have led to big debt bubbles and busts. And he's deeply concerned about what he sees. The supply that's going to be produced by deficits is greater than the demand for that debt. Like watching somebody having a circulatory system condition, you can measure those things. It's getting very severe. To raise money and help pay for the growing deficit, the U.S. government issues and sells treasuries. When investors start getting jittery about too much debt flooding the markets and the risk of inflation, they'll insist they get paid even higher rates to buy treasuries. Ed Yardeni first started noticing this behavior in the 80s, a response to the raging inflation from the prior decade. There was a lot of fear among investors that they could get burned again. And as a result of that, I coined the phrase bond vigilantes with the notion that if the Fed and the government weren't going to be responsible, weren't going to be the sheriffs in town to manage the economy in a way that would keep inflation down, that the bond vigilantes would do it. Yardeni wrote in his newsletter in 1983 that the vigilantes were concerned about a $200 billion deficit. Today, the levels are 10 times that. The bond vigilantes are more powerful than ever. And the question is, are they going to use that power, that extraordinary impact that they could have on the bond market, which is now more important than ever, and push bond yields up to levels that cause a recession in order to bring inflation down. One country that experienced a mini debt crisis in the fall of 2022 was the United Kingdom. Liz Truss, who was then the prime minister, unveiled a plan to cut taxes by 45 billion pounds. I have a bold plan to grow the economy through tax cuts and reform. Immediately, the pound collapsed. Investors dumped UK bonds. The local pension funds were forced to sell to manage their risk, all of which threatened a downward spiral. The Bank of England had to come in and stabilize the market, and the government quickly undid the tax cuts. But prime minister Truss never regained credibility, and she resigned after just six weeks in the role. But can that type of crisis, where the market quickly loses confidence, happen in the U.S.? It's a risk that we think remains low in terms of the probability of this occurring here in the United States. PIMCO is the world's largest bond manager, overseeing $2 trillion. Back in December, PIMCO said it was cutting exposure to long-dated U.S. debt because of deteriorating deficit dynamics. Can you explain more about your positioning there and just your overall concern as it pertains to the deficit? The U.S. continues to be the global reserve currency. We have an incredibly dynamic economy. We have very strong institutions. We will likely continue to attract a significant share of global capital. We do see other countries' sovereign debt that looks at least as good as the rate levels of the United States and is running much more prudent overall fiscal policy. So we're not running from U.S. treasuries. We're just looking to diversify into other areas of the world. Economists try to estimate how much investors will want to be compensated for longer-term risks like the federal budget and inflation. That's something called the term premium. If that is rising, it may mean investors are experiencing more uncertainty about macro conditions, whereas if it's declining, there's likely more stability. It's not a perfect statistic and models tend to vary, but in January, the term premium hit its highest level in more than a decade. It's pulled back a bit since then, but remains elevated. If we don't see signs of attempting to get debt under control, those probabilities of a more crisis-level type situation occurring will steadily go higher with time. And then again, when people worry about these tail scenarios, including PIMCO, we want to get paid a little bit more to combat against those types of risks. The more expensive borrowing costs become, that has broad ramifications for the economy. Because it can affect our economy, the health of our economy and the growth of our economy. Thanks to a combination of soaring debt and higher rates, the U.S. is expected to spend the most it ever has, nearly a trillion dollars on interest payments this year. The Congressional Budget Office expects net interest costs in 2025 to surpass spending on Medicare, Medicaid and national defense. Squeezing out other parts of the budget, whether it's tax cuts you want, whether it's higher defense, whether it's higher social spending, all of those things get squeezed out when your interest piece of the pie is growing as it is now. The cost to service the U.S. debt is expected to be 18 percent of total tax revenue this year. In 2022, that figure was less than 10 percent. You've borrowed so much that your interest payments are growing as a share of the federal budget and your debt is growing as a share of the economy. And it leaves you in a situation where it's slowing economic growth. The tax and spending legislation that just passed has garnered mixed reactions about what it may mean for the deficit. The nonpartisan CBO has estimated it would increase the deficit by trillions over the next decade. I tell policymakers in D.C., you might have your big, beautiful plan, but fixed income markets are the Mike Tyson. You might have your big, beautiful plan until you get punched in the face because they often are not polite. They often just break instead of bend. But some Republicans believe the one big, beautiful bill act will spur economic growth thanks to tax cuts. I don't believe in the CBO forecast. So let's just look at common sense and logic that if the bill for some reason hadn't passed, we would have the biggest tax hike in history. Treasury Secretary Scott Besant, who was unavailable to be interviewed for the piece, says the administration's focus is to grow the economy faster than the debt. His long-term goal is to cut in half the current 6.7 percent deficit to GDP ratio, which is the highest outside of a war or recession. That question has left bond vigilantes on the sidelines for now. I think the bond vigilantes are essentially correct. The U.S. should not be running a deficit like this. But for whatever reason, we're not at the levels yet where debt sustainability is a question. But that could change quickly. And if debt levels go unchecked, the U.S. risks leaving a weaker economy to the next generation. It used to be that people would say, it's okay, it's okay to borrow from the future generations because