Author: Lyn Alden, Investment Analyst; Compilation: AIMan@Golden Finance
The persistence of deficits has multiple implications for investment, but in the process, it is important not to be distracted by illogical things.
Fiscal Debt and Deficit 101
Before I delve into these misconceptions, it is necessary to quickly review the specific meanings of debt and deficit.
-In most years, the U.S. federal government spends more than it collects in tax revenue. This difference is the annual deficit. We can see the change in the deficit over time in the figure, including the nominal deficit and the percentage of GDP:
-Since the U.S. federal government has been in deficit for many years, these deficits have accumulated to form the total outstanding debt. This part of the debt is the debt stock that the U.S. federal government owes to creditors, and the federal government needs to pay interest on it. When some bonds mature, they issue new bonds to repay the old ones.
A few weeks ago, at a conference in Las Vegas, I gave a keynote speech on the state of US fiscal debt, a 20-minute simple summary of the state of US fiscal debt.
As that speech and what has been elaborated over the years, my view is that the US fiscal deficit will be quite large for the foreseeable future.
Misconception 1. It's debt we owe to ourselves
A common saying promoted by Paul Krugman and others is: 'We owe it to ourselves.' Supporters of Modern Monetary Theory also often make similar statements, for example, they believe that accumulated outstanding debt is mainly just the total amount of surplus allocated to the private sector.
The implicit meaning behind this sentence is that the debt is actually not a big problem. Another potential meaning is that we may be able to selectively default on some of the debt because it is just 'we owe it to ourselves'. Let's analyze these two parts separately.
Who is owed?
The federal government owes money to holders of U.S. Treasury bonds. This includes foreign entities, U.S. institutions, and U.S. individuals. Of course, the amount of Treasury bonds held by these entities is fixed. For example, the Japanese government is owed much more dollars than I am, even though we both hold Treasury bonds.
If you, me, and eight other people go out to dinner together, we will all end up owing money. If we each eat different amounts, then we may owe different amounts. The expenses usually need to be split fairly.
In the case of the aforementioned dinner, it's really not a big deal, because the people who dine together are usually friendly with each other, and people are willing to generously provide meal expenses for others at the dinner. But in a country with 340 million people living in 130 million different households, this is no small matter. If you divide the $36 trillion in federal debt by 130 million households, each household's total federal debt is $277,000. Do you think this is your family's fair share? If not, how should we calculate it?
In other words, if you have $1 million in Treasury bonds in your retirement account, and I have $100,000 in Treasury bonds in my retirement account, but we are both taxpayers, then while in some sense 'we owe it to ourselves,' it is certainly not equal.
In other words, numbers and ratios do matter. Bondholders expect (usually incorrectly) that their bonds will maintain their purchasing power. Taxpayers expect (also usually incorrectly) that their governments will maintain a sound foundation for their currency, taxation, and spending. This seems obvious, but sometimes it needs to be clarified anyway.
We have a shared ledger, and we have a division of powers over how we manage that ledger. These rules may change over time, but the overall reliability of the ledger is why the whole world uses it.
Can we selectively default?
Individuals, businesses, and countries that owe debts denominated in currencies that cannot be printed (such as gold ounces or other currencies) can indeed default if they lack sufficient cash flow or assets to repay the debts. However, the debt of developed countries is usually denominated in their own currency and can be printed, so nominal defaults rarely occur. For them, it is easier to print money and devalue the debt relative to their own economic output and scarce assets.
I and many others would consider a sharp currency devaluation to be a default. In this sense, the U.S. government defaulted on bondholders in the 1930s by devaluing the dollar against gold, and then again in the 1970s by completely decoupling the dollar from gold. The period of 2020-2021 was also a default, as the broad money supply grew by 40% in a short period of time, and bondholders experienced the worst bear market in over a century, with their purchasing power declining sharply relative to almost all other assets.
But from a technical level, a country may nominally default even if it does not have to default. Rather than making all bondholders and currency holders suffer the pain of devaluation, it may be preferable to protect currency holders and non-defaulting bondholders broadly by defaulting only on unfriendly entities or entities that can afford it. In such a tense geopolitical environment, this is a possibility worth considering seriously.
So the real question is: are there certain situations where the consequences of an entity defaulting are limited?
