Debt is always a liability from an accounting perspective, but can be either a liability or an asset from an economic perspective. That is to say, debt from an economic perspective can in some cases help the borrower do things he or she or it could not have otherwise done. Mortgages help people buy houses that many could not otherwise buy. Corporate debt used properly helps companies do projects that are good for the economy and society.  

Not many would argue that federal debt has been on balance an economic asset for the United States. Debt has helped the U.S. win military conflicts, combat several depressions, weather multiple stock market crashes, and endure the largest pandemic in history. The federal government funded its responses in every case partly with debt (also by printing money, but that is a separate topic). The U.S. has survived many disasters and part of its very survival is due in part to its ability to borrow and spend at certain crucial turning points in its history.

Today’s debt, though, feels different to us. Today’s debt seems far more like an economic liability than an economic asset, perhaps an enormous liability. We see at least five aspects of today’s federal debt that make it so.

First, it is unprecedented both in its absolute size and in its size relative to the U.S. economy. The $31 trillion of federal debt is about 130% of U.S. GDP. It has never been higher in the history of the country.

Second, today’s debt exists after one of the more prosperous and peaceful episodes in U.S. history. Federal debt as a percentage of GDP has spiked in the past during and after major military conflicts: after World War II it stood at about 100%, after World War I at 38%, after the U.S. Civil War at about 30%. In each case it came down relatively quickly as the economy flourished post-conflict.

Today’s debt is the result not of a major military conflict, but of good old fashioned complacency by the U.S. in its spending, a complacency fueled by ever-decreasing (until recently) interest rates.

The bursts in government debt in the past to fight major military conflicts were made possible by low levels of debt heading into those conflicts. Untapped borrowing capacity was a great competitive advantage for the U.S. back then. Since the U.S. accumulated its current debt during a period of peace and prosperity, it no longer has the untapped borrowing capacity to fight the next catastrophe, military or otherwise. The U.S. federal debt is starting at the wrong end of the spectrum (that is, it is too high) if the U.S. encounters problems in the months and years ahead; it has in short lost the option value that comes with large unused borrowing capacity.  

Third, we know with certainty that the U.S. does have some big financing requirements in the not-too-distant future. Interest payments on the growing mountain of debt in an increasing-interest-rate environment is one. Funding social programs like Social Security, Medicare, and Medicaid that will soon turn into major deficits as the baby boomers retire is a second. These are trillions of dollars of annual and incremental obligations that will continue for as far as the eye can see.

Fourth, the U.S. has not just one issue to solve, but two. It has a debt problem and an inflation problem. Having both at once complicates the solution to each. In order to fight inflation, the U.S. Fed needs to jack up interest rates, both real and nominal. Jacking up interest rates increases the financing burden of the U.S. Government. The larger the amount of debt, the bigger the burden.

The last time the U.S. successfully fought inflation with Paul Volcker as Fed Chairman in the early 1980s, federal debt as a percent of GDP was just 32%, versus 130% today. Raising interest rates to fight inflation will create a far bigger funding burden for the U.S. Government today than it did in the 1980s.

The other alternative for the Fed is to abandon its inflation-fighting campaign and let a depreciating dollar ease the financing burden of the U.S. Government.

It will be difficult - impossible in our view - for the U.S. to solve its dual problems without significant economic pain either in the form of debt-related issues or in the form of inflation. The U.S. Government (including the Federal Reserve) has no attractive options.   

Fifth, traditional buyers of U.S. Government debt over the last decade and a half are today all major sellers.

The U.S. Federal Reserve has been the biggest buyer in recent years. It now holds $6 trillion of U.S. debt.  Today, the Fed is selling U.S. debt (or not replacing it when it matures) to the tune of $95 billion a month in its campaign to fight inflation.

The Social Security Trust Fund has been the second largest buyer and now holds nearly $3 trillion of government debt. The U.S. Social Security program has until recently taken in more than it has doled out as the baby boomer generation was in its peak-earnings years. The surplus went into the Social Security Trust Fund and the Social Security Trust Fund invested it in U.S. Federal Debt. With a constant influx of funds, The Social Security Trust Fund was a reliable buyer of U.S. Federal debt. The baby boomers are now retiring. Their contributions are now turning to withdrawals. The surplus has turned into a deficit. The Social Security Trust Fund will increasingly need to sell government debt (or not replace it when it matures) in order to close the deficit.    

China and Japan have also traditionally bought U.S. Government debt. Combined they now own just over $2 trillion of it. Both were once reliable purchasers. Both are now sellers.

At the very time U.S. borrowing requirements are set to explode higher, the traditional buyers of U.S. Government debt are drying up.

We think there is a problem brewing.

The U.S. will get through it. It always does. We think it will be painful, though. We suspect problems will surface sometime within our 3 to 5-year investment horizon, quite possibly in the next twelve months or so. We have all but eliminated our direct exposure to the U.S. economy. When storm clouds gather, we take shelter.