Deficits & Debt Ceiling Limits

It works, until it doesn't

May 31, 2025 ~ Vol. # 26

One of my favorite British expressions, which I was reminded of this spring on a trip to London, is “own goal”, referring to a player scoring a goal for the opposition by driving the ball into their own team’s net. An own goal has more intentionality than say, “shooting yourself in the foot”, which could be just an accidental combination of going off halfcocked and bad aim. An own goal usually requires supremely poor planning, or a very pronounced lack of awareness of your surroundings. You are probably thinking that this is going to be another story about tariffs, and that would be a good guess (and what most Brits were referring to when they spoke of an “own goal”) but something else happened this month that could portend an event that would be even more harmful, with potentially more dire consequences for the US and the global economy.

On May 16, Moody’s Ratings Service downgraded US Treasury’s debt rating from AAA to AA1, citing the growing federal deficit and the rising interest rate burden on financing that debt. Moody’s specifically cited the current proposed budget and associated tax cuts, projecting that the legislation would add $4 trillion dollars to the US debt load over the next decade. Moody’s action followed similar downgrades by the two other primary bond rating services, Standard and Poor’s in 2011, and Fitch in 2023. The significance of these downgrades, and the circumstances that precipitated the downgrades, cannot be overstated. Some perspective is in order.

It is hard for me to wrap my brain around the scale of “trillion dollar” stories—and I spent a career analyzing big numbers. It is sometimes easy to forget that “just” a billion dollars is one-thousand-million-dollars. One trillion dollars, $1,000,000,000,000 (twelve zeros) is one thousand billion dollars, or – one million million dollars. Here’s a fun (and frightening) thought experiment: if you were flying a jet at the speed of sound, reeling off a one trillion dollar roll of dollar bills behind you, it would take you fourteen years to reel off the bills.

The current national debt is $36 trillion, double what it was just ten years ago. Last year, interest payments to finance that debt totaled $973 billion, fast approaching $1 trillion. For context, the size of the US economy—US Gross Domestic Product (GDP)— is $30 trillion dollars. Importantly, our outstanding debt as a percentage of our GDP ($36T / $30T) is 120%. That statistic is significant for a number of reasons, which I will get into in a moment.

The Peterson Foundation released this statement earlier this week:

Results of this new survey, jointly conducted by Democratic firm Global Strategy Group and Republican firm North Star Opinion Research, include:

80% of voters agree that Moody’s U.S. credit rating downgrade makes addressing the national debt a more urgent priority (82% of Democrats/77% of independents/80% of Republicans).

Following the downgrade, 84% of voters say they are concerned that the budget bill under consideration by Congress would add trillions of dollars to the national debt (90% of Democrats/83% of independents/78% of Republicans).

87% of voters agree lawmakers should take the new lower U.S. credit ratings into account as they consider the fiscal impact of this year’s budget legislation (91% of Democrats/85% of independents/84% of Republicans).

One of the curiosities of our country’s political process is the way that we handle approving our national budgets and our national debt limit ceiling—as separate discussions and debates. Each requires Congressional approval – the budget and the debt ceiling. Nobody else does it that way. Well, actually one body does it that way—Denmark, but nobody else uses a fixed debt ceiling to limit spending, they either set a limit on government debt as a “percentage of GDP”, or they do not set an upside limit. Japan, the UK, Canada, the EU and every EU member country (Germany, France, et al.) target total outstanding debt to a percentage of GDP, and that percentage is 60%, in all cases. Offenders who exceed the threshold, like Greece in 2018, are placed under a microscope and placed on “probation”. For what it’s worth, Denmark’s Debt to GDP ratio is currently only 26%. 60% of GDP is considered by the rest of the industrialized world to be the maximum prudent amount of debt to carry, and the US debt level at this moment—120% and rising—is exactly double that number. Which explains the downgrades.

This chart illustrates the (necessary) use of debt to finance deficit spending during times of economic stress like wars, pandemics, and depressions. Planned post-pandemic spending has been the most problematic.

This scenario will have repercussions in the global economy—some immediate, some longer term, some obvious, and some yet to be understood. The decline in US credit standing, and credibility, coupled with the decline of our standing with our allies and trading partners exacerbated by the current tariffs and trade wars, will have serious long term negative impacts on our economy. The US dollar has always stood supreme among all of the world’s currencies and is considered the world’s “reserve currency” for international trade settlements for two reasons. One reason is, or was, the unquestioned full faith and credit of the US government and its unrivaled capacity to pay its debts on a timely basis. The second, and equally important reason for the dollar’s primacy was its liquidity—there are lots of them, and they are freely available and readily transferrable in the global marketplace.

There are actually many countries that now have a higher credit rating than US sovereign debt. Australia, Canada, Denmark, Germany, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, and Switzerland are all rated AAA, and we no longer are. The reason that the currencies of these countries are not candidates to replace the US dollar as the world’s reserve currency is the lack of liquidity and the lack of scale. There are not enough Australian dollars or Swiss francs to underpin the global trading platform—but there are contenders looking to enter the ring, including proposed “baskets of currencies”, and new digital currencies.

