With the election now behind us, attention has shifted to the new administration’s policy proposals. Of particular interest will be policies that impact government spending and the national debt. Like it or not, the new administration will need to address these topics as the debt ceiling (the maximum amount the government is allowed to borrow) suspension previously passed by Congress expired January 2nd.

If you've read even a handful of headlines in the last 20 years, you're probably aware government debt is high. The US national debt is quickly approaching $36 trillion, according to the US Treasury. The federal debt has nearly quadrupled since before the 2008 global financial crisis, and has grown every year since 2001. Such concerns are at the center of recurring debates over budget deficits, the debt ceiling, and government shutdowns.

Against this backdrop, let's examine government debt and deficits from an investment perspective. Does it affect markets in the long run? Should investors worry?

The national debt has grown rapidly since 2008

But simply tossing around large dollar amounts does not tell us much. The US government is a massive entity, so pretty much any number related to its income, spending and debt will be large. We need to relate the debt to something meaningful.

Think about it in personal finance terms. Imagine a person with $10,000 of credit card debt. Is that a problem? Before we can say so, it would be helpful to know the person's income and spending habits. A person making $40,000 per year might struggle with a $10,000 debt, while someone making $200,000 per year may hardly notice it.

Along these lines, it is more meaningful to examine the size of the national debt against that of the US economy - all goods and services the country produces (measured by Gross Domestic Product or "GDP"). Because the government has taxing authority, a growing economy suggests the debt may be more manageable, while a shrinking economy suggests the opposite.

The economy has grown since 2008, but the national debt has grown faster. The chart below shows that the national debt now represents 121% of GDP, up from roughly 56% of GDP 20 years ago. There was a huge jump in 2020 due to pandemic stimulus.

The gross number includes debt the government owes itself, i.e., Treasuries held by government agencies like the Social Security Trust Fund. Excluding these, "net" debt is 96% of GDP.

Large budget deficits have driven up the national debt

How has the federal debt increased so quickly? In two words, budget deficits. Budget deficits occur when the government spends more than it collects in taxes, which adds to the total debt. Taxes here include individual and corporate taxes, as well as social insurance taxes, such as those that fund Social Security, excise taxes, and others. The government also generates revenue from sources such as tariffs, but these are small by comparison, making up 2% or less of total government revenue each year.

Even though tax revenues tend to increase as the economy grows (even without raising tax rates), they have been outpaced by government spending over time. These expenditures have grown across what are known as "mandatory" programs such as Social Security and Medicare as well as so-called "discretionary" items such as defense and education.

The shortfall is funded by government borrowing, i.e., by issuing Treasury securities. Investors, institutions, and other countries buy these Treasuries and, in effect, fund the federal government.

The current deficit of around 6% of GDP is by no means small, but there have been many periods across history - primarily during economic downturns and wars - when the government has been forced to spend at these levels. History shows that, over time, deficits improve as the economy stabilizes, even if they don't turn into surpluses.

The elephant in the room

These commentaries are focused on investments, and usually eschew politics but it bears a brief mention here. The national debt has become a "politicized" issue. It's important to distinguish between what matters as citizens and taxpayers, and what matters as investors. Concerns around the political consequences of government spending and taxation over coming generations are separate from whether the federal debt directly or indirectly impacts the economy and markets.

Some may, based on political leanings and a fractured media landscape, view the debt as the "fault" of one political party, group, or administration vs. another. The data however does not support this view. It's clear in the chart that debt levels (and economic growth) have been increasing for the better part of 50 years, under both Republican and Democratic administrations. Unfortunately the data does not give us a magical answer and suggests that neither party is managing the debt (or the economy) better (or worse) than the other.

With politics providing few answers, we still need to address whether or not high debt levels are problematic.

If they are, what might the investment consequences be?

Are high public debt levels a problem?

How can we identify whether the rising debt burden is a problem? Let's look at Japan, a country with a similarly large developed economy and large national debt, to see if we can identify where the limits of borrowing might be.

Japan's government debt has remained above 200% of their economy's GDP over the past 15 years, and over 250% of GDP since 2020. Like the U.S., Japan has an aging population which some worried might lead to a crisis as increasingly more government benefits were supported by fewer working-age people. So, how are things going in Japan?

According to YCharts, during the 15 years ending in December 2024, Japan's economy averaged growth of 0.73% per year  (real GDP, seasonally adjusted annual rate). While perhaps not an exceptional growth rate (the US economy grew at 2.25% per year during the same period), the Japanese economy has grown steadily since the 2008 financial crisis despite high debt levels. This implies that Japanese citizens, like their counterparts in the US, have enjoyed rising living standards.

What about equity markets? Data from YCharts shows that, over the same 15 year period, the MSCI Japan index returned roughly 7.6% annualized per year in local currency terms, while the S&P 500 index averaged 12.4% annualized growth. Japanese stock investors were able to make money despite large government debt.

Japan's example suggests high government debt doesn't automatically result in economic stagnation or poor stock returns.

The whole picture - public debt vs. assets in Japan

Japan's situation, while perhaps analogous to that of the U.S., is also different for a few reasons. Exploring these may hold clues as to why government debt is a complex topic.

Whether we're talking about personal or government finances, debt isn't the only thing that matters. If you've taken a basic accounting class you know that debts (liabilities) are just one part of the overall financial picture. A balance sheet, which shows the financial position of a company, has three sections: assets, liabilities, and equity. The basic accounting formula tells us that assets owned must be financed by some combination of equity and debt.