Some entities, if defaulted on, will have very serious and obvious consequences:
-If the government defaults on retirees or asset management companies holding Treasury bonds on behalf of retirees, this will undermine their ability to support themselves after working their entire lives, and we will see older people taking to the streets to protest.
-If the government defaults on debts to insurance companies, it will weaken their ability to pay insurance claims, thereby harming American citizens in the same terrible way.
-If the government defaults on banks, the banks will lose their solvency, and consumer bank deposits will not be fully supported by assets.
Of course, most entities (the surviving ones) will refuse to buy Treasury bonds again.
What remains are some easier targets. Are there entities that the government can default on that would be less damaging and less life-threatening than the options above? The possibilities usually lie with foreign companies and the Fed, so let's analyze them separately.
Analysis: Default on Foreign Debt
Currently, foreign entities hold approximately $9 trillion in U.S. Treasury bonds, approximately one-quarter of the total U.S. outstanding debt of $36 trillion.
Of this $9 trillion, approximately $4 trillion is held by sovereign entities and $5 trillion is held by foreign private entities.
In recent years, the possibility of defaulting on specific foreign entities has undoubtedly increased significantly. In the past, the United States froze sovereign assets of Iran and Afghanistan, but these assets were small and extreme cases and were not enough to constitute any 'real' defaults. However, after Russia's invasion of Ukraine in 2022, the United States and its allies in Europe and other regions froze more than $300 billion in Russian reserves. Freezing is not exactly the same as defaulting (it depends on the ultimate fate of the assets), but it is very close to defaulting.
Since then, foreign central banks have become significant buyers of gold. Gold represents an asset they can hold themselves, thereby avoiding default and confiscation, while also being less prone to depreciation.
The vast majority of U.S. debt held by foreigners is held by friendly countries and allies. These countries include Japan, the United Kingdom, Canada, and so on. Some of these countries, such as the Cayman Islands, Luxembourg, Belgium, and Ireland, are havens where many institutions set up institutions and hold U.S. Treasury bonds. Therefore, some of these foreign holders are actually U.S. entities incorporated in these places.
China currently holds less than $800 billion in Treasury bonds, equivalent to only 5 months of U.S. deficit spending. They are at the top of the risk of potential 'selective default', and they are aware of this.
If the U.S. defaults on such entities on a large scale, it will greatly weaken the U.S.'s ability to persuade foreign entities to hold its Treasury bonds for the long term. Freezing Russian reserves has already sent a signal, to which countries have reacted, but at the time they did so under the guise of Russia's 'de facto invasion'. Defaulting on debt held by non-aggressive countries would be seen as a clear default.
So, overall, this is not a particularly viable option, although it is not impossible in some cases.
Analysis: Fed Default
Another option is that the Treasury could default on the U.S. Treasury bonds held by the Fed. Currently, the Fed holds slightly more than $4 trillion in U.S. Treasury bonds. After all, this is the closest thing to 'we owe it to ourselves,' right?
There are also significant problems with this.
The Fed, like any bank, has assets and liabilities. Its main liabilities are 1) physical currency and 2) bank reserves owed to commercial banks. Its main assets are 1) US Treasury bonds and 2) mortgage-backed securities. The Fed's assets pay it interest, and the Fed pays interest on bank reserves to set a floor for interest rates, curb banks' incentives to lend, and create more broad money.
Currently, the Fed is bearing huge unrealized losses (hundreds of billions of dollars) and paying far more in interest each week than it earns in revenue. If the Fed were a normal bank, it would certainly experience a run and eventually fail. But since the Fed is the central bank, no one can run on it, so it can operate at a loss for a long time. The Fed has accumulated net interest losses of over $230 billion over the past three years:
If the Treasury completely defaults on the Fed's debt, then at actual exchange rates, it will be severely insolvent (liabilities will exceed assets by trillions of dollars), but as a central bank, they can still avoid bank runs. Their weekly net interest losses will be even greater, because by then they will have lost most of their interest income (because they will only have mortgage-backed securities left).
The main problem with this approach is that it undermines any notion of central bank independence. The central bank should be fundamentally separate from the executive branch. For example, the president cannot cut interest rates before an election and raise them after, or do similar mischief. The president and Congress appoint the Fed board and give them long terms, but from then on the Fed has its own budget and should generally be profitable and self-sufficient. A defaulted Fed is an unprofitable Fed with huge negative equity. Such a Fed is no longer independent, or even an illusion of independence.
