National Debt Masterclass Finale - What To Do
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Welcome money for the rest of us. This is a personal financial on money, how IT works, how to invest IT and how to live without worrying about IT. I'm your host David's stein.

Today is episode four seventy nine. It's our finally in our three part master class on the national debt. In the past two episode, i've reviewed some important principles.

When IT comes to federal government borrowing first, the national debt will never be paid off. IT will just continue to be rolled over and potentially grow over time. What matters is the size of the debt relative to the economy.

The private sector economy that creates the bulk of the income pays the taxes that are used to service the that private sector owns much of the debt in the form of assets. A second principle we discussed with how the federal government, working with the central bank, can control the terms of the dead issuance, including controlling the interest rate through what is known as financial repression. Now, even though governments can do that, they don't get a free pass.

The private sector can decide whether they want to hold the debt or hold the currency that the debt is dominated in. If the central bank of coordinating with the government is buying up the debt, monetizing the debt, at the same time, the government running a budget deficit that leads to big increases in the money supply, which there are capacity constraint, can lead to much higher inflation, and that's something we've seen in the U. S.

Over the past few years. Consequently, there, there are consequences to government borrowing and government money creation. Too much of IT can overwhelm the private sector, leading to inflation.

Now, in part three, we're going to look at a simple formula to understand where are we at what level is the debt too high, where a potential default becomes a reality, even if that default is through monetization, higher inflation because the private sector doesn't want to hold the debt. If we go back to two thousand eight, just prior to the great financial crisis, the size of the U. S.

National debt, the publicly held debt as a percent of economic output or GDP, that's the the best way to measure IT the size of the debt relative to the economy IT was thirty five percent in two thousand and seven. The lowest to god was back in nineteen seventy four at twenty three point two percent. Now there are various entities that project the level of the national debt going forward.

The most renowned is the gresson's budget office. This is a federal agency that produces non part an independent analysis of the impact of U. S.

Government's budget, new bills and then projects our levels of the national debt back in two thousand and eight. The congressional budget office issued the report. They do this annually, and they expected that in twenty fourteen that det.

GDP six years later would be between sixty percent and sixty nine percent. And the actual debt to GDP amount in twenty fourteen was seventy four percent. The amount was higher than the prediction.

And there is a pattern here. In twenty fourteen, the congressional budget office predicted that in twenty twenty three, debt to GDP would be seventy eight percent. Actual was ninety nine percent. Now the congressional during office predicts in twenty thirty four that debt to GDP will be one hundred and thirty nine percent.

The amount is increasing relative to the site, the economy, and we could get at a level words too high and people don't want to hold the debt, leading to a Spike in interest rates earlier this year. Federal serve chair power, speaking on sixty minutes, says in the long run, the U. S.

Is on an unsustainable fiscal path, us federal governments on an unsustainable fiscal path. And that just means that the debt is growing faster than the economy. That's why the debt baLance relative to GDP is increasing now continues.

So it's unsustainable. I don't think that at all controversial. I think we need to know that we have to get back on a sustainable fiscal path.

And I think you're starting to hear now from people in the elected branches who can make that. It's time that we get back to that focus, he said. It's time to have an adult conversation among elected officials to get the federal government back on a sustainable path.

And we look at how I had done in this episode. Rent jury secretary and former chair, the fear reserve Janet yEllen says the rise and long term interests rates would create a chAllenge to debt sustainability if at last she's not ready to admit that the government is on an unsustainable path because interest rates remain low. And we will look at a key formula to analyze interest rates relative to economic growth and how that impacts the national dead.

This year, the international monetary fund in its annual world economic outlook said the exceptional recent performance of the united states is such currently impressive in a major driver of global growth. They're talking about economic growth. M, F continues, though, but IT reflects strong demand factors as well, including a fiscal stance that is out of line with long term fiscal sustainability.

They're suggesting the budget deficits are too high, that isn't allow the economy to expand more rapidly. But IT also potentially means the dead baLance is getting too big relative to the economy. The I M, S has something will have to give if the private sector becomes worried about the size of U.

S. National debt, they'll not want to hold IT. And as a result, interest rates could increase. About one third of the national that is owned by foreign tits and includes countries or private citizens outside of the us.

Two thirds is held by us household and businesses, as well as the federal reserve entities like the congressional budget office, and also pen warton, which does an ongoing analysis of the national debt they use. What are known as dynamic, overlapping generations models is based on work by previous academics, and they forecast all the variables of the economy, consumption, government spending, and they estimate what the debt to G D. P.

