The United States had a bad debt problem going into 2020 – and it got a lot worse.
As of August 2020, the public debt of the United States amounted to more than $26.72 trillion. More than $3 trillion of that debt was larded on since February, thanks to a rapid economic contraction due to the COVID-19 pandemic and substantial stimulus spending as Congress and the Treasury tried to keep the economy from going into a general meltdown.
As of September 2020, the total outstanding U.S. debt now nearly matches that of the U.S. economy. By year end, according to the Congressional Budget Office, the debt will have reached 98% of the gross national product. That is, the U.S. government has borrowed the equivalent of the total annual economic output of the country for a full year.
Measured as a percentage of the U.S. economy, that debt level exceeds what we incurred to fight World War Two.
The problem is accelerating: The fiscal year 2020 budget deficit of $3.3 trillion is three times what it was in the previous year.
Not Just the Coronavirus
As mentioned, the COVID-19 pandemic is responsible for most of that increase. But not all of it: Tax cuts also contributed somewhat to the deficit. Normally, the fiscal damage of tax cuts is offset to some degree by expanded economic growth as a result of the stimulus. But courtesy of the pandemic and related shutdowns and job losses, we did not realize the economic growth we hoped for in 2020.
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The National Debt and Politics
In Congress, stimulus has 535 fathers; fiscal responsibility is an orphan. Both major parties pay lip service to deficit reduction and eventual budget balance. But when push comes to shove, hardly any politicians can resist giveaways to favored interest groups – whether in the form of spending or tax cuts: From a fiscal management point of view, the two forms of expenditure are merely two sides to the same coin.
President Trump represents a political party that has long branded itself as wanting to reduce the size of government and federal expenditure – which then (theoretically, anyway) justifies tax cuts. But the President has shown little interest in deficit reduction, even prior to the passage of the massive economic stimulus package called the CARES Act.
Here he’s finally running into some resistance from members of his own party: Trump has called for an additional $2 trillion in stimulus spending to further shore up the U.S. economy, which despite recent stock market gains, is still struggling to find its footing.
Here the President is finding a more sympathetic ear among Democrats than among GOP conservatives. But these Democrats are calling for substantial tax increases, especially for wealthier Americans and corporations.
But in the long run, every dollar the U.S. borrows must be paid back, one way or another.
And fiscal responsibility has not been an issue thus far in the campaign. Neither Democrats or Republicans are in the mood for fiscal restraint.
The national debt will get much worse – and it may never get better.
Thus far, we’ve managed to avoid the economic worst-case scenario. But every dollar borrowed must eventually be paid back.
The Makeup of the Federal Debt
As of 2019, foreigners held 41% of the national debt. America’s two biggest creditors are Japan and China, which each hold 7% of outstanding debt. Both have sharply reduced their exposure to U.S. debt over the past decade.
The remaining 59%, it follows, is held by Americans and American institutions. The Federal Reserve itself holds 13% of that debt – largely in unmarketable securities that comprise the Social Security Trust Fund. But these aren’t really assets, as these bonds are essentially IOUs that Congress has promised to pay the Social Security Administration in future years to fund future benefits. That money has to come from somewhere.
The Effect of Low Interest Rates
At the moment, interest rates are still close to historic lows. It’s very cheap to borrow money. And that encourages borrowing to make purchases in the short run.
But low interest rates can act like sugar to the body: It provides a short-term burst of energy. But too much of it for too long can cause the system to break down from diabetes.
But low interest rates have a significant long-term cost of their own: First, they destroy the incentive to lend. Those who’ve managed to save over their lifetimes receive much less return on their money.
Chronically low interest rates act like a cancer, eating away at Americans’ incomes. They are economically devastating to those who live on fixed incomes: In July of 1984, a retiree could buy a one-year CD and earn 11.24% on average. That is, a $1 million nest egg would generate a six-figure income that year – with no risk.
Fast forward to today, and the average 1-year CD rate is just 0.28%. That is, that same $1 million investment in a 1-year CD generates just $2,800. That’s not even enough for most to live on for a month.
If your Aunt Bee can’t get a decent rate of return on her savings with any degree of safety, neither can anyone else. Chronically low interest rates erode confidence in the dollar. Since dollar-denominated investments don’t command a decent interest rate, global demand for dollars goes down.
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National Debt and the Global Economy
After all, capital flows where it’s treated best. If the global investment community is abused for too long by interest rates that are too low, they will eventually decide to move their capital to a better market: One where they can get more than 0.3% for low-risk money.
When that happens, they sell dollars and dollar-denominated investments so they can buy something else.