One potential way to alleviate this problem is to eliminate the interest the Fed pays on bank reserves to commercial banks. However, this interest exists for a reason. This is one of the ways the Fed sets a floor for interest rates in a reserve-rich environment. Congress can legislate: 1) mandate banks to hold a certain percentage of assets as reserves; 2) eliminate the Fed's ability to pay commercial banks interest on these reserves. This would shift more of the problem to commercial banks.
The last option is one of the more viable routes and has relatively limited consequences. Bank investors (rather than depositors) will be harmed, and the Fed's ability to influence interest rates and the size of bank lending will be weakened, but this will not be an overnight disaster. However, the federal deficits held by the Fed are only equivalent to about two years of federal deficits, about 12% of the total federal debt, so this slightly extreme financial repression program can only serve as a temporary 'ointment' to alleviate the problem.
In short, we don't owe it to ourselves. The federal government owes specific entities, both domestic and foreign, which, if defaulted on, would suffer a series of consequential damages, many of which would in turn harm the federal government and American taxpayers.
Misconception 2. People have been saying this for decades
Another thing you often hear about debt and deficits is that people have been calling it a problem for decades, and things have been fine. The implication of this view is that debt and deficits are not a big problem, and those who think they are important will eventually just 'cry wolf' prematurely over and over again, and can therefore be safely ignored.
Like many misconceptions, there is some truth here.
As I pointed out earlier, the 'zeitgeist peak' of the view that federal debt and deficits are a problem can be traced back to the late 1980s and early 1990s. The famous 'Debt Clock' was erected in New York in the late 1980s, and Ross Perot's most successful independent presidential campaign in modern history (winning 19% of the popular vote) largely revolved around the theme of debt and deficits. Interest rates were very high at the time, so interest expense was a high percentage of GDP:
Those who thought debt would get out of control at the time were indeed wrong. Things have been fine for decades. There are two main things that have caused this. First, the opening of China in the 1980s and the dissolution of the Soviet Union in the early 1990s had a very serious deflationary impact on the world. A large amount of Eastern labor and resources were able to connect with Western capital, bringing a large supply of new goods to the world. Second, partly due to these factors, interest rates were able to continue to fall, which made the interest expense on the growing total debt in the 1990s, early 2000s, and 2010s more manageable.
So, yes, if someone said 35 years ago that debt was an imminent problem and is still talking about it today, I can understand why someone would choose to ignore them.
However, people should not think too far ahead and think that just because this has been irrelevant during this time, it will always be irrelevant. This is a fallacy.
Multiple trend changes occurred in the late 2010s. Interest rates fell to zero and have not been on a structural downward trend since. The baby boomer generation began to retire, causing Social Security trusts to peak and enter reduction mode, and globalization also reached a potential peak, with three decades of interconnection between Western capital and Eastern labor/resources largely ending (and now perhaps slightly reversing).
Some trend changes, visualized as follows:
We have not reached the point where debt or deficits will trigger a massive disaster in the short term. However, we have entered an era where deficits do have an impact and produce consequences. Depending on whether you bear these deficits, you may feel that the impact of these deficits is positive or negative, but in any case, they will have an impact. These effects can be measured and reasoned, and therefore have an impact on the economy and investment.
For six years, after witnessing some early stages of trend changes, I have been emphasizing that fiscal spending is playing an increasingly important role in modern macroeconomic and investment decisions. For years, it has been my main 'North Star' as I navigate this rather chaotic macroeconomic environment.
Since these trend changes began to occur, taking debt and deficits seriously has been a good way to: 1) not be surprised by some of what has happened; 2) manage investment portfolios more successfully than a typical 60/40 stock/bond portfolio.
-My 2019 article (Are We In A Bond Bubble?) was the preface to this paper. I concluded that, yes, we may be in a debt bubble, and that the combination of fiscal spending and central bank debt monetization may be more influential and inflationary than people think, and that this is likely to happen in the next economic downturn. In early 2020, I wrote (The Subtle Risks of Treasuries), warning that Treasuries could depreciate significantly. In the 5-6 years since that article was published, the bond market has experienced its worst bear market in over a century.