BaLance will be going forward. Pen warton in their analysis points out that in most cases with these models, they assume something fixes the national debt situation in the future, because as they predict the to GDP baLance gets higher and higher IT effectively blows up to the model. And so there could be additional taxes put in place, things that haven't been passed by congress.

But they assume that something has got to give. As the I M F says, in looking at these models and the other formula, and I I spent some time doing that as part of of this episode, there is a key formula that you can grasp, that we can grasp, that we can understand to mathematical concept called jenson's inequality. And it's a formulate that i'll include these packed c numbers in our weekly inside guide email newsletter.

In the podcast, i'll describe IT conceptual so that we can grasp IT. But at its base, the level of national debt to G D P, which is just under one hundred percent today, IT increases by the level of that year's budget deficit, putting aside the growth in the economy and interest rates. But just add its core.

And as part of this agents inequality, the current debt to GDP number ninety nine percent is increased by that years. Budget deficit. Budget deficit last year was six percent.

We assume the current level of debt to GDP is one hundred percent and the budget deficit to GDP, which is six percent, then the new in debt to GDP number is one hundred and six percent. That's just basic math. And because the U.

S. Has run an ongoing budget deficit that has allowed the debt to G D P number increase, the average budget deficit from nineteen seventy four to two thousand seven was two and a half percent, two and a hf percent. That's the amount relative to decide the economy.

So the tax revenue was taken in around typically around eighteen percent per year, sometimes higher, sometimes lower. And then outlays er spending would have been around twenty point five percent and so on. Spending was greater than the revenue taken in.

The difference is the budget deficit and it's been around two thousand eight percent on the average that was from nineteen nineteen seventy four or two thousand seven since sano, from two thousand and seven through twenty twenty three. The budget deficit to G D P has average six point two percent, much higher. That includes a deficit fourteen point percent and twenty twenty twelve point one percent in twenty twenty one.

In last year, IT was six point three percent. Deficits were also higher, close to ten percent in two thousand and nine coming out of the great financial crisis. So if we think about them just going from one thousand nine hundred and seventy four to two thousand and seven to thirty three year period, average budget deficit was two and five percent.

So in theory, we ignore interest rates in the growth, the economy, that debt to GDP, which was at twenty three point two percent in one thousand hundred and seventy four thirty three years of two and half percent of budget deficit to GDP, could have potentially seen the debt to GDP number increased by over eighty percent at thirty three years, times two and a half percent that would have taken the debt to GDP number to over one hundred percent in two thousand and seven. But the reality is in two thousand seven he was only at thirty five point two percent, so about a twelve percentage point increase over that thirty three years, which means for something else driving IT other than the annual budget deficit. The two other factors are the average interest rate on the debt and the growth of the economy.

Growth of economic output, as measured by GDP, when the average interest rate on the debt is less than the nomo growth in GDP that pushes down, reduces the debt GDP. So if the economy is growing at four and every interest rates at two percent combined, that will reduce the dead to G, D. P. number.

Before we add back that year's budget deficit, the combination of the growth in the economy and the average interest rate, because the average interest rate on the debt has been less than economic growth for most of the past fifty years, that has kept the growth groth in the national debt relative to the economy is held IT back, which is a good thing. Budget deficits increased IT, but because the economy was growing Better than the interest rate on the debt that kept the debt baLance relative to economic output, if the average first rate over the past fifty years had equal economic growth, we would be looking at U. S.

A debt to GDP number of over two hundred percent. Where's it's around a hundred percent to. And this all comes from this formula known as jenson in inequality, where the current debt to G, D P baLance equals the one plus the average Price rate divided by one plus the economic growth.

And that's multiply by the prior years debt to G D P. baLance. So if the rate on interest is less than the growth rate, the top number is small, older than the denominator, that reduces the debt to GDP baLance, and then we end back the budget deficit. That's the matter how that works. And so.

When we look at the congressional budget office budgetary model, their forecasts of debt baLances in the future or the pen warton model, the key component in these models is what interest rather they assuming in the future and what economic growth last year twenty twenty three, nominal G D P growth was around five and a half percent, and the average interest rate on the debt was three point two percent. That much higher interest rate. Back in twenty twenty one, the average age rate was under one point seven five percent.