they're going to have a higher standard of living anyhow. But right now, it's a very risky moment where it's quite clear for younger generations, they don't know exactly what they're inheriting. Kyla Scanlon is an author and content creator focused on economic issues. On this day, she was speaking at George Mason University to a crowd of faculty and researchers. What structural issues do you see as the most significant threats to economic stability or growth in the next decade? What's your view of debts and deficit in that assessment? I think the debt and the deficit have to be analyzed. The interest payments are quite a weight and rates probably aren't going down anytime soon. Scanlon says young people risk not ever having access to Social Security, Medicaid and Medicare. Not only are they not going to have access to those services, but they're also going to have to pay for those who did before them. So it's kind of this double-edged issue. A growing debt load also limits the government's ability to fight off an emergency should there be one. 2008 financial crisis, COVID, we actually used debt to get our way out. People got used to those checks in the mail and other types of benefits and so forth. What happens now when debt itself is the problem? You can't use debt to get out of the debt problem. It's too late at that point. One thing that the past years and the growing geopolitical environment have shown us is that we should assume there will be future emergencies. We are not in an emergency-free moment. When Admiral Michael Mullen was asked back in 2010 what he thought was the biggest threat to national security, his answer shocked the nation. I responded that the most significant threat was our national debt, which was a bit of a surprise. The reporter and others actually would have expected some kind of weapon system or some kind of country or something like that. Mullen served as the chairman of the Joint Chiefs of Staff under Presidents George W. Bush and Barack Obama. Typically each year, the Defense Department budget takes up about half of that uncommitted money. As interest rates possibly would go up, as our debt continued to increase, and we pay off our debt with some of that uncommitted money as well, it would just squeeze the defense budget at a time of increasing international and geopolitical concerns, where it was my view the defense budget really needed to at least be maintained or rise over time. This year, the U.S. is expected to spend about $93 billion more on interest payments than on defense. The great power is spending more on interest payments than on defense. It won't be great for very much longer. The U.S. crossed that threshold last year. Ferguson says the debt burden draws in scarce resources, with less for national security, which leaves an otherwise great power vulnerable to a military challenge. Less interest rates come crashing down, which they haven't yet done. That means that interest payments are going up. So that is a really major problem for a superpower that it is in a game of chicken with another superpower. Do our adversaries pay attention to our debt levels and our deficits and see that as a potential vulnerability and a potential weakness in light of all this instability? I would think that Putin in Russia, Xi Jinping in China, see this as a vulnerability. And you've heard President Xi in China over the last, certainly decade plus, talk about the United States being in decline. The irony is China is one of the largest foreign holders of U.S. treasuries, although it's been steadily reducing its stash. International holdings of U.S. treasuries were near a record $9 trillion in April. Experts have warned that foreign creditors theoretically could use their bonds as financial leverage in a geopolitical disagreement. We don't know exactly how many treasuries they have. Certainly it's probably about $800 billion, but there's more that's not even transparent. It's not clear that this would happen, but you could dump treasuries if one wanted to create a lot of different fiscal risks at one time. Though dumping treasuries is unlikely, as the country would have to accept steep losses. Japan, one of the largest exporters to the U.S., holds more than a trillion dollars worth of U.S. debt, the most of any foreign country. It really, really took off in the late 70s, in the 80s, as Japan was an exporting nation, accumulating dollars over time through the trade balance side of things, and they had to reinvest that money. Here's an example of how that works. When a Japanese automaker sells a car to a U.S. consumer, the company receives, let's say, $30,000. The automaker needs to then convert that cash to Japanese yen to pay its expenses, like workers and suppliers. The money goes to a Japanese bank to help with the exchange. The bank then invests the dollars it receives into U.S. treasuries because they're safe and easily traded. As the Trump administration reworks global trade relationships, there's a looming question around how it all could shift foreign appetite for treasuries. The White House says higher tariffs will generate additional revenue to shrink the budget deficit. It's our turn to prosper, and in so doing, use trillions and trillions of dollars to reduce our taxes and pay down our national debt, and it'll all happen very quickly. The Tax Foundation estimates that a 10% universal tariff could bring in trillions of dollars, but that revenue would diminish when accounting for the broader economic impact. Eventually, the solution to the deficit is likely to come down to the hard work of budgeting. Dangerously polarized moment that we're in, where partisan politics seems to be far more important to lawmakers than actually governing, has led both parties to adopt all of the easy things. They both love cutting taxes and growing spending. I think it's going to be very difficult to turn this fiscal situation around without also looking at the underlying political challenges. Do you still see this as the biggest threat to national security? Great question, and my answer is no. I actually think the political division in the country has risen to our biggest threat. The debt is one, education is another, the health care issue, the social security issue. That is going to take bipartisan support. It's going to take leaders from both sides of the political aisle to agree, and I think to compromise, in order to generate solutions which can move us ahead. And with the political divide seemingly increasing, that becomes harder and harder.