-At the height of the deflationary shock in March 2020, I wrote (Why This Is Different From The Great Depression), emphasizing how massive fiscal stimulus (i.e., deficits) was starting and could get us back to nominal equity highs faster than people thought, albeit at the cost of high inflation.
For the rest of 2020, I successively published a series of articles, such as (Quantitative Easing, Modern Monetary Theory, and Inflation/Deflation), (A Century of Fiscal and Monetary Policy), and (Banks, Quantitative Easing, and Printing Money), exploring why the strong combination of fiscal stimulus and central bank support is very different from the bank capital restructuring quantitative easing policy in 2008/2009. In short, my argument is that this is more like war financing during the inflationary period of the 1940s than private debt deleveraging during the deflationary period of the 1930s, so holding stocks and hard currency would be better than holding bonds. As a bond short, I spent a lot of time debating this topic with bond longs.
By the spring of 2021, the stock market had risen sharply, and price inflation did start to break out. My May 2021 newsletter (Fiscal Driven Inflation) further described and predicted this issue.
In 2022, as price increases peaked and fiscal stimulus during the pandemic gradually failed, I became quite cautious about fiscal consolidation and potential recession. My January 2022 newsletter (Capital Sponge) was one of my early frameworks for this scenario. Most of 2022 was indeed a bad year in terms of broad asset prices, and the economy slowed down significantly, but by most metrics, the recession was avoided due to what started happening later that year.
Towards the end of 2022, and especially in early 2023, the fiscal deficit widened again, largely due to the rapid rise in interest rates inflating interest payments on public debt. The Treasury General Account pulled liquidity out of the banking system, and the Treasury turned to issuing excess T-bills, a liquidity-friendly move designed to draw funds from reverse repurchase facilities back into the banking system. Overall, deficit expansion was back 'at war'. My July 2023 newsletter, titled 'Fiscal Dominance', focused on this theme.
- In October 2023, the 2023 federal fiscal year (from October 2022 to September 2023) has ended, and the nominal deficit has increased again. I started the 'Nothing Can Stop This Train' meme with this theme (originally from the TV series (Breaking Bad), but here it refers to the U.S. fiscal deficit). My tweet was like this:
I constantly emphasize this because it effectively expresses the point:
My view is that we are in an era where the total amount of debt and the sustained federal deficit are having a real impact. Depending on whether you bear these deficits, you may feel that the effects of these deficits are positive or negative, but in any case, they will have an impact. These effects can be measured and reasoned and therefore have an impact on the economy and investment.
Misconception 3. The dollar is about to collapse
The first two misconceptions contradict the common view that debt doesn't matter.
The third is a bit different because it refutes the view that things will explode tomorrow, next week, next month, or next year.
Those who claim that things will explode soon tend to fall into two camps. The first camp is people who benefit from sensationalism, click rates, and so on. The second camp is people who really misunderstand the situation. Many people in the second camp have not conducted in-depth analysis of foreign markets, so they cannot really understand the real reasons for the collapse of sovereign bond markets.
The US deficit is currently around 7% of GDP. As I have pointed out many times, this is largely structural and will be difficult to significantly reduce now or in the next decade. However, a deficit of 70% of GDP is not the problem. Scale matters.
Here are some important metrics to quantify.
-The federal government's debt is slightly above $36 trillion. In contrast, the total assets of U.S. households are $180 trillion, and after deducting liabilities (mainly mortgages), net assets are $160 trillion. However, since we don't 'owe it to ourselves,' this comparison is a bit like apples and oranges, but it helps put the huge numbers into a more specific context.
The U.S. monetary base is approximately $6 trillion. The total amount of outstanding dollar-denominated loans and bonds (including public and private sectors, domestic and international sectors, excluding derivatives) exceeds $120 trillion. In the overseas sector alone, dollar-denominated debt is approximately $18 trillion, three times the existing base dollars.
This means that the demand for dollars, both domestically and internationally, is extremely large and inflexible. All holders of U.S. debt need dollars.
When countries like Turkey or Argentina experience hyperinflation or near-hyperinflation, the context is that almost no one needs their lira or peso. There is no deep-rooted demand for their currencies. Therefore, if their currencies become unpopular for any reason (usually due to rapid money supply growth), people can easily reject it and send its value to hell.