In looking at the assumption then for the congressional budget office, they include some data that from nineteen ninety four, the twenty three nomo GDP growth, so before backing at inflation average around four point six percent per year, and the average interest rate on the debt was three point seven percent. So that brought down the debt to GDP number. They are estimating, though, the cbo, that in twenty thirty four, economic growth to be around three point seven percent per year in the average interest rate at three point four percent.

So they're closer. And then by twenty forty four, there are summer. The average first rate at three point six percent will be higher than the three and a half percent G D P growth rate.

And once you get the every genre higher than economic, and that's where the debt baLance starts become unsustainable and keeps growing and growing faster, the economy to our ultimately, there is a default, either a direct default or money is printed to cover IT inflation source. The currency declined potentially collapses all of the different models than those that are more pessimistic or more optimistic. IT comes down to long term forecasts of interest rates and economic growth, which are incredibly difficult, pen ward says.

Under current policy in united states has about twenty years for correct the action, after which no amount of future tax increases or spending cuts could avoid the government defaulting on its debt, whether explicitly or implicitly. I, E, debt monetization in significant inflation and like technical default payments, are merely delayed. This default would be much larger and would reverberate across the U.

S. And world economies. Before we continue, let me pause and share some words from this weak sponsors.

Pn warton is effectively predicting a the fall in the U. S. Eventually because there are been more pessimistic in their expectation for interest rates in twenty fifty. They assume that dead to G D P will be a hundred and ninety percent, but if interest rates are one percent higher than their assumptions, that would take the to GDP baLanced to two hundred and twenty nine percent.

If illustrator two percent higher than they assumed, where there are much higher than economic growth than the debt to G D P, baLance will be two hundred and eighty percent. What does that mean for us though? IT means that there is some certain things that we can monitor.

There is this risk and decades ahead. But forecasters are not very good at predicting interest strates or economic growth or as we look at the CPU, predicting what the debt to GDP baLance will be. But we do know where things are now.

So we can look at the average interest rate on the debt. We can look at the average GDP growth rate. We can look at the budget deficit to GDP.

And that budget deficit needs to be brought down. It's at six percent over six percent. It's too high. IT needs to be closer to three percent to GDP such that parentis between the average interest rates and economic growth, almost assets.

The budget deficit each year the budget deficit was two and a half percent, and every genres, two and a hp percentage points below economic growth in the debt to GDP baLance wouldn't grow at all if those three numbers get out of line. That's what makes the debt baLance and sustainable. Not it's fair to say at the average budget deficit to GDP over the past fifteen years at six percent, that is unsustainable.

Surprisingly, though, IT hasn't shown up in interest rates. There is a term known as bond vigilantes, was developed by Edward ardini, is a research journalist. And this was back in the nineties during bill clinton presidency. And there was great concern, nan, about the federal budget deficit, the national debt and that the bond market and wouldn't take IT and the bond market through higher interest rates would force the government to reduce its budget deficit and slow the rate of the national debt increase.

And and that did happen now the amount of new supply of government bonds because of the budget deficit issue and was over four trillion dollars in twenty twenty IT, was over two trillion dollars last year. The supply a bonds is increasing significantly. And IT was worried that the bond market absorb the supply, but we've not seen a big bike and interest rata, and we can see that most directly.

And what is known as the term premium interest rates are driven by inflation expectations and driven by expectations for what the federal reserve or other central bank policy rate will be when the feed reserve starts to lower its policy rate. Finally, that will put downward pressure on interest rates forward. Interest rates to be lower, but there's also the term premium do by investors demand higher.

Yelled for this potential risk default, bob mico, whose chief investment officer and head of global fixed income currency commodities at jp organic management, said. The whole fear, oversupply and bond vigilantes is a lot of rubbish. I'm not seeing any evidence of IT whatsoever for the last six months of these clients have been coming to us asking, where do I get into the bond market? When do I get into the bond market? Everyone has money to put in the bonds because they want to get interest rate that are higher than theyve been in a long time.

And we've discussed several times in the last year on money for the rest of us. So at this point, when we look at where we stand today, the term premium for ten year treasury bonds is around zero point one percent, ten basis points, eleven basis points, really very, very small. It's been over one percent at times.

So that's current based on current yids. A link to this in the show notes. There is also so the expectation for what the term premium will be ten years from now, and that's something that has changed. The expected term premium a decade from now is zero point seven six percent.

