What are the implications for U.S. consumers and investors of the rising U.S. debt? And what is the difference between the country’s debt and its deficit? These are just some of the questions tackled in the new Wells Fargo Investment Institute Report: Paying America’s Bills.
Wells Fargo Stories asked Brian Rehling and George Rusnak, co-heads of global fixed income for Wells Fargo Investment Institute and authors of the report, to discuss what investors need to know about how the U.S. government manages its finances.
Q: What is the difference between the U.S. debt and deficit?
Rehling: The debt and the deficit really are two different concepts. Debt is our accumulated money owed over time; the budget deficit is the difference between revenues and spending in the current fiscal year. Of course, each year’s deficit adds to the nation’s overall debt.
The financial sustainability of the U.S. comes up in almost every investment conversation, so we wanted to help investors understand why there’s so much talk about debt.
Q: What is our current debt and deficit?
Rusnak: At $21.3 trillion, our debt is certainly large. The budget deficit for fiscal year 2018 is about $814 billion. But these are also manageable amounts in the short run for a very large, diverse, and growing economy like the U.S. It’s the long run that becomes more challenging. As a country, we have tremendous resources that increase our ability to make payments on the debt.
Q: What’s the impact for consumers and investors?
Rehling: Higher government debt levels divert resources to service the debt, limit fiscal spending flexibility, and, over the long term, bring an environment of lower growth and lower returns. As growth rates decline and returns decrease, investors may have to save more to compensate and reach the same financial goals they set previously. The federal debt is a cost on the country if it grows faster than the country’s earnings — also called gross domestic product, or GDP. When this happens, diverted resources, coupled with an aging population that will demand more support, lower the potential for future returns.
Q: Where does all the money go?
Rusnak: Today, the government spends nearly 70 percent of its revenue on mandatory spending — mostly on social programs such as Social Security and Medicare — and interest on the debt. Forty years ago, mandatory spending comprised about 30 percent of the annual budget. This change in budget allocation offers legislators far less fiscal flexibility.
Graphic with “The U.S. faces concerning fiscal trends” heading at the bottom and left to right in five columns above: total U.S. debt at $21.3 trillion, $5.7 trillion portion of U.S. debt borrowed from government sources, $33.9 trillion projected U.S. debt in 2028, the $1.7 trillion projected 2018 spending on Social Security and Medicare, and the 2.43 percent current average rate the government pays to finance the debt.
Q: Can debt ever be a good thing?
Rehling: Deficits allow governments to invest in programs that benefit growth for the economy and people. In fact, fiscal stimulus, or the government targeting increased spending, may purposely increase the deficit in a given year and overall debt to stimulate economic growth during times of economic slowdown. For example, massive government spending during the Great Recession helped pull us out of the downturn that may have been much greater without it.
If spent on projects or resources that benefit growth, government spending can be a good thing and produce more growth and money to service the overall debt. Deficit spending can also be helpful to smooth out business cycles — higher spending during recessions and lower deficit spending during good times.
Unfortunately, the U.S. has become more accustomed to deficit spending as the norm versus when it might be most beneficial to the economy. As we continue to systematically increase deficit spending, and therefore increase the overall debt, we run the risk of not being able to increase spending as easily during economic downturns.
Q: Who owns our debt?
Rusnak: The largest share of our debt is held by U.S. investors (43 percent). The rest is held by the U.S. government (27 percent) and foreign countries (30 percent). China and Japan are the biggest foreign holders of U.S. debt, each holding a bit more than $1 trillion in U.S. securities. While it’s unlikely, the Treasury would need to find new investors if they chose to sell or decrease their holdings.
If these countries sell their bonds back into the open market or decide not to repurchase new Treasurys when the bonds mature, then the U.S. will need to find someone else to buy those bonds — as debts are unlikely to shrink — and the U.S. may have to pay more interest to entice new buyers.
Debt financing is like a country’s mortgage. For individuals, you find a bank to fund your debts. For the U.S. government, investors — both foreign and domestic — fund the nation’s debts.
Who Owns the Debt infographic
Under the red “Who Owns the Debt” heading, three columns of numbers are superimposed over a gray $100 dollar bill shaped like the U.S.
