As of today, the U.S. debt now stands at over $20 trillion. $20 trillion! It’s almost incomprehensible. The media’s attempt to illustrate it has only made it more frightening:
-If you had spent $1 million per day since Jesus was born, you would not have even spent $1 trillion yet!
-If the $20 trillion national debt was laid in a single line of $1 bills, the pile would stretch from the Earth past Uranus!
That’s scary imagery, but as Arthur Clarke told us, “Only small minds are impressed by large numbers.” The hysteria over the $20 trillion debt is misplaced.
There is a perception, perpetuated by the media and many of our elected officials, that the U.S. debt is already out of control. Tens of trillions of dollars in entitlement spending loom — and there is nothing that the federal government (or the voters) can do to address the problems. Many believe that a day of reckoning lurks, when the U.S. government will collapse under the weight of its own debt.
The reality is very different. Let’s take a look at the history of U.S. debt (Exhibit 1) and address the most common misperceptions about it.
1. Misperception: The United States is a bad credit risk.
a. Land: The U.S. government owns 640 million acres of land. That’s 28% of the nation’s total surface and includes 47% of all the land in the west. What’s it all worth? A lot.
b. Commodities: It is estimated that the United States sits atop $119 trillion in oil, $22 trillion in coal, and more than $8 trillion in natural gas.
c. Military equipment: What are the P-8A Poseidon and F-35 Lightning aircraft, the CVN-78 aircraft carriers, the Arleigh Burke DDG 51 destroyer warships and the Trident II submarine-launched ballistic missiles all worth? All U.S military equipment is estimated at $6 trillion to $20 trillion.
d. Present value of future taxes: The average nominal growth rate since 1980 has been 5.5% annually. If the economy grows at a rate of only 4% for the next 50 years, the economy will grow to be $131 trillion. The United States, on average, collects tax revenue equal to 17% of gross domestic product. In this scenario, by 2066, the country will be collecting $22 trillion per year in tax revenue.
In short, the assets and taxing power of the U.S. government dwarf its liabilities, which aren’t even close to threatening the country’s solvency. So, any notion that the United States is bad credit risk is, in our view, a myth (Exhibit 2).
2. Misperception: The United States is reliant on foreign investors to fund the debt. There will be trouble ahead when the Chinese decide to sell their Treasuries.
The biggest holders of U.S. debt are entities of the federal government, including the U.S. Federal Reserve and the Social Security Trust Fund. Fully 27% of the debt outstanding is money that the federal government owes to itself. In fact, the debt held by the public stands at $14.4 trillion, representing 76% of gross domestic product, a ratio that — though high — isn’t necessarily exorbitant considering the relative size of the U.S. economy and investor demand for U.S. Treasury bonds.
Foreign investors own 40% of U.S. Treasury debt outstanding. A primary reason that foreigners own a lot of the U.S. debt is that we buy their goods and they either sell the dollars in favor of their home currency or buy U.S. assets, the favorite of which has been U.S. Treasuries.
So what happens if China ever decides to reduce their holdings of U.S. Treasuries? It’s already happening at a generally passive rate. Chinese ownership of U.S. Treasuries peaked at $1.3 trillion in 2013 and now stands at close to $1 trillion. The Chinese have reduced their exposure by $300 billion (nearly a quarter of their peak exposure) of Treasuries over the past three years and the borrowing costs of the U.S. government actually fell over that time!
Finally, all of the federal government debt is in U.S. dollars. This is very different than other countries, such as Russia, Argentina, and Mexico for example, who have gotten into debt trouble because they had much, if not most, of their debt in foreign currencies. The U.S. debt could become inflationary at some point (we’ll pay you back but those dollars might not be worth as much as you originally hoped) but it is domestic factors (revenue and expenditures) that will determine the sustainability of the debt and not trade or current account flows.
3. Misperception: The government spends most of your money on pork projects and random programs.
Contrary to popular opinion, the annual deficits are not the result of pork spending and random projects. In a given year, roughly 80% of federal spending is allocated to mandatory entitlement programs like Social Security, Medicare, and the Supplemental Nutrition Assistance Program (formerly known as the Food Stamp Program), and to military spending. Add in the interest on the debt and you’re at 87%.
Ezra Klein said it best: “If you look at how the federal government spends our money, it is an insurance conglomerate protected by a large, standing army.”
4. Misperception: The U.S. has over $100 trillion in unfunded liabilities. This is catastrophic for the country and signals that the nation is already insolvent.
$100 trillion in unfunded liabilities! End times are here, right? Fortunately, the answer is a resounding no.
Unfunded liabilities are forecasts of the federal government’s obligations in healthcare and Social Security over the next century and beyond. That’s not the debt. It’s simply promises made to future retirees, many of whom are children or not yet even born.
Our politicians can make changes to the programs without damage to the credit rating of the federal government. It’s happened before. In the late 1970s and early 1980s, the costs of funding Social Security benefits exceeded the assets in the trust fund. The Greenspan Commission, chaired by the namesake who would later become Federal Reserve Chairman, proposed a series of amendments to rebuild the Social Security Trust Fund, including increasing the payroll tax, raising the retirement age, and requiring government employees to pay into Social Security. President Ronald Reagan signed the bill into law and the trust fund was rebuilt.
Today, the expected shortfall in Social Security that begins in 2035 could be covered entirely by eliminating the taxable maximum (the Federal Insurance Contributions Act tax currently applies only to the first $127,200 of earnings) or by increasing the retirement age, increasing the payroll tax and reducing cost of living adjustments. These are not exactly draconian measures.
As for Medicare, the unfunded liabilities are calculated by extrapolating the current growth rate of health care costs forward. It assumes that seven decades of innovation will do nothing to change the rate of health care inflation. For example, ongoing advancements in personalized medicine (a.k.a. genomic or precision medicine) have the potential to forever transform healthcare and the costs associated with it. And just to play it safe, we can cover the entire present value shortfall of Medicare by simply increasing the payroll tax rate from 2.9% to 3.6%.
5. Misperception: The debt is not a problem today because interest rates are low. The trouble begins when interest rates rise.
Interest rates tend to track the nominal growth rate of the country. History suggests that a move in the 10-year Treasury rate from 2.5% to 4.5% would coincide with a similar move in the nominal growth rate.
- Let’s assume that the U.S. issues $10 trillion in new bonds over the next 10 years.
- A one-time sustained 2% increase in the 10-year Treasury rate today, all else being equal, would add approximately $200 billion in interest expense to the federal government over the next 10 years. At first glance, the figure is disconcerting.
- The high historical correlation between U.S. Treasury rates and nominal gross domestic product (GDP) suggests that the country’s growth rate will have also increased by 2%. At a 2.5% growth rate, U.S. nominal GDP will be $23 trillion by 2026; but at a 4.5% growth rate, U.S nominal GDP will be nearly $29 trillion by 2026.
- The U.S. Treasury collects tax revenue, on average, equal to 17% of GDP. Seventeen percent of the additional $6 trillion in gross domestic product is $1 trillion in additional tax revenue, which would more than offset the $200 billion in extra interest expense.
$20 trillion is a scary number and U.S. debt, if left unchecked, can become a bigger problem over time. Fortunately, the solutions to the nation’s debt problems are not unworkable. Rather, they will come down to the political will of the nation to slow the rate of spending or generate new and/or growing sources of revenue.
As always, investors can come up with 20 trillion reasons to not be invested. I posit that for today and the foreseeable future, the debt should not be one of them.
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