The bond market is starting to anticipate higher term premiums, higher interest rates ten years from now of inflation expectations or where policy rates will be just additional compensation is starting to be reflected in forward expectations for rates, but not today despite many predictions that investors would not be willing to take on this new supply bonds. And that would lead to a Spike in interest rates. Interest rates are higher today because the policy rate is higher at four and a half percent.

But as inflation comes down, hopefully comes down, that will lead to lower short term rates and thus lower long term rates, allowing the economy to continue to grow. So that GDP growth is higher than the average interest rate on the debt. That's what we monitor.

Then what is the budget deficit to GDP? IT needs to come down. It's six percent today. IT needs to be about half that.

And when we look at what the money being spent on about seventeen and a half percent of GDP is, the revenue taxes in terms of spending, it'll be around nineteen point six percent of GDP this year, twenty three point one percent if we include interest for a expected budget deficit of still, five point six percent of about five point two percent of GDP goes to social security, three point two percent to medicare, two point four percent to medicaid and related spending. So most of the body is such a security medicare medicate. And then another three percent in additional Mandatory spending, only about six percent of the federal budget is directionally.

So when we talk about cutting the budget, there is only about six percent that there's some leeway there than that. There needs to be formula changes to such a security, medicare and medicare, potentially even delaying benefits, increasing the tax rate. And then we have another three percent of spending goes to pay interest.

Pin morton has ideas for what they think should be done, raising the top or an income tax rate from thirty seven percent to forty five percent, introducing additional alternative minimum taxes, changing the tax rate on capital gains and dividends, adJusting corporate tax rates, doubling the thresh hold for security taxes. Right now, individuals only tax on the first hundred sixty nine thousand of income for national security. That threshold could be doubled to wear.

You're paying service security and more of income. Those are all things that can be done in the coming decade to reduce the budget deficit, hopefully leading to lower interest rates and allowing economic growth to be higher than the average interest ate on the debt. That's where we are then we have had higher economic growth and every but the debt to GDP the national death relative to the sized, the economy has grown too big or too quickly because the budget deficit to GDP has been too high, averaging over six percent.

Sce, two thousand seven. Now we do not need to panic. We can stay vigilant.

One of the things I have taught for years on this podcast and is how I invest is know where we stand today, what are current conditions. That's why we offer plus membership to monitor those things. We offer asa camp to monitor current conditions in the stock market.

We can look at those drivers, they have interest rate, the budget deficit, the aver economic th, and look at the deck dynamics year by year. And that knowledge can give us confident and power that we don't have to freak out. Yes, the U.

S. Is on an unsustainable path. But we are now with the underlying drivers, and we can monitor IT to see if there's something that we need to do. These are just numbers. The reality is the economy is so much more complex, the demographics.

I just spent two weeks in japan taking an input, walking the streets of tokyo in other areas of japan, interacting with people, realize yeah national, that's one thing. It's important. But there are so many underlying drivers, complexities, innovation, that we can't just let one number or a few numbers drive our investment decisions.

Our investments need to be tied to this innovating global economy, and we do that through stocks. We can also protect ourselves from currency declines. If the bomb market suddenly decide, no, we don't like the direction that things are going.

We want to hire term premium interest rates Spike or the currency falls, inflation picks up. We need to have some exposure to alternative currencies such is gold, crypto currency, bitcoin, but it's not the workforce of our portfolio that should be stocks. We can also have exposure to real resources, land realistic collectible things that hold their value if the currency is falling in value due to higher inflation.

We don't know what's gonna happen. The cbo congressional budget office doesn't know, pen warden's analysts don't know, other private economists don't know. We know how the numbers interact.

We can monitor that, and we will add money for the rest of us. But will diversify portfolio, have multiple return drivers? Should we own treasure inflation protection security? That's an interesting investment.

I own them for a portion to keep up inflation source tips will do fine if default happen through debt monetization, higher inflation, higher interest rates, if there's an alright default and principle and interest payments are not made, then tips won't do fine. And so that becomes a particularly tRicky asset class. But we can have a variety and monitor IT, and we will in a panic.

Yet these dead dynamics, currency dynamics, inflation DNA ics will evolve in a decade ahead, will look at IT, we'll monitor IT, we'll diversify and we will see how things turn out. That concludes. And art are three part series on the national debt will stay vigilant, but we won't panic.

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