If the process gets out of hand, investors flock for the exits, and the value of the dollar declines rapidly. This can lead to hyperinflation – and tremendous economic hardship for those who are not sufficiently diversified.
This is why many U.S. investors are taking a position in gold: Over time, it’s a proven hedge against a declining dollar. When investors are selling off dollars, or when faith in the stability of the dollar declines, the price of gold and other assets goes up.
For the moment, the U.S. is benefitting from the fact that all the major global economies are in a similar situation: The COVID pandemic has forced all of them to spend massive amounts on stimulus, while their central banks push interest rates down to rock-bottom levels, just to keep things from freezing up.
But eventually, something will have to give.
The Demise of the Gold Standard
The stage was set for today’s massive deficit levels when Nixon took the country off of the Gold Standard in 1971. Prior to that point, the U.S. dollar was directly linked to gold. If the U.S. wanted to expand the money supply, we would have to acquire a corresponding amount in gold to back each new dollar issued.
Since that time, the National Debt ballooned.
When interest rates rise again, so will the amount of interest the U.S. must pay to our creditors in order to maintain the same level of spending.
The Coming Reckoning
At that point, we will have to face the music: The debt must somehow be repaid, with now increasing interest.
That will force Congress to make some difficult choices: There are only a few ways for the government to repay its debt at that point, and none of them are pleasant:
- Keep spending. Congress can do nothing, and allow our prosperity to be choked off as an increasing amount of our GDP goes simply to pay the interest on the national debt.
- Reduce spending. But we won’t be able to take the whole amount out of the defense budget. Unless the U.S. radically reduces our strategic interests and objectives and totally guts our Navy, for example, we will have to reduce spending on healthcare, transportation, infrastructure, social services and even Social Security.
- Increase taxes. This will make U.S. businesses less competitive and reduce the incentive to produce, which has significant second-order consequences of its own.
- Continue to debase the currency. We’re well on our way along this path. And many other countries have allowed their currencies to fall. In the short term, this benefits the borrower who borrowed full-size dollars and gets to pay them back with smaller ones.
- This can lead to economic disaster, as we saw in 1920s Germany and the Weimar Republic. The German government was saddled with a war debt they couldn’t repay, except by running the printing presses, and presenting the WWI victors with reparations in worthless currency. A loaf of bread that cost 250 marks in January of 1923 sold for millions just months later.
Inflation was so bad in early 20s Germany that workers had to be paid twice per day so they could go get lunch before the value of their wages was slashed again by inflation.
- We saw this more recently in Venezuela, which did the same thing under Chavez. By 2019, the Venezuelan people saw hyperinflation in excess of 10 million percent. In both cases, the effects of hyperinflation quickly resulted in chaos and human misery on a massive scale.
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Eventually, Congress will probably be forced to adopt some combination of. Measures 2, 3, and 4. Doing nothing will simply not be sustainable – especially as interest rates eventually recover.
Option 4 is the nightmare scenario. It's also why investors, institutions and national sovereign wealth funds all over the globe have been buying gold. Recently, sovereign wealth funds have been selling stocks to buy gold.
Gold prices rose more than 18% in 2019, even before the Pandemic. Over the trailing twelve months, the increasing demand for gold has pushed the price up from $1,500 to $1,950 as of late September 2020.
Year to date the spot price of gold has risen 22.65%, and has generated returns of 12.65% over the previous three years.
The reader can access more current trailing returns here.
According to the Congressional Budget Office, the outlook is grim. Currently, the CBO’s pre-COVID projections estimate that the overall debt held by the public will increase by 5.9% per year – far outstripping economic growth. By 2030, the debt will exceed $31.4 trillion.
At that point, the CBO estimates that taxpayers will have to come up with $858 billion per year just to cover the interest on the national debt. That figure represents about 2.7% of GDP, and will consume about 11.7% of total federal expenditures.
The CBO further estimates that this debt burden will act as a significant drag on future economic growth: Nearly a trillion dollars per year will go to debt service and be unavailable for profitable investment or future stimulus. Much of it to foreign holders, where it will be removed from the U.S. economy, reducing national income.
Higher debt levels also increase the risk of a major economic crisis. If global investors lose confidence in the U.S. fiscal position and creditworthiness, it could jeopardize the dollar’s status as the premier global reserve currency. This, in turn, could lead to a major reduction in the value of all dollar-denominated assets.
That’s why many planners recommend a significant portfolio allocation to physical commodities, such as gold, precious metals and real estate – each of which has value that is not directly tied to the dollar itself.