Along these lines, the St. Louis Fed's blog post from November 2023 (link below) has a detailed comparison of the U.S. and Japan's public sectors. The article explains, "it is important to look at the public sector as a whole, given that its overall level of assets indicates the country’s ability to offset any outstanding liabilities, including debts."

source: https://www.stlouisfed.org/on-the-economy/2023/nov/what-lessons-drawn-japans-high-debt-gdp-ratio

The article shows that, despite Japan having liabilities of over 250% of GDP, their public sector also had assets valued at 134% of GDP, including foreign securities and equities. Japan's large social security fund alone was valued at 55% of GDP. Thus Japan's net debt (liabilities minus assets) was "only" 119% of GDP.

Public debt vs. assets in the United States

Let's now review the overall balance sheet for the United States using data from the St. Louis Fed article.

When we include unfunded U.S. government pension liabilities, the gross national debts situation in the US was 142% of GDP as of Q3 2022. Unlike Japan, U.S. public sector assets were only 23% of GDP, with lower currency reserves and no equities, for example.  

While Japan's overall debt in isolation was 252% of GDP, much higher than the U.S. at 142%, Japan's public sector assets helped offset that burden, leaving the net debts for each country around 119%.

Key differences

The Japanese government uses a financial repression strategy to finance their public debt. This involves borrowing short-term at low rates (the Bank of Japan (BOJ) has held short-term interest rates below 1% since 1995) and investing in riskier assets with higher expected returns, including long-term bonds and stocks.

The behavior of Japanese investors also helps offset high government debt levels. Japanese households have higher saving rates than their US counterparts, and are willing to own large amounts of government bonds despite the paltry interest rates.

If any of these factors were different, Japan's large debt levels could become more of a problem.

The U.S. would find such a strategy challenging. The Social Security trust fund in the United States can only invest in US Treasury securities (bonds), which modest returns. Short-term US interest rates are currently above 4%, but were spent most of the last 15 years below 2%. US investors also tend to be more risk inclined, with a higher propensity to hold stocks in their portfolios.

Ok, so both the Japanese economy and stock market have grown despite high government debt. From that perspective we might conclude that high debt levels in Japan aren't a problem.

However, the U.S. has some differences when it comes to:

• Government balance sheet (fewer public assets to offset liabilities; agencies must invest in low return assets)
• Saving habits (less household savings which could absorb new government bond issues)
• Investor mentality (less desire for bonds in portfolios)

The best answer we can give to the question of whether large debt levels matter for markets, based on a careful examination of Japan is, "maybe". It depends on many other factors.

U.S. dollar reserve status

Perhaps most importantly, some worry that mismanaging the national debt could cause the United States to lose its leading position in the global economy. The U.S. dollar plays a critical role as a global reserve currency. This means that, whatever the fiscal profligacy of U.S. politicians, other countries must acquire US dollars to participate in the global economy.

The chart below shows about two-thirds of the U.S. national debt is held by the government itself (the Social Security Trust Fund for example) or by US citizens. Other countries hold the rest with China owning about 2% (this proportion has declined over time). Many investors worry that growing debt levels means that Treasuries could be less attractive in the future. In the extreme, this could hamper the government's ability to roll its debt, possibly leading to skyrocketing interest rates (we saw this with the UK budget fiasco in 2022), or weaken the dollar’s standing as the world’s reserve currency.

Anything is possible, but this seems unlikely to occur any time soon, despite increased enthusiasm for supposed dollar alternatives like cryptocurrencies and gold. In fact, the US dollar's reserve status has been a concern among economists for decades. And yet, when the global economy faces distress, investors turn to US bonds as a safe haven. In 2011, for instance, when Standard & Poor's downgraded the credit rating on US debt during the "fiscal cliff" standoff, investors didn't sell their Treasuries - they rushed to buy more.

Despite our fiscal challenges, U.S. debt securities remain the global standard for stable, "risk-free" assets. It's not clear what would need to happen to change this but none of the events since WWII including a global pandemic, smaller wars, terrorist attacks, a financial crisis, and multiple recessions -  all failed to do so.

The debt burden will only grow as interest payments rise

The unfortunate reality is that deficit spending does not seem to be going away, with neither major party focusing on the issue. The last balanced budgets occurred during the Clinton years and the Nixon administration before that. The accompanying chart shows that left unchecked, government projections suggest that interest payments on the debt alone could rise to $1.71 trillion in ten years.

With new leadership in Washington, this issue will surely be front-and-center in the coming months.

Finally, and perhaps most importantly, markets have done well regardless of the exact level of the government debt and taxes over the past century. Ironically, the best time to invest over the past two decades has been when the deficit has been the worst. These periods represent times of economic crisis when the government is engaging in emergency spending, which tends to coincide with the worst points of the market. And while this isn't exactly a robust investment strategy, it does underscore the importance of not over-reacting to fiscal policy in one's portfolio.

Conclusion

Without diminishing the importance of the national debt, we need to keep in mind that markets have generated strong returns over the past two economic cycles. Investors should avoid overreacting with their portfolios at the expense of their long-term financial plans.

The federal debt is a complex and controversial topic. It's important for investors to separate their personal concerns and not react with their hard-earned savings or investments.

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