The first column at left in green text says “Owned by the U.S government, 27%”
Below that in three lines of green text are:
Social Security trust fund, $2,82T
Medicare trust fund, $87B
Other Trust funds, $2,82T
for a total of $5.73T
The middle and right columns have the “Owned by the public” heading in blue text.
Under 43% in the middle column, five rows of blue text under the “U.S. investors” subheading identify the breakdown:
State and local governments, $717B
Private pensions, $385B
Mutual funds, $1.79T
Federal Reserve, $2.40T
for a total of $8.86T
Under 30% in the right column, three rows of blue text appear under the red “Foreign countries” heading to breakdown the investors:
Q: What role does growth play in a country’s ability to carry debt?
Rehling: While the U.S. has the most debt of any country in the world, the good news is that the U.S. also has the world’s biggest and most diverse economy and largest GDP, which represents a country’s ability to make money and pay back debt.
When we look at public debt — debt that a country needs investors to finance — relative to the GDP, the U.S. compares favorably to the world’s top economies. As of 2017, the U.S. public debt-to-GDP ratio was 77.4 percent, with only Germany better at 65.7 percent. Japan has a materially worse ratio at 223.8 percent public debt to GDP. For those worried that high debt-to-GDP ratios could cause interest rates to skyrocket, remember that 10-year government rates in Japan are near zero percent.
Public Debt-to-GDP of World’s Largest Economies infographic
Underneath the red “Public Debt-to-GDP of World’s Largest” heading, seven columns of data appear left to right, each topped with a circle and part of their flag, and then — in blue text — the country name and percentages to show their debt-to-GDP ratios:
United States, 77.4%
A red bar at the bottom of the page has this text inside in white letters: “PROBLEMS MAY ARISE IF THE DEBT CONTINUES TO GROW.”
Q: Can individuals learn anything from how the government pays its bills?
Rusnak: An investor is different from the government when it comes to paying off debt. Individuals, like governments, will take on debts like mortgages, auto loans, and other obligations. But unlike governments, individuals have finite lives and need to pay off their debts over a shorter period. Governments have the ability to run consistent deficits, and they don’t need to fully pay off their debts, but to keep them at a “reasonable” level relative to the size of their economy and their growth rates.
The government, like most companies, is most efficient when it operates with some debt. It wouldn’t be the best use of resources to eliminate debt entirely, because the benefits of utilizing debt to stimulate the economy when necessary outweigh the impact of additional interest payments. However, it is important that debt be properly managed and not allowed to overly burden the economic health of the country.
Q: What can the U.S. do to address its fiscal challenges?
Rusnak: There’s no easy answer, and the longer we wait, the more challenging it will become. Basically, we have three alternatives: spend less, increase revenues, or outgrow spending.
- Spending less is very challenging given that more than two-thirds of today’s spending is on mandatory spending items like Social Security and Medicare, along with interest on our existing debt. Reducing spending in these areas will be challenging, so the spending reductions would likely need to come from discretionary spending.
- Increasing revenues by raising taxes will be challenging as well, since it runs counter to the new tax plan implemented late 2017. The plan reduced tax rates for individuals and corporations. Additionally, increasing taxes tends to dampen future growth and could offset the higher anticipated revenues.
- Outgrowing the debt and bringing in more revenue through GDP growth — making more money than we’re spending — appears to be the most attractive way to reduce deficit spending and the overall debt ratio. However, since the Congressional Budget Office projects a 6.21 percent annualized spending increase for mandatory and interest spending over the next five years, it’s highly unlikely we’ll be able to outgrow that spending rate.
We recommend taking small steps now to improve our chances of minimizing the debt impacts. Small reductions in spending and revenue increasing policies should slightly dampen the long-term impacts of our rising debt burden.
Q: With both the deficit and debt growing, what should investors do?
Rehling: With longer life expectancies, there could be reduced entitlement benefits and/or higher taxes. We recommend saving more or staying in the workforce longer. Also, creating or updating your investment plan sooner rather than later may limit your need to take on additional risks to meet your income goals in retirement. Finally, the country’s lack of fiscal flexibility to smooth out economic shocks underscores the importance of diversifying your investments across asset classes to help manage market fluctuations and other stresses.
All investing involves risks including the possible loss of principal. Diversification cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification also does not guarantee profit or protect against loss in declining markets.
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