The US enjoys substantial financial benefits because of our currency’s reserve status. US debt obligations have always been considered “safe assets” and as such enjoy a “convenience yield” at a lower rate than comparably rated assets, allowing the country, and all of us individually, to finance our debt at “reduced rates”. Global investors want to own US assets, particularly during times of economic instability, and this upward pricing pressure on US assets drives rates down. (When bond prices go up, yields go down.) This allows us to print dollars and issue debt at discounted rates as long as interest rates are lower than global GDP growth. It also allows US residents to enjoy the resulting lower yields on things like consumer loans and mortgages. This all works until it doesn’t, and it doesn’t when one of a few things happens.

One substantial risk is that interest rates rise above GDP growth, with multiple negative consequences. Borrowing money to grow your economy, or your business, makes sense if growth exceeds the interest rate paid. If interest rates exceed growth, it no longer works. The amount required to service our debt, currently approaching $1 trillion annually, would rise significantly. If rates were to rise just one percent, from 5% to 6%, that would represent a twenty percent increase - $200 billion - in annual borrowing costs. Rates can be pushed upward for a variety of reasons. Rates rise when inflation expectations are elevated from current outlooks. Any increase in prices caused by tariffs imposed on imports will elevate inflation, and the Fed’s number one mission is to keep inflation at its 2% target. They will be forced to raise rates to combat any rise in inflation. The most graphic example of this maneuver was during the tenure of Paul Volcker as Fed Chair in the 1980’s. Volcker raised rates to 20% to strangle inflation (and the housing market along with it), but at that time our total national debt was under $1 trillion, not the current $36 trillion. Historically, the Fed has also raised rates to protect the dollar during dollar price declines, which would now be problematic because increasing rates to protect the dollar would only exacerbate the debt problem.

There is little or no concern in the global marketplace about the US’s capacity to pay its bills. There is increasing and well earned concern in the marketplace about the erratic behavior of Freedom Caucus “deficit hawks” that will hold the debt ceiling legislation hostage to their demands, refusing to raise the ceiling to accommodate expenditures that have already been approved in the budget. This is the “two step” process that the US (and Denmark) employ to facilitate debt payments to be made on a timely basis. In the opinion of many, this extra step should be eliminated as these expenditures have already been approved by both houses of Congress when they voted to approve the budget. Threatening to block the enabling legislation to pay our bills is the political grandstanding that S&P noted very specifically in their comments regarding their rating downgrade. We have the financial capacity to make the payments; we just don’t have a functioning House of Representatives that will allow it to happen without the annual drama, like threatening to shut down the government. Markets do not like drama.

A related and very real issue is the inflationary impact on the value of the payment of principal and interest on our sovereign debt. The “real rate of return” (the nominal rate less the inflation rate) on fixed income investments is eroded by the impact of inflation, and bond prices and yields will reflect that erosion of purchasing power.

I am no longer surprised by anything that happens in this Congress, and I will not be surprised if later this summer we see this drama once again unfold when the debt ceiling needs to be raised in order for us to pay our bills. Defaulting on our sovereign debt or even threatening to default on our debt by refusing to raise the debt ceiling will do more damage to our place in the global economy than the current trade war.

I am not at all suggesting that the amount of debt we have incurred is OK, or sustainable. I am also not a deficit hawk that believes that any debt over x dollars or x percent is too much debt. The world will loan us money as long as investors feel absolutely comfortable that they will be paid back. Period, full stop. Some argue that there should be no limits on our debt, that the government requires the flexibility to be responsive to economic shocks that require deficit spending. On the other side of the debate, deficit hawks compare our national budget to a household budget and denounce any and all deficit budgeting. In a perfect world with responsible government representation, we would not have to constrain our own representatives with guard rails to limit unreasonable expenditures. In times of economic stress like pandemics or recessions, the rising number of unemployed and uninsured people will call for deficit spending and a rising national debt—temporarily. During times of economic prosperity, that debt should be paid down, and a balance built up for the next emergency. Congress has not done that lately, especially during these last few years, and the planned additional deficit spending is worse still. There is no reason to be adding to the deficit in times of a booming economy, especially using fallacious economic tactics like “temporary” tax cuts that expire in a few years just to change the accounting for those expenditures to make it look better on paper. Borrowing trillions of dollars when unemployment is at 4.2% makes no sense at all and is irresponsible at best. We have gotten away with it until now, but certainly this cannot go on forever.

A ballon is at its highest utility when it is at its largest—just before it explodes. I remember House Speaker, Paul Ryan warning ten years ago that our debt levels were that balloon, and we were on an imminent path to insolvency. Former Fed Chair Alan Greenspan had expressed the same sentiment ten years earlier. Those warnings might have been premature, but our debt is now more than twice what it was then, in dollar terms and as a percentage of GDP. Certainly, these numbers are not sustainable, and the path to fiscal responsibility does not start with layering on trillions of additional new debt—or with threating to default on our existing obligations. Nobody knows when the balloon is going to explode, but we do not want to find out.

As Hemingway famously observed about bankruptcy, it happens gradually, then suddenly.

Comments and suggestions are always welcome, as are Shares. If you like what you have read and you would like to receive a Saturday morning email with the current week’s newsletter, please consider subscribing. All posts are public and available for free.

~~~~~~~~~~~~~~~ Join me on BlueSky @northcountryjoe.bsky.social ~~~~~~~~~~~~~~~