This is not the case with the dollar. All of this $18 trillion in foreign debt represents rigid demand for the dollar. Most of it is not owed to the United States (the United States is a net debtor country), but foreigners do not 'owe it to themselves' either. Countless specific entities around the world owe a certain amount of dollars to countless other specific entities around the world by contract before a specific date, so they need to constantly try to acquire dollars.
The fact that they owe more dollars in total than there are base dollars in existence is critically important. This is why the monetary base can double, triple, or more without triggering outright hyperinflation. Relative to the contractual demand for dollars, this is still a small increase. When outstanding debt far exceeds the amount of base dollars, it takes a lot of base dollar printing to make that base dollar worthless.
In other words, people seriously underestimate how much the U.S. money supply can grow before triggering a real dollar crisis. It's not hard to create politically problematic levels of inflation or other problems, but creating a real crisis is another matter.
Imagine debt and deficits as a dial, not a switch. Many people will ask 'When will it matter?', as if it were a light switch that would go from no problem to disaster. But the answer is, it's usually a dial. It already matters now. We're already running hot. The Fed's ability to regulate the growth of total new credit has been damaged, putting it in a position of fiscal dominance. But the rest of the dial has a lot of room to turn before it really reaches the end.
That's why I use the phrase 'Nothing Can Stop This Train'. The deficit problem is more difficult than the bulls imagine, which means the U.S. federal government is unlikely to get them under control in the short term. But on the other hand, it's not as imminent as the bears imagine; it's unlikely to trigger a complete dollar crisis in the short term. It's a long and slow train wreck. A pointer is gradually turned.
Of course, we may encounter a small crisis similar to the UK gilt crisis in 2022. Once it happens, hundreds of billions of dollars can usually put out the fire at the cost of devaluation.
Suppose bond yields soar to the point where they cause bank bankruptcies or severe illiquidity in the U.S. Treasury market. The Fed can take measures such as quantitative easing or yield suppression. Yes, this comes at the cost of potential price inflation and has an impact on asset prices, but in this case, it will not trigger hyperinflation.
In the long run, the dollar does face significant problems. But there is no indication of a catastrophic problem in the short term, unless we become socially and politically divided (which is not related to data and is therefore not discussed in this article).
Here is some background information. Over the past decade, the US broad money supply has cumulatively increased by 82%. During the same period, the Egyptian broad money supply increased by 638%. The Egyptian pound has also depreciated about 8 times more than the dollar; ten years ago, $1 exchanged for slightly less than 8 Egyptian pounds, while today, $1 exchanges for slightly more than 50 Egyptian pounds. For most of this decade, Egyptians have faced double-digit price inflation.
I live in Egypt for a period of time every year. Life is not easy there. They often suffer from energy shortages and economic stagnation. But life goes on. Even that degree of currency devaluation is not enough to throw them into a complete crisis, especially with institutions like the International Monetary Fund (IMF) present, they can basically continue down the path of increasing debt and currency devaluation.
Imagine how much it would take to put the dollar in that situation, let alone a worse one, considering how inflexible the demand for the dollar is. When people think the dollar is about to collapse, I usually assume they haven't been to many places or studied other currencies. Things may be much worse than people think, but still able to function partially.
More data shows that broad money supply in China has grown by 145% in the past decade, Brazil by 131%, and India by 183%.
In other words, the dollar does not go directly from a developed market currency to a collapsing currency. In the process, it has to go through 'emerging market syndrome'. Foreign demand for the dollar may weaken over time. Persistent budget deficits and the increasing control of the Fed may lead to a gradual acceleration in money supply growth and financial repression. Our structural trade deficit gives us monetary vulnerabilities that structurally trade surplus countries do not have. But we start as a developed market with deep-rooted global network effects, and as things get worse, our currency may resemble emerging market currencies in many ways. For quite some time, it may be more like the Brazilian currency, then the Egyptian currency, then the Turkish currency. It won't jump from the dollar to the Venezuelan Bolivar in a year or even five years, unless there is an event like a nuclear strike or civil war.
In summary, the United States' rising debt and deficit situation is indeed having increasingly realistic consequences, both now and in the future. It is neither as negligible as the 'everything is fine' camp claims, nor is it about to bring disaster as the sensationalist camp claims. It is likely to be a thorny issue and will haunt us as a background factor for quite some time, and investors and economists must take this into account in order to make